Interest rates and exchange rates – a macro-economics 101

28 January 2015


Interest rates and the hungry investor

Smart rational and hungry investors are always on the hunt for stronger returns on their investment funds. The return on fixed income securities is usually measured by the interest rate. Ceteris Paribus the larger the interest rate the more attractive the security.Hungry investors exist in all countries and in the modern world they will seek out desirable investments in every corner of the planet. In other words a bond (or indeed any marketable investment) issued in one country may attract foreign as well as domestic investors.

Who sets the interest rate?

Generally interest rates are set on an investment by investment basis taking into account many factors the most notable being the risk related to the particular investment. The higher the risk the greater the return the investor will require.However this is only part of the story. There is a single interest rate that underpins all the available investments in a particular country. This interest rate is set by a central financial institution (in the United States the Federal Reserve, in Trinidad and Tobago the Central Bank) and is usually referred to as the repo rate.

The repo rate (defined below) is the rate at which the commercial banks can borrow liquidity on a temporary basis from the central bank.
The commercial banks operate by taking in money from investors on deposit and lending this to consumers by way of loans. The commercial banks therefore operate two interest rates. A rate that they pay to depositors, and a rate that they charge to borrowers. The rate that is charged to borrowers is higher than the rate they pay to depositors (effectively this is known as “the spread”). This spread or differential is one way that the commercial banks make money.

How the central bank can influence commercial banks rates

If the central bank increase the repo rate that they charge the commercial banks like most businesses the commercial banks will increase both the rates they charge borrowers and pay to depositors. In other words the change gets passed on to the end consumer.
The key concept to understand here is that the commercial banks increase both rates. Therefore borrowing money becomes more expensive. Conversely saving money is a more attractive option because you receive a higher return on your deposited funds.

Why would the central bank want to influence the commercial banks rates?

Let’s say that the central bank wishes to control inflation in the economy. One of the ways it can do this is by increasing the repo rate since if borrowing becomes more expensive and saving more attractive demand for goods and services should fall. The reasoning is simple. People would rather save (or not borrow because it is too expensive) rather than consume. A fall in demand –ceteris paribus – should lead to a fall in prices (inflation).The link between the interest rate and the exchange rate
As I stated above investors today are truly international. There are large pools of funds that flow between countries seeking out the best possible return. To explain this consider the following:
If the central bank in Trinidad and Tobago (as an example) increases its interest rates saving money becomes more attractive not just to Trinidadians but also to foreigners. An investor in the United Kingdom wishing to invest in a Trinidad interest bearing investment will have to buy Trinidad and Tobago dollars with his pounds in order to make that investment. This increases the demand for Trinidad and Tobago dollars meaning that the dollar will appreciate in value against the pound.

The knock on effects of an appreciating dollar – a double edged sword?

An appreciating currency can be a double edged sword. On the one hand it can help to reduce domestic inflation by making the price of goods and services imported into the country cheaper. But there is another edge to this and it is less desirable. The downside is that domestically produced goods and services offered for export become comparatively more expensive. This can lead to loss of competitiveness in export markets.

The impact on foreign currency reserves

If a foreign investor sells pounds to buy Trinidad and Tobago dollars in order to make an investment in a Trinidad and Tobago interest bearing security there is an inflow of foreign funds into the country. This is important and beneficial. If a country has a high level of foreign reserves it will attract more overseas investors because the potential overseas investor knows that the country has the foreign currency reserves to both service the investment and repay it if necessary.

It all links back to the key concept of risk

What I have written in the section above all links back to a key concept in investment. That is the concept of risk. In the situation above having a high level of foreign reserves is one factor that will help investors to perceive an investment in that country as being less risky. In essence it is a concept of country risk as opposed to a separate investment risk.
We can therefore say that ceteris paribus the more risky a country is perceived the higher the return the investor will require in order to pursue an investment in that country.

The link between risk, confidence in the economy, and liquidity

When investors lack confidence or are in general unsure about the state of the economy they tend – being risk averse creatures – to invest in safer investments. Safer investments are easy to define. For the concerned investor they are those that offer the lowest level of risk.
More often than not the safest investments available are those offered by the government itself. In economic text books you will often find these referred to as GILTS and they can be broadly defined as government backed securities and treasury bonds.
If investors (and for that matter consumers too) lack confidence they are also less likely to spend money and are more inclined to hold onto it. This increases the liquidity in the system.

Mopping up liquidity and boosting economic activity

If the level of economic activity in the country is low and investors have lost confidence and are not spending money in the economy governments can through the central bank step in to boost economic activity.
One of the ways they can do this is to issue new government bonds mopping up surplus liquidity in the system. The funds received can then be reintroduced or spent in the economy by the government of the day (more often than not on capital projects) with a view to stimulating economic activity and boosting confidence.

Conclusions

Because funds can flow easily between countries movements in domestic interest rates can and do have knock on effects. Movements in domestic interest rates (both actual and anticipated) do lead to movements of funds across borders and do therefore have an impact on exchange rates and the pattern of international trade.
What happens in one country is therefore often highly relevant to what will happen in the domestic economy. In economic terms the world is highly connected.

Definitions and key concepts used above:

Ceteris Paribus: a Latin term often used in economic theory. It means “all other things being equal”.

 

Inflation: a general and persistent increase in prices and a fall in the purchasing power of money.

 

Repo Rate: the rate at which the central bank of a country lends money to commercial banks in the event that the commercial bank has a shortfall in funds.
The central bank use the repo rate to stimulate desired changes in the economy. For example central banks will often increase the repo rate to attempt to control inflation as an increase in the repo rate acts as a disincentive for the commercial banks to borrow.

Liquidity: The amount of liquid assets (at its narrowest definition cash) in the economy.

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