The 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.
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.
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.
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.