The Erosion of Purchase Power on Your Financial Investments Amid the COVID-19 Pandemic

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By Dr Irene Irungu

A retired primary school teacher – after working for thirty years – received a partial lump sum of his pension monies in February 2019.

Having been unsuccessful in several business ventures and farming, he has been considering investing this money in financial investment products.

His need was intensified by the fact his pre-existing medical condition, diabetes, was flagged as one of the pre-existing medical conditions that could accelerate the chance of one contracting the coronavirus yet he no longer has access to his former employer’s medical scheme.

Following the advice of his banks’ financial advisor, he is considering investing in government treasury bills and bonds as they are secure, saying, “I am guaranteed that the government will never go broke. I will also know how much I will earn throughout the term of the contract.”

While the retiree’s decision is anchored on solid facts, what he has not considered is the erosion of the purchase power his investment will be exposed to due to inflation.

This article aims at explaining the effects of inflation on the purchase power of financial investment products amid the COVID-19 pandemic.

Purchase Power

The value of a currency expressed in terms of the number of goods or services that one unit of money can buy is referred to as purchase power.

Inflation decreases the purchasing power of money since the rise of inflation rates increases prices, causing the number of goods or services one unit of money would be able to purchase to be reduced.

The chart above shows the deteriorating purchase power of the Kenya shilling from 2019. It shows that KShs 100 earned in February 2019, is only worth KShs 92 in August 2020.

This means that the retiree would have to spend more money to pay for goods and services in August 2020 than they did in February 2020.

In light of this, he needs to consider the effect of the loss of purchase power over time on the choice of financial investment products.

We can now evaluate the effect of inflation on three financial investment products: fixed deposit account, treasury bills, treasury bonds and stocks.

Fixed Deposit Account

A fixed deposit account is a financial product offered by a bank where customers make a fixed deposit amount into an account that earns a fixed interest rate over a specified period of time.

Banks in Kenya offer marginal interest rates on fixed deposit account ranging from 1 percent to 5 percent per year. The interest rates vary depending on the amount deposited in the account and increases as the length of the investment period increases.

While this investment product offers the retiree liquidity so that he is able to meet his short-term needs, inflation can shrink the savings.

Say the retiree invested KShs 100,000 into a fixed deposit account in February 2019 that pays 2% interest rate per year as offered by the Standard Chartered Bank. After a year, he will have KShs 102,000 in his account.

He would have gained KShs 2,000 from his investment. However, due to the prevailing inflation rate, the fixed deposit investment at the end of the one year term would only be worth KShs 95,176, an indication that the investment purchase power is lost.

This means that if the retiree is living off his savings invested into a fixed deposit account, he may not afford to keep up the same standard of living or lifestyle especially if inflation cuts into the purchasing power year on year.

However, we observe that, if he chose not to invest at all, he would have ended up losing more money as the value of the KShs 100,000 he had in February 2019 would only be worth KShs 93,310 in February 2020.

We can now look at the purchase power of the same fixed deposit account in 2020 to determine the effect of the COVID-19 pandemic.

It is observed that separate investments of KShs 100,000 made in February 2019 and 2020 were worth KShs 97,665 and KShs 99,692 in August 2019 and 2020 respectively. This shows that purchase power did not deteriorate as fast during the COVID-19 pandemic period compared to the same period last year.

Treasury Bills and Treasury Bonds

Treasury bills (T-bills) are short-term financial contracts issued by the government through the Central Bank of Kenya (CBK) with a maturity period of one year or less. These securities are widely regarded as low-risk and secure investments.

Treasury bonds (T-bonds) are also issued by the government through the CBK but differs from the (T-bills) in that they are typically long-term financial contracts with a maturity period of more than one year. In addition, T-bonds offer the investor periodic payments until maturity, known as coupons.

While the T-bill promises to deliver with certainty a fixed amount of money at maturity of the contract, it does not guarantee the retiree consumer goods.

At maturity, he does not know how many goods the fixed amount he will receive at maturity will buy. How much he will be able to consume depends on the realized inflation between T-bill purchase and maturity dates.

T-bills and T-bonds are issued at a discount rate.

Suppose the retiree bought into a 364-Days Treasury Bills issue 2273/364 at the beginning of the year 2020. This means that they would pay KShs 91,032 and receive KShs 100,000 at the end of the 1 year (364 days). This means that at maturity, the retiree is paid back what he paid for the contract plus a rolled-up interest of 9.879 percent per year.

A look into the chart above shows that the KShs 100,000 invested by the retiree in a T-bill in Feb 2020 would have grown to KShs 104,823 by August 2020.

However, it is good to note that the purchase power of the investment had deteriorated as the accumulated amount of KShs 104,823 in August could only purchase goods and services worth KShs 103,471 – representing a loss of KShs 1,352.

This reveals that the retiree’s financial position would have been cushioned against the loss in purchase power of his investment had he invested in the T-bill compared to if he had not invested the money at all.

A comparison with the same period in 2019 is made for the 364-Days Treasury Bills issue 2218/364.

The chart above shows that KShs 100,000 invested by the T-bill would have grown to KShs 104,812 by August 2019. However, this amount could only purchase goods and services worth KShs 101,356 – representing a loss of KShs 3,456.

This shows that the purchase power of the T-bill investment declined at a slower rate during the COVID-19 pandemic compared to the same period last year.

Since T-bonds earn periodic fixed interest in terms of coupons, an increase in inflation rates erodes their purchasing power.

While the inflation rates remained relatively lower during most of the COVID-19 pandemic period, we may not conclusively speak on the impact of this on the purchase power as they are long-term contracts.

In general, however, rising inflation is even more unfavourable to T-bonds with a longer term to maturity. This is so due to the cumulative effect of lower purchasing power for coupons received in the future.

Stocks

Stocks are a financial investment that allows one to own a portion of a publicly listed company.

This means that if you bought 1000 shares of a company that has 100,000 shares, you will own 1% of it. This investment will earn you money in form of periodic dividend as well as earn from the company’s growth.

Investors in the stock market – known as shareholders – also earn through the trading of the stock by buying and selling.

When there are more people selling a stock, the price of the stock will drop. In contrast, when there are more people buying a stock, the higher the price will rise.

Investors make a return on their investment by selling shares at a higher price than they were purchased.

Trading is guided by investors’ expectations of corporate earnings. If a company is not doing well, and its shares decrease in value, its shareholders could lose part or even all of their investment when they sell.

It is expected that a company’s revenues and profit would increase at a similar pace as inflation. As a result, its share price would rise along with the prices of goods and services offered. Conversely, when inflation declines, so do the revenues and profits, resulting in the declining share price.

This is observed in most of 2019 where the purchase power of the investment in Safaricom stock portfolio remained relatively close to the realized growth in the investment.

However, in 2020, the value of the portfolio was seen to dip sharply following the confirmation of the first COVID-19 case in the country in March 2020, exposing the weakening of the investment due to the prevailing inflation. This reduced the purchase power of the investment valued at KShs 100,000 to KShs 93,049.

This was followed by an increase in inflation in April 2020, which led to a growth in the investment increase in the value. The loss of purchase power however remained higher compared to earlier – well above KShs 8,000.

It is good to note that this case is only considered for the Safaricom stock. Other companies’ share price trends may appear differently.

Stocks are commonly thought of as an inflation protection assets since, over time, stock performance will outpace inflation. For this reason, stocks are assets that provide inflation protection that benefits long-term investing.

What is the best choice of financial investment for the retiree?

Fixed-income financial investments such as Fixed Deposit accounts, T-Bills and T-bonds offer the retiree a stable income stream in the form of fixed interest payments. However, as the rate of interest remains the same until maturity, the purchasing power of the interest payments declines as inflation rises.

Stock prices on the other hand are often seen to vary along with inflation. However, due to tendency of share prices  to change unpredictably it poses s great investment risk to the retiree.

In a nutshell, when an investment does not grow at the same rate as inflation, an investor will effectively lose money.

Inflation can weaken the performance of your investments and thus impact its value.

It is therefore prudent for the retiree to factor inflation into his retirement investment to ensure he has enough assets to last through their retirement years. This can be achieved through the diversification of investment products.

 

Dr Irene Irungu is a lecturer of Actuarial Science in the Department of Mathematics, Statistics and Actuarial Science at Karatina University, Kenya. She holds a BSc Actuarial Science and MSc Applied Statistics from the Jomo Kenyatta University of Agriculture and Technology (JKUAT) and a PhD Financial Mathematics from the Pan African University Institute for Basic Sciences Technology and Innovation (PAUISTI). 

Additional contribution by Purity Mukami

This work is supported by the Heinrich-Böll Foundation.

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