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The Fall and Rise of Major Economies’ Interest Rates

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Interest rate challengesThe world financial crisis, the worst since the great depression of 1930s, has forced the major economies of the world reduce their central banks’ interest rates to their least level possible. This was done to overcome “the credit crunch” that erupted as a byproduct of the financial crisis. Credit crunch was also a result of the bankers ceasing their lending to one another, due to mistrust developed out of lack of transparency over the exposure of each bank to toxic sub-prime mortgage loans.

As the banks, investment as well as commercial, stopped releasing their funds for lending, the central banks stepped in to see that the required funds are available to market. This prompts people to believe that the banks were in short of funds, which was not true. If market players stall their activities, the theories of free market economy would become useless. Ironically, the people (or consumers in market language), on whose purchasing capacity and spending activity the markets depend, had no role in this entire fiasco, except paying taxes and losing jobs.

Interest Rates

The central banks exercise their control mainly on four rates. They are the Bank Rate (or discount rate), repo rate (repurchasing rate), reverse repo rate and CRR (cash reserve ratio). A bank rate is the interest rate that is charged by a country’s central bank (federal bank in some countries) on loans and advances to financial institutions like banks. Federal banks use the bank rate to control the money supply in the economic system and banking sector. The rate is reviewed periodically with respect to  developments during the period in question, taking into account the particularities as well as generalities of the developments.

The repo rate is the interest rate at which banks lend money to banks and other financial firms. The reverse repo rate is the rate at which the banks are paid for depositing their money at central bank. Cash reserve ratio is the rate at which the banks have to keep their deposits at central banks as reserves. CRR is operated as a safety measure to prevent the banks putting all their money deposited by the consumers, into the market. It is also safe for the bankers to make use of their reserves in difficult times. Again, people do not have any role in decision making on their own money.

Stimulus Roll Back

As a measure to stimulate the financial sectors and hence the economies, the governments reduced interest rates to their lowest possible level. As the countries are recovering from the crisis, the central banks have to roll back their stimulus measures. Otherwise, inflation, price hike, overheating and even bubble formation would result. The pace of that rollback for a given country reveals the pace of recovery of that country. In other words, one can estimate whether the GDP of a country is growing at slow pace, moderate pace, medium pace, fast pace, or robust pace by comparing their rates at which they stood during pre-crisis and post-crisis periods. One should note that this observation was only limited to the analysis of developments surrounding the financial crisis.

In the backdrop of the debt crisis of the Europe, countries are forced to balance between fiscal consolidation and GDP growths. Europe is stressing for fiscal consolidation as their debts and deficits are threatening another economic collapse. The US, on the other hand, is stressing for continuation of stimulus measures as it is still reeling under slow pace of growth. The US has the advantage of the dollar as world reserve currency in maintaining huge debt and deficit. Even then, it is not a blank cheque given to the US to proceed with adding on more debt or deficit.

Emerging Economies

So far, relatively, China is the only country that is able to maintain GDP growth at robust level without endangering fiscal fundamentals. Still, it has its own weaknesses.  China did not touch the bank rate after the crisis. This implies that China’s growth is more or less propelled by the lower interest rate. The last time it changed the interest rate was on 22 December 2008, when it reduced it from 5.58% to 5.31% during the crisis.

Before the crisis, China’s rate was at 7.47%. Rate reduction started in Sept. 2008 and reached  5.31% by December 2008. It shows that China reduced its rate by 216 basis points or 2.16% within 3 months, a very rapid rate of reduction, letting lose the money for massive lending.

Another emerging economy to be considered is India, the second fastest growing country in terms of GDP. The maximum rate before the crisis for India was 9%. Rate reduction began in October 2008. India continued its rate reduction until it reached its lowest level of 4.75% by April 2009. It was reduction of 425 basis points or 4.25% within 5 months. However, India increased the rate to 5% in March 2010 amid pressures of double-digit inflation and popular protests against highest price levels of all essential goods and consumer durables.

Developed Economies

The biggest economy of the world, the U.S., has drastically decreased the Fed’s policy rate comparing with its size of the economy. Changes in Federal Reserve policy rate have wider implications on developed as well as developing economies, as the economies have been integrated as a global village in last 10 to 15 years with strong interconnections between them. At the center lies the US economy. The US is also the world financial center. It has the world’s reserve currency as its national currency. These factors made the US carry the entire world economy into the crisis.

The Fed began the rate reduction even before the crisis broke out. The collapse of  Lehman Brothers in September 15, 2008  triggered the chain reaction and  countries were trapped into recession one after another. The Fed’s maximum rate was 5.25% in August 2007. It was reduced to 4.75% in September 2007. It continued its downward path to reach 1% in Oct. 2008 and finally to 0.25% in December 2008. It is still at 0.25%. The Fed thinks the US economy still needs stimulation, a belief that is widely accepted.

One cannot resort to linear comparison between the US and  other countries because of its enormous size. Even the growth rate of China cannot be compared straightaway with that of the US. The size of the US economy (nearly $15 trillion) is almost triple to the second largest economy, China. China surpassed Japan to grab second position in Q2 of this year. When we see numbers as percentage, there is a base, on which percentage is calculated. When the base of the US is three times wider than that of China, how their percentage growths can be equated? For that matter, some of the macro-economic indicators like GDP, per-capita income do not give the actual picture of a given economy. (This is the personal view of this author i.e. me)

The European Union has a history of maintaining a stable interest rate for almost 7 years from June 2000 to March 2007 at 4.25%. The EU’s rate was at 4.25% when the crisis was broke out. It began its rate reduction in October 2008 to reach its lowest of 1% in May 2009. It was a decrease of 325 basis points or 3.25% in 7 months. Even after the recovery was said to begin the ECB kept the rate 1%. The debt crisis became a massive problem for the Europe.

Canada is the only  developed country that increased its policy rate (from 0.25% to 1%) in 3 steps in June to Sept 2010. Norway also increased its rate from 1.25% to 1.75% well in advance in October 2009. Among emerging economies, Australia is the first to increase the rate from its lowest of 3.25% to 4.5% beginning in October 2009. The last upward change was made in May 2010. India followed suit in March 2010.

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About Sekhar

  • STM

    Thing thing with the Australian economy, though, is that rates never went down to the low levels of the other western economies.

    The GFC, which might have been staved off in Australia by the government’s very swift multi-billion stimulus efforts that kept the money going round, had very little impact on Australia.

    There was no recession, few job losses (unemployment is now at near-record levels), wages are still among the highest in the world, (above even those of the US and most of Europe, as is the cost of living, the standard of living, along with what most believe are artificially high property prices in the major capitals, especially Perth, Melbourne, Sydney and Brisbane).

    The Aussie economy is regarded by pundits the world over as the canary in the coal mine.

    In other words, if it falls over early and does the death rattle, so does everyone else … down the track. That is particularly true given that most of the export commodities sales are to China, India and Japan and Australia is lucky to have an entire continent full of goodies these powerhouses need, and an agriculture sector that makes it a food bowl for other parts of the world.

    Conversely, of course, given those factors, if the Australian economy is doing well, it augurs well for other economies. So the light at the end of the tunnel is probably not an oncoming freight train, at least from where I sit down here in my paradise on the edge of the south pacific.

    The other key to the Aussie economy not falling over is strong banks (four of the major Aussie banks are in the world’s top 10), and that’s all because of sensible prudential regulation introduced as legislation by the previous government which effectively stopped the kind of lunacy we saw in Wall Street and London – the epicentre of the GFC.

    The flip side of this: I am currently looking at a home-loan mortgage increase that will take me up over 7 per cent by the end of the year.

    No good for those with a mortgage in Australia, but it does indicate that things are getting back to normal, and not as slowly as everyopne thought.

    I predict that in a few years, the GFC will be all but forgotten and remembered as the crisis we had to have – even if only to bring an end to the kind of “smartest guy in the room” shysterism that caused it in the first place.

    Despite the problems it has caused for many millions in the developedv world, in the long run that can only be good.

    Let’s hope the other decade of greed is well and truly over.

  • STM

    Make that: “employment is now at near-record levels”.

  • http://nvs-stream.com/ Sekhar

    Hi STM,
    I got your point. The answer to your indirect query is present itself in your piece of writing. Your mention of “… the government’s very swift multibillion stimulus efforts…,” provides the clue.

    Why the Australian govt has swiftly moved to counter the impact of GFC? Going for stimulus is moving out of normal course of doing things. Moving out of normal course is telling that there was an impact. If there was not an impact the stimulus amount would have been saved and addition to the govt debt would not have happened.

    There was impact but staved off by bringing in stimulus measures as you have pointed out. Australia decreased its bank rate from 7.25% to 3% between Aug 2008 to Apr 2009 i.e in 10 months) during the ciris. 3% may not be lower than 0.25% numerically, but when we compare the economies’ sizes of Australia and the US, relatively 3% is much lower than 0.25%.

    To make the issue more clear, let me point out that the financial stimulus (let alone GDP) sanctioned by the US($1.5 trillion) is nearly 1.5 times of Australia’s GDP ($0.997 trillion)in 2009 as per IMF statistics. 2009 is the year when Australia began recovering, while the US was still in recession. There are several other factors that reveal a situation where strengths of structures of the developed economies cannot be compared with those of emerging economies.

    Though India did not give financial stimulus, it took many stimulus measures. Reducing bank rate, reducing CRR, repo and reverse-repo rates, tax cuts, export incentives much higher than the normal ones etc.

    The bottom-line is that the GFC influenced various countries depending upon how they are integrated into the capitalist world economy as a result of globalization policies. The more the countries exposed to the world financial system, the more was the impact of the GFC for a given country.

    Living standards, HDI, per capita income etc.. are not considered fundamentals in capitalist economies. If they are considered the IMF would not have imposed austerity measures on the countries that approach it for loans.

    The capitalist system, its macro economic fundamentals, IMF strictures are not meant to improve the living standards of the people. In fact, they are maintained at the cost of the living standards of the people for the benefit of big business houses.

    There is a general talk that India and China also were untouched by GFC which is not true. China is the second most country that has offered a big stimulus to counter the impact of GFC. Apart from the financial stimulus China lent above $2 trillions as consumer loans, property loans, loans to local governments and provincial governments. These are meant to counter the effects of GFC, i.e. credit crunch, decreased consumer confidence etc…

  • STM

    There is plenty of talk here that probably the stimulus measures weren’t even needed.

    However, were they to know that at the time? No.

    I think the general consensus was that lack of government action to puff up economies at the start of the Great Depression led to it being worse than anyone imagined.

    So they moved swiftly.

    Will we ever know, though, in regard to the GFC? Probably not.

    All I can go on is what happened: stimulus + no recession = something worked.

  • http://nvs-stream.com/ Sekhar

    Why not?

    The question is whether we are ready to see it or not? If we push a thing being part of it, it won’t move. We have to come out and push it to move it.

    Similarly to enable ourselves to see what actually went wrong, we have to come out and see. If we see being part of it, the picture will be confusing and can never find a single reason but several, at a time or at different times.

    Coming out of the system means not physically but ideologically. We need not take any particular ideology. Just forget what you have assumed so far, and start from the scratch without preconceived views. And leave behind the biases.

    I promise you, you would find it.