Interest rate charged is the reward for taking the risk on the capital. Interest rate is often referred to as the “cost of funds” or hurdle rate.
Risk to Capital
If the lender perceives a higher default risk on capital lent out, the higher the interest demanded. The causes to credit risks can come from shocks to the financial system from within the country or beyond. As the world’s financial systems are increasingly interlinked, any credit event far away can increase potential default risk.
Demand for funds
The increased demand for funds when it outstrips the supply will also cause interest rates to rise. Genuine demand of funds comes from the industry’s need for investment. Industrywill borrow money for investments if they think their investments returns can better the interest rate. This type of capital demand can help a country increase its productive capacity.
The other types of demand are for household consumption such as housing mortgages, car loans, renovation loans or personal consumption.
Supply of funds
The supply of funds varies in each country. The supply of funds can come in local currency or foreign currency. The supply of funds generally comes from the banks. The banks in turn receive their funds from equity and depositor’s funds. These funds are then lent out to borrowers, less offcapital reserves requirement such as BASEL III to maintain the stability of the banks via a capital adequacy ratio.
Financial institution having excess capital may then lend these funds to other financial institution other on an over-night basis, 1 month, 3 months, 6 months and so on. This is referred to as the interbank rate or benchmark interest rate. In Singapore it is referred to as the Sibor rate, in London, it is referred to as the Libor rate, in the USA it is referred to as the Federal Funds Rate (overnight rate).
The supply of funds in a country depends on the money supply and the amount of depositor’s funds within a financial system. And in recent decades, the availability of credit (Debt) also increases the supply of funds is further complicating the issue of funds availability.
A regulator or central bank usually intervenes in the overnight funds market. The effects of intervention then filters through to the rest of the tenures of the interbank lending rate.
Core Inflation and headline inflation
Core inflation measures the more constant inflation over a longer period, this helps any regulator to avoid knee jerk policy reaction. Headline inflation measures the current inflation and can be impacted by short-term supply and demand imbalances,causing temporary spikes and troughs in pricing. Every country varies in their measurement of inflation.
When Core Inflation is on an uptrend, it can start to erode purchasing power and real growth. Rise in Core Inflation which is due to the economy overheating maylead to intervention by addressed by increasing interest rates. Core Inflation can rise when a nation is approaching full employment as disposable income increases causing wage inflation, potentially pushing up prices of goods and material. “Full employment” seems to be around 4% for the US economy where interest rates have to rise to start to curb inflation.
Chart: USA & UK Unemployment Rate 1990 to 2015, (Source: Trading Economics)
When a country’s total gross domestic production grows too quickly, it can cause Core Inflation to rise. For example, if a country’s GDP grows by 5% and inflation grows by 6%, this means that the country have negative real growth. When an economy grows at a fast rate, it is usually accompanied by a higher inflation rate as industry clamour for limited supplies of raw materials, and pushes production toward or beyond capacity. If income does not keep pace with inflation, this can cause social unrest. A regulator may hence pull the brakes on the economy by increasing interest rates to cool down the economy. Generally interest rates should somewhat track inflation, i.e. high interest rates high inflation. However interest rates can be kept artificially at a certain level for extended duration of time through intervention.
Note: Many factors are at play and another chapter needs to be devoted to this topic.
Cross border Interest Rates
As the world’s major economies are increasingly interlinked, policies and regulations in other countries may affect another country. If for instance the global environment is rising in interest rates and going on a reduced risk appetite mode, then all connected economies will be affected competitively. Funds may then move away to seek higher returns via higher interest rates (all factors being equal).
Hence if you are a chicken Rice stall selling your chicken rise at $5. Suddenly the other chicken rice stalls within 200m of your stall have raised their chicken rice to $10, this means that many customers may come to your stall. You and your staff will be swamped with customers. Your staff will be stretched and tired and you may have to pay them more to work over-time. Soon you have to increase your prices too.
Chart: USA Overnight Fed funds rate Vs Sibor overnight rate (Source: iEconomics)
Funds Flows and Exchange Rate
The movement of capital across the globe has implications on each country’s economy. Some developing countries have higher percentage of corporate and household debt denominated in foreign currency and therefore at a greater risk from sudden funds arrival and withdrawal from their markets. Money supply in local currency may also suffer from withdrawals of deposits and repatriation of profits to foreign markets.
Exchange rate plays an important part for investorsparking their funds in any country. If the investment currency is expected to weaken significantlyagainst the investor’s base currency, investors may then decide to withdraw their funds from the invested currency.
(However do note that investors do not park all their funds in a local currency, they can park their funds in USD.)
Interest rates may have to rise when funds become scarce. Alternatively some country’s regulator or banks may have mechanisms to react preemptively to raise interest rates to cushion against a weakened currency by increasing interest rates.
Many countries regulate the economy by varying the interest rates to regulate the speed of the economy. These policy levers are effective for countries with a large domestic economyrelative to trade.
Some countries such as Singapore where trade is 2 to 3 times the GDP, import prices contribute a higher percentage towards inflation relative to domestic prices. (Reference 1). Singapore manages its exchange rate to import inflation. Hence there may be less impetus for intervening in the interest rates, except as a preventive measure to stabilize exchange rate movements. (Note: Regulatory intervention in interest rates in Singapore is a presumption)
Shocks to the Financial System
Shocks to the financial system (systemic risks) may cause bankruptcies and defaults.
There are many possible shocks to the financial system, just to name a few: –
Exchange Rate Volatility via Quantitative Easing
Quantitative Easing (Printing money) leads to currency devaluation. A currency which is devaluing may need to raise interest rates to slow down its devaluation as compensation to investors for holding the currency. Financial institutions and fund houses with un-hedged cross currency borrowings may end up bankrupt leading to a cascade of possible defaults. (A case being the recent unexpected de-pegging of the Swiss franc to the Euro, which caught many by surprise)
Sovereign Debt Defaults
Slow economic growth and high sovereign debt especially in European nations are risky. Budget deficits causes potential defaults. Any possible risk of defaults or downgrade of the economy could cause interest rates to swing upwards further escalating risks. Sovereign bonds could become worthless causing a cascade of asset losses and bankruptcies for investors.
Other Troubled Assets and Toxic Assets
Banks typically hold very little equity and are overleveraged. Hence asset depreciation or write-downs (in the form of loss of asset value) could make the banks insolvent. Hence the Basel Accord was formed to mandate minimum reserve liquidity in the world’s banking systems (Reference 2). Increase in the minimum capital adequacy ratio (CAR) means that the banks will have less capital to lend out and hence banks may demand higher interest rates.
The above are some of the key factors that affect interest rate movements. It is inherently hard to decipher and predict the time frame of interest rate movement. Many more credit events and unexpected shocks awaits which could severely impact interest rates.
1. Singapore’s nominal GDP, USD $298 billion (2013). Total imports SGD $362 billion in 2015. Total Exports SDG $449 billion in 2015. (Source: TradingEconomics.com)
2. Understanding of Basel III. (Source: vimeo.com/59895335)
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