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CHAPTER- 1
INTRODUCTION INTEREST RATE Interest rates are the single most important fundamental driver in Forex and the direction of monetary policy is essential in shaping developments in currencies. This direction is determined by the vast array of economic reports, central bank rhetoric and movements in equity and bond markets. Knowing where the various interest rates stand is not enough by itself. Instead, assessing where each nations monetary policy is heading relative to others is paramount in getting the best bang out of your buck in selecting the appropriate foreign exchange pair. DETERMINATION FO INTEREST RATES We have referred in various places in the course to the 'interest rate' in the economy and we have considered the interest rate as an instrument of monetary policy. However, we have not looked in a systematic way at the factors influencing the level of interest rates in the economy. In fact, two quite different appraoches to the determination of interest rates have been taken by economists. One of these we considered when we were discussing the demand for money notably, the idea of the speculative demand for money put forward by Keynes. This is known as the liquidity preferencetheory of interest rates. Influential though this model has been, another theory has dominated the thoughts of most economists. It is known as the loanable funds theory. We shall look at it first here. The Loanable Funds Theory of Interest Rates The loanable funds theory is a theory of the determination of real interest rates - that is, rates of return expressed in terms of real purchasing power. The theory derives from the notion that savers make a decision between consumption now and consumption in the future. The more people consume now out of present income (and the less they save and hence the smaller are the funds available for investment), the lower will be future income. Thus, a trade off always exists between present consumption and future consumption. It is assumed that people would prefer to consume now, other things being equal. Hence, to persuade them to save and provide funds for investment, they must be paid interest. The real interest rate is therefore the rate needed to persuade people to forgo present consumption. It was sometimes referred to as the
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CHAPTER 2
GLOBAL INTEREST RATE:
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Interest rates are the single most important fundamental driver in Forex and the direction of monetary policy is essential in shaping developments in currencies. This direction is determined by the vast array of economic reports, central bank rhetoric and movements in equity and bond markets. Knowing where the various interest rates stand is not enough by itself. Instead, assessing where each nations monetary policy is heading relative to others is paramount in getting the best bang out of your buck in selecting the appropriate foreign exchange pair. The chart shows the interest rate path of 6 central banks since 2002. The much discussed carry trade (selling low yielding currencies to purchase in higher yielding ones) was its strongest between 2005 and 2007 when Japanese interest rates remained below 1.00% while all other central banks began raising rates. The rate hikes of the U.S., Australia, Canada and the Eurozone were particularly aggressive during the period, allowing their currencies to post sharp gains versus the yen. The Japanese yen and Swiss franc are characterized by their low-yielding status, but the yen is more notorious for its sharp declines during the accumulation of carry trades as well as for its rapid gains during the unwinding of carry trades. The main reason is the size of the Japanese economy, whose GDP of $4.3 trillion is the worlds second largest. More significantly, only 1 to 2 % of Japans 1,500 trillion yen (US$13 trillion) in household financial assets is invested
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Assessing the global interest rate story from a US perspective, the chart below suggests the eroding interest rate differential may have reached its worst thanks to US rates being unchanged since April while other nations rates have been cut since then (UK, Canada and New Zealand). And even if the Federal Reserve were forced to cut rates later this year, it would have to do so due to clear economic deterioration, in which case may also drive other central banks to ease. The exception to this assumption is in the event that further rate cuts are a result of deepening corrosion in US-specific dynamics (renewed housing slump, accelerating unemployment, deteriorating consumption and re-emerging worries to the financial system). Such would be a repeat of conditions in mid June into early July when escalating worries dragged US and global stocks as well as the dollar2.
Global interest rates have increased in 2011. Led by China and other Asian countries, more central banks have increased benchmark lending rates than decreased them this year. Earlier this year, The People's Bank of China pushed the one-year yuan lending rate in China up to 6.06 percent from 5.81 percent. Other major economic powers like Australia, Canada and the European Central Bank have held rates steady at recent meetings, but the tone from
2 http://www.ashraflaidi.com/charts/global-interest-rates.asp
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The Central Bank of Iceland and Central Bank of Kenya are two of the few central banks to lower their rates recently. Both countries have much higher inflation targets than the major economic powers and could afford to drop rates in order to try to spur growth. Economists are now forecasting that the European Central Bank (ECB) and the Bank of England are likely to increase interest rates in 2011 after holding their key interest rates low for over two years. Inflation has accelerated across Europe, led by food and energy prices. The ECB also continues to face significant battles with the potential default of the sovereign debt of weaker members. The benchmark ECB interest rate, currently set at 1.00 percent, is expected to be increased to at least 1.75 percent by the end of the year. The United States could be one the last G-20 economic powers to raise interest rates if the Fed stays true to their public comments. The Bernanke-led Fed is showing no resistance to the calls from inflation hawks to slowly raise rates. Other countries with interest rates nearly as low as
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INDIAN PERSPECTIVE: After the first phase and second phase of financial reforms, in the 1980s commercial banks began to function in a highly regulated environment, with administered interest rate structure, quantitative restrictions on credit flows, high reserve requirements and reservation of a significant proportion of lendable resources for the priority and the government sectors. The restrictive regulatory norms led to the credit rationing for the private sector and the interest rate controls led to the unproductive use of credit and low levels of investment and growth. The resultant financial repression led to decline in productivity and efficiency and erosion of profitability of the banking sector in general. This was when the need to develop a sound commercial banking system was felt. This was worked out mainly with the help of the recommendations of the Committee on the Financial System (Chairman: Shri M. Narasimham), 1991. The resultant financial sector reforms called for interest rate flexibility for banks, reduction in reserve requirements, and a number of structural measures. Interest rates have thus been steadily deregulated in the past few years with banks being free to fix their Prime Lending Rates(PLRs) and deposit rates for most banking products. Credit market reforms included introduction of new instruments of credit, changes in the credit delivery system and integration of functional roles of diverse players, such as, banks, financial institutions and non-banking financial companies (Nbfcs). Domestic Private Sector Banks were allowed to be set up, PSBs were allowed to access the markets to shore up their Cars. BPLR and its advantages and disadvantages: BPLR (Benchmark Prime Lending Rate) is the interest rate that commercial banks charge their most credit-worthy customers. According to the Reserve Bank of India banks are free to fix the Benchmark Prime Lending Rate (BPLR) with the approval of their respective Boards. The PLR is influenced by RBIs policy rates the repo rate, reverse repo rate and cash reserve ratio apart from the banks policy. In simple words, availability of funds i.e. liquidity in the banking
3 http://www.money-rates.com/keyrates.htm
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RBI had announced the base rate system which will set the interest rates for the bankers to lend their borrowers. Earlier the rate is known as the Prime Lending Rate(PLR) for the banks. Normally the banks can not lend the money below the PLR to avoid any loss or risk. But, banks started offering the loans cheaper than the PLR to lure the customers. This is also called as the Teaser Loan Rates where the actual loan rates will increase in the later period of time. That will put the extra burden on the borrowers. RBI come up with the new base rate system where banks can lend the loans based on the new rating system. Earlier it announced that the new system will be effective from April 1,2010. After hearing the request from most of the banks to postpone the new system implementation for another few months, recently RBI announced that the new system will be effective from July 1, 2010. Also RBI had agreed to exempt the three categories of the loans under this system as follows: Staffer Loans
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4 http://www.thinkplaninvest.com/2010/03/implementation-of-base-rates-from-july-12010/
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5 http://articles.economictimes.indiatimes.com/2010-07-18/news/27597168_1_base-raterate-system-lending-rate 6 http://in.news.yahoo.com/factbox-global-interest-rates-2011-20110319-023232-390.html
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BIBLIOGRAPHY
Websites Referred:
10 http://www.merinews.com/article/is-us-is-moving-towards-zero-interest-rateregime/146567.shtml
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Books Referred:
D.M. Mithani, Money, Banking, International Trade and Public Finance, 15th Edition, Himalaya Publishing House.
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