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Introduction
Interest rates have significant impacts on the agricultural industry by affecting the cost of borrowing money, affecting investment decisions and affecting values of farmland. This module explains how interest rates are determined, the different types of interest rates, the agriculture finance system in Canada, and how interest rates impact agricultural markets.
What is the interest rate?
Interest is the amount paid by a borrower to a lender in exchange for the use of the lender’s money for a certain period of time. Interest is paid on loans or on debt securities, such as bonds, either at regular intervals or as part of a lump sum payment when the loan matures. In the case of operating loans from the bank, interest is paid in instalments based on an annual rate of interest for the life of the loan. In the case of bonds, the bond buyer (the lender) pays less than face value for the bond at the time of purchase. At maturity the buyer receives a lump sum payment equal to the amount originally paid plus the accumulated interest. The interest earned on the bond equals the full or face value of the bond less the amount originally paid for the bond when it was purchased.
Changes in interest rates directly affect profitability of the agricultural sector by influencing borrowing, spending and investing, since agriculture is an especially capital-intensive industry. Changing interest rates indirectly also impact agriculture through affecting the level of general economic activity, such as output and employment, exchange rates and international trade.
What factors influence the interest rate?
Interest rates are determined by the supply of money and demand for money within an economy. The demand for money is based on people’s desire for current spending and investment opportunities. The major source of the supply of money is from savings and the willingness of consumers, firms, and governments to delay spending. The demand for and supply of money can also be influenced through the monetary policy of a country’s central bank, in Canada, the Bank of Canada.
The major target of Canadian monetary policy, which the Bank of Canada and the federal government have established, is to keep inflation low and stable. The Bank of Canada uses its powers to influence the credit conditions that exist in the economy. The two main tools the Bank of Canada uses to influence the money supply are the Target for the Overnight Rate (see Definitions) in the drawdown/redeposit mechanism and through Open Market Operations (see Definitions). The Bank of Canada influences very short-term interest rates, which in turn influence the direction of the long-term rates and may lead to movements in the exchange rate of the Canadian dollar.
Types of interest rates
There are different types of interest rates, such as the bank rate (see Definitions), the prime rate (see Definitions), and the market rate (see Definitions). These types of interest rates are nominal rates of interest. The nominal interest rate is composed of two parts: one part covers the expected inflation, and the other part represents the real rate of return, which is referred to the real rate of interest.
The real interest rate is the difference between the nominal interest rate and the expected rate of inflation. For instance, if the nominal interest rate is 6 percent and the expected inflation rate is 2 percent, the real interest rate would be 4 percent. Theoretically, what determines the real rate of interest is the productivity of capital. That is, the real rate of interest within a country is based on the return from investments on physical capital goods like a herd of cattle, for example. In practice, interest rates in Canada are broadly determined by three factors: interest rates in the U.S., the relative inflation rates in both countries, and the relative stances of each country’s monetary policies.
The agricultural finance system in Canada
Agricultural credit is a proportion of the total business and household credit demand. Interest rates on farm loans are mainly decided outside of the agricultural sector. However, farm-lending rates vary at the micro-level with respect to financial conditions of the borrower, lender risk-bearing ability, borrower and lender maturity, borrower and lender liquidity and size of the agricultural loan.
The Canadian agricultural sector is a capital-intensive industry. Over the past 10 years, total farm debt has doubled with an average annual growth rate of 6.7%. By December 31, 2003, total farm debt outstanding was $47.7 billion, including $25.0 billion non-mortgaged debt and $22.7 billion mortgaged debt according to Statistics Canada.
In Canada, agricultural loan funds can be obtained from various sources such as chartered banks, federal government agencies, provincial government agencies, credit unions, insurance and trust companies, private individuals, and advance payment programs. By the end of 2003, most non-mortgaged farm debt was held by the chartered banks (59.1%) and credit unions (22.8%). In 2003, major lenders of the mortgaged farm debt included Farm Credit Canada (37.9%), chartered banks (26.1%), private individuals (15.0%), credit unions (8.5%) and provincial government agencies (6.0%) according to Statistics Canada.
Impacts of interest rates on agricultural markets
Interest rates affect agricultural markets in three major ways. The first is the effect on costs of holding inventory. The second is the effect on investment decisions such as land, machinery and input purchases. The third is overall farm business risk associated with possible rising interest rates.
Costs
Interest expenses on holding inventory could have a significant impact on farm profitability and associated agribusinesses. The cost of holding inventory is the interest paid if the business has debt or the interest that would have been collected, usually called opportunity cost, if the inventory had been sold. In practice, interest rates can vary in a large range from five to six per cent for operating loans to 18 to 24 per cent for short-term loans from agri-businesses. High interest rates usually result in additional financial burden for agribusinesses.
Stored production is inventory and the impact of interest rates on the cost of holding inventory should be considered in farm and agri-business decisions. For example, storage costs are important in determining when to sell grain. Price increases on stored grain must be enough to make up for the interest foregone, if a producer decides to store crop production rather than sell it at harvest. This is true for both grain companies and producers.
Interest costs must be included in the calculation of any cost of production analysis as well. For example, when determining the breakeven for feeder cattle, the interest cost for purchasing the calves must be included in the analysis. Even if the calves come from within the operation, the interest foregone from the sale of the calves should be included in the cost calculation.
Investment
Business investment is negatively affected by increasing interest rates, particularly the real interest rate. Investment refers to spending on land, buildings, machinery, equipment and inventories, which are for use in future production. The decision on whether to invest, how much to invest and when to invest in a project depends on the comparison of the expected rate of return on the investment and the interest rate. If investors think the rate of return on a project is higher than the interest rate, they will carry out the project. Therefore, farmers and agri-businesses will have more incentives to invest when interest rates are low. In contrast, high interest rates will deter investment, since investment becomes more costly with rising real interest rates. Higher interest rates may slow the rate of investment in a particular sector as well.
Interest rates are a key determinant of agricultural land values. In most cases, farmland prices are determined by the relationships between expected earnings and interest rates. Higher interest rates will lower the expected earnings by making borrowing and cost of production more costly. Interest rates are critical in considering the base of wealth in agriculture, since according to Statistics Canada, farmland and buildings account for 53% of all farm assets in Canada and 58% in Alberta.
Interest rate risk
The increasingly unexpected and adverse movement of interest rates is a source of operating risk for farms and agri-businesses. A sudden increase in interest rates may result in higher than planned interest expenses if a business is holding a variable rate loan. Higher interest expenses reduce profitability of farms and agri-businesses, discourage investment and decrease farmland values. A strategy for avoiding losses caused from an expected increase in interest rates may be to lock in a fixed rate loan when the interest rates are lower.
Summary
Interest rates are determined by the supply and demand for money within an economy. The central bank can influence rates by changing monetary policy. The Canadian agricultural sector is a capital-intensive industry. Agricultural loans can be obtained from various sources, such as chartered banks, federal & provincial government agencies, credit unions, insurance and other financial institutions, private individuals and advance payment programs. Interest rates affect agricultural markets through the changing costs, influencing investment decisions, and interest rate risk.
Definitions
Target for the Overnight Rate
“The Target for the Overnight Rate” is the main tool used by the Bank of Canada to implement monetary policy. By law, Canada’s major commercial banks and non-bank financial institutions maintain a certain amount of base money on deposit in the BoC. They also settle the net outcome of the daily clearings of payments directly on the books of the Bank of Canada. Those financial institutions borrow and lend money among themselves overnight, in order to cover their transactions during the day. The interest rate charged on those loans is called the overnight rate. The BoC sets the target for the overnight rate to tell the financial institutions the average interest rate the BofC wants charged for the overnight loans between the major financial institutions. The overnight rate is determined in a range of a half of a percentage point, which is called Operating Band. The overnight rate target is always at the middle of the band. When the BoC changes the target for the overnight rate, this change clearly signals the direction of policy shifts. Changes in the overnight rate influence other short-term interest rates, such as mortgage rates and prime rates. (Source: Bank of Canada)
Open Market Operation
The Open Market Operation is discretionary BoC intervention in the financial securities market. It plays an important supplementary role in the Bank’s monetary policy. The BoC can choose between repurchase operations, which affect the overnight market, and outright purchases or sales of treasury bills, which affect the money market more generally. The BoC can intervene in the overnight market through repurchase operations in two ways: Sale and Repurchase Agreement (SPA) to put a ceiling on rates, or Special Purchase and Resale Agreement (SPRA) to put a floor on rates. The bank can also directly participate in the treasury bills market to influence bond yields by selling bonds from a government securities portfolio held by the BoC, or by purchasing bonds from the market into the portfolio. Generally, the sales of treasury bills will increase the supply of a particular security, which, in turn lowers the price of treasury bills and raising the interest yield. Since 1995, the transactions of open market operation mostly involved SPA and SPRA. (Source: Bank of Canada)
The Bank Rate
The Bank Rate is the interest rate that the BoC charges on one-day loans to financial institutions. The Bank Rate is highly related to the overnight rate. The Bank Rate is at the top end of the Operating Band. For example, if the operating band is between 4.00 percent to 4.50 percent, the Bank Rate would be 4.50 percent. The Bank Rate and the Operating Band are adjusted at the same time. The Bank of Canada announces these rate changes according to a calendar of eight fixed days every year. (Source: Bank of Canada)
The Prime Rate
The Prime Rate is a benchmark rate of interest established by commercial banks and is the rate charged for large loans made to their most credit worthy business and industrial customers. The prime rate is generally the lowest rate of interest charged by a bank, with other loans calculated as a certain amount “over prime”.
The Market Rate
The Market Rate of interest is the rate charged by the bank to customers other than those that qualify for the prime rate. A market rate can vary from loan to loan according to the perceived risks, the size and the length of the loan, the nature of collateral offered and competition in the loan market. |
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