Will higher interest rates encourage Nigerians to save more?

I once read a quote that said, "Savings is the gap between your ego and your income”, from a book by Morgan Housel—The Psychology of Money.

In his book, Housel argues that wealth is created by suppressing what you could buy today to have more stuff or more options in the future.

And while this is true, does it mean that if I simply had the humility of a lamb, I would save more or be wealthy? Of course not. 

At this point, we can turn to standard economic theory, which states that interest rates influence the direction the broader economy will go when making decisions concerning savings.

Essentially, two classes of people make up the economy. The first group are those with more money or income than they need to spend on goods and services. The other group represents those that want or need more money than they currently have. 

These two classes of people form a natural market between those with a surplus or excess funds (i.e. savers) and those with a deficit to fill (borrowers).

The savers (who can be investors or lenders are only willing to part with their excess funds today because they are promised more money in the future (high returns). The interest rate on savings determines how much savers are willing to part with or save.

Even in countries with negative interest rates (where you pay to save), we still see the effect of interest rates.

But how does this work, and are interest rates enough to boost savings?
 

Relationship between interest rates and savings

If we recall, on the 19th of July 2022, the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) raised the Monetary Policy Rate (MPR) for the second time this year to 14%.

The rationale was to tame rising inflation and narrow the negative interest rate gap to stimulate investment flows.

In my last article, I focused on the last part of that statement, “narrow the negative interest rate gap to stimulate investment flows”. I  argued that interest rate hikes would not be enough to whet investors’ appetite. So today, we will look at the first reason the MPC gave to justify the interest rate hike “tame rising inflation”.

The rationale is simple: interest rates affect the cost of borrowing in the economy. So when interest rates are low, the cost of borrowing is also low, so individuals, firms and even the government can get more loans to spend or invest.

However, when interest rates are high, people are discouraged from borrowing and look to save more.

In other words, the MPC raised interest rates to incentivise people to save more and reduce their spending (demand), which should help tame rising prices (inflation). The move should also reduce the pressure on the naira, which has seen heavy depreciation recently due to a lack of confidence in the local currency.

A fundamental thing to note here is the difference between saving and investing. In economics, saving refers to putting money aside for rainy days or accumulating capital, e.g. money in your bank account or piggyvest or even buying stocks or bonds, etc.

This implies that your motive for savings is to secure and ensure the safety of your money.

On the other hand, investing is an addition to your capital stock or wealth creation. So the motive for investing according to economics refers to financial gain.

While both are used interchangeably in everyday terminology, you know, the way people say they’re investing in the stock market by buying MTN Nigeria’s shares, this is not an investment in an economic sense. It's simply saving.

Moreover, savings inform investments. As our senior development analyst, Gbemi, explained, savings is important for economic growth. Our savings are deposited in the banks, which are then loaned out to people and businesses to invest and expand, thus boosting economic activities.

Income and substitution effect of interest rates

From what we have seen so far, it should be clear that interest rates affect the cost of borrowing money over time, and so lower interest rates make borrowing cheaper. This encourages people to spend and invest more freely. On the other hand, increasing rates makes borrowing more costly and can reduce spending in favour of saving.

However, the rule above is insufficient to determine whether a person will save or spend more when interest rates are altered. 

The ultimate effect of interest rate changes depends on whether consumers believe they are better off spending or saving in light of the change.

For example, take Femi Banks, a 23-year-old who stays with his parents and just started working in a bank. He would be willing to save more when interest rates are high and defer taking a car loan with expensive interest payments. Here, the substitution effect dominates because the interest rates were high enough to increase the price of consuming more (buying a car). 

However, there is also the income effect of interest rates. Lower interest rates reduce the income received from saving, so people may need to save more to gain a reasonable return on their savings in the future. This is important for the older generation thinking of retirement.

Ultimately, at any point in time, economic agents (like Femi) are always making a decision about whether to save or spend. Interest rates are a useful tool for swaying this decision, but the final outcome will depend on whether the income or substitution effect dominates. These can be determined by an individual's personal preference. For example, if Femi's mum knows she has enough savings set aside, she might actually see an increase in interest rates as a reason to increase her consumption rather than set more money aside like her son did. In that case, the income effect dominates because Mrs Banks feels she has earned more money with the higher interest rates on her savings. 

In the meantime, it is essential to also note that lower interest rates could also motivate other forms of saving, like investing in the stock market. Since the cost of borrowing is reduced, the expectation is that firms would borrow more to expand, which would translate into higher earnings.

As firms profit more, dividends and stock prices could increase (capital appreciation). This makes it attractive for savers to move their monies from low-yielding fixed income instruments or bank savings to the stock market.
 

Savings on the rise

We would consider two monetary statistics (bank savings deposit rates and total bank demand deposits) to analyse if this theory of higher interest rates leads to higher savings. 

Bank demand deposits simply refer to bank accounts from which deposited funds can be withdrawn at any time and without advance notice. Benchmark savings deposit rates are the benchmark rate banks pay customers on funds in their savings accounts.

Theoretically, a rise in the benchmark savings rate should lead to higher bank demand deposits, as people are better incentivised to save and vice versa.

The savings deposit rate is usually calculated as 10% of MPR (formerly 30%). However, in reality, banks offer different rates on savings due to increased competition.

For example, as of 22nd July 2022, Heritage bank offered a 4.2% interest rate per annum (p.a) compared to FCMB (1.2% p.a) and the benchmark of 1.4% p.a (i.e. 10% of MPR; 14%)—which about nine banks out of 21 currently offer.

So the benchmark savings rate represents the minimum interest banks should pay on savings accounts.  

As we can see from the chart, demand deposits (savings) have been rising despite a drop in the benchmark savings rate (interest rate). That is because the interest rate is only one factor that determines savings.

Factors that affect savings

From the explanation of the income effect of interest rates stated earlier, we can already tell that age group is one factor that affects savings.

A youth or middle-aged individual could have student loans or more pressing expenses with limited capacity to save. However, people in their 50s will be seeking to increase savings and improve their pensions.

The interest rate does little to alter the fundamental individual plan. Someone nearing retirement will not increase consumer spending because interest rates are very low.

Nonetheless, other factors that impact savings include investor confidence and savings alternatives.

Investor confidence and expectations play a vital role in influencing savings. For instance, if the outlook is for the naira to continue depreciating against the dollar, people might be more motivated to engage in speculative activities by withdrawing their savings to convert to dollars and sell for higher later. This is not saving.

Also, if people expect an economic recession with higher unemployment, people would tend to save more because of the fear of unemployment.

Even if interest rates fell to 1% from 10%, people would rather save more than go and acquire a loan that will saddle them with debt obligations they may not have the cash flows to service in the future.

Looking at the chart above, we can see that savings took off in 2020 despite a drop in interest rates.

Similarly, the local equities market posted a stellar performance in 2020, as the local bourse returned 50% year-on-year. The performance was primarily driven by domestic investors who abandoned low-yielding fixed income instruments for the riskier equity market.

For context, in 2020, the CBN had intentionally crashed interest rates to boost growth and stir the economy out of the Covid-19 and oil price-induced recession. As such, yields on fixed income instruments like the 1-year treasury bill fell to 0.6% in December 2020 versus 6% in January that same year. 

This made domestic investors and savers alike look to the stock market, and take advantage of the relatively low prices at the time. 

This is also evidenced in the ratio of foreign to domestic investors' participation in the Nigerian stock market. The ratio stood at 49:51 respectively as of December 2019 but changed to 34:66 as of December.

As foreign investors sold off their positions in the stock market, domestic investors/savers swept in to mop up the supply. The potential returns in the equity market were more attractive than the low-interest rates offered on savings deposits and fixed income instruments. As of H1 2022, the ratio of foreign to domestic investors’ participation stood at 15:85 respectively, reflecting even higher participation from domestic investors/savers.

While this seems all well and good, when we look at savings from an even broader lens, it paints a different picture.

Savings is actually on a decline

It would have been too easy to just look at the absolute numbers and conclude that savings are rising because of increased savings deposits. But this is not the full picture, especially considering the Nigeria Deposit Insurance Corporation (NDIC) statistics that only 2% of customers own 90% of bank deposits and  99% of bank accounts held less than ₦500,000 last year.

Facts like these reduce the reliability of using absolute numbers of the demand deposits to paint a true picture of savings in Nigeria.

Thankfully, the savings to GDP ratio calculated as the difference between total income and consumption provides a more robust view. I use this ratio because we can agree that for savings to grow, the economy has to grow adequately enough, even though savings is also necessary to boost growth, as Gbemi argues. 

The above chart shows that savings (what is left from income after consumption) is declining. This decline can be attributed to inflation and the economy's overall health.

Let's start off with a closer look at inflation.

As our head of intelligence, Michael, explained, double-digit inflation could wipe out any investment returns. We’ve equally shown how an individual earning ₦200,000 for the past five years (2018-2022) can only afford goods worth ₦164,560 when you account for inflation eroding purchasing power. Also, as I explained in this article, investors and savers prefer savings returns to beat inflation.

For example, in Nigeria, inflation is almost 20%, and the nominal interest rate (interest rate unadjusted for inflation) is about 11.85%—the yield on 10-yr bonds (reference point for nominal interest rate). This means savers will see an erosion in the value of their money saved, discouraging savings. 

Furthermore, the overall health and wealth of the economy also play a significant role, if not the most important. Take Nigeria, a country where GDP growth has averaged 1% during the Buhari administration; compared to the average population growth of 3%, essentially, more people are hustling for the same level of wealth; people have only gotten poorer.

According to the National Bureau of Statistics (NBS), as of 2019, 40.1% of Nigerians live under the poverty line of ₦137,430. Similarly, the NBS also reports that Nigerians spend almost 60% of their income on food, leaving very little for other daily expenses like data, transportation etc. before we even come to savings.

When you factor in food inflation at 21% and relatively low wage growth, disposable income continues to erode fast, with little wiggle room to increase savings or even save.

As we can see, as inflation continues to erode purchasing ability by increasing what we spend (consumption), savings suffer as people dip into what they have to sustain living conditions.

For most Nigerians, movement in interest rates is not a major influence on their savings culture or even how much they save, as they are more focused on keeping their heads above water.

Again, considering total unemployment (unemployment plus underemployment) at 56.1% in 2020, the currently employed have seen their expenses increase as more people depend on them.

This point is evidenced in the fact that despite the recent growth in absolute demand deposit numbers when we view savings as a percentage of GDP (which compares savings to the total wealth), we can see that unless the other factors limiting savings are solved, we might not see any real change.

In conclusion, higher interest rates alone are insufficient to stimulate higher savings and might not give the desired effect the CBN hopes for by hiking interest rates. As the apex regulator for our financial services industry, the CBN must do all it can to win back investor confidence for savings to start growing again.