Category Archives: Interest Rates

Climate change = higher interest rates for developing countries

A significant number of developing countries are located in and around the equator which also means that they are more exposed to the extremes of climate change. As the world gets hotter these countries will suffer the most which makes their ability to advance their standard of living even harder. Temperatures in tropical climates will become far more variable and soil near the equator will dry up reducing its ability to dampen temperature swings e.g. Amazon rainforest, Congo, Indonesia etc.

The additional cost to poor countries in avoiding the damage caused by climate change is estimated to be between US$140bn – US$300bn each year on measures such as costal defences, strengthening buildings etc. This is according to the UN Environment Programme which assumes that global temperatures will be only 2°C above pre-industrial levels by the end of the century – unlikely according to The Economist. Not only are these countries suffering from climate change‑related drought, which will lead to a consequent drop in agricultural production and rise in food insecurity, but it also means higher interest payments than similar countries that are less exposed to climate change.

Climate Change = Higher risk of default = Higher Interest Payments

The V20 countries
The Vulnerable Twenty (V20) Group of Ministers of Finance of the Climate Vulnerable Forum is a dedicated cooperation initiative of economies systemically vulnerable to climate change. The call to create the V20 originated from the Climate Vulnerable Forum’s Costa Rica Action Plan (2013-2015) in a major effort to strengthen economic and financial responses to climate change. Originally 20 countries it has now expanded to 48 and the membership is mostly from poor countries that make up less than 5% of global GDP. They include the following:

Afghanistan, Bangladesh, Barbados, Bhutan, Burkina Faso, Cambodia, Colombia, Comoros, Costa Rica, Democratic Republic of the Congo, Dominican Republic, Ethiopia, Fiji, The Gambia, Ghana, Grenada, Guatemala, Haïti, Honduras, Kenya, Kiribati, Lebanon, Madagascar, Malawi, Maldives, Marshall Islands, Mongolia, Morocco, Nepal, Niger, Palau, Palestine, Papua New Guinea, Philippines, Rwanda, Saint Lucia, Samoa, Senegal, South Sudan, Sri Lanka, Sudan, Tanzania, Timor-Leste, Tunisia, Tuvalu, Vanuatu, Viet Nam and Yemen.

Research has estimated that V20 countries pay 1.2% higher than comparable countries which raises the V20’s borrowing costs by about 10% which is equivalent to an extra US$4bn each year in interest payments. It has also been estimated that of corporate debt a significant amount is held by countries who are the most at risk of climate change. This equates to 3% of total debt in more than 60,000 firms in 80 countries. These high risk countries were charged 0.83% higher interest on loans which equates to roughly a 10% premium. Therefore credit rating agencies are including climate change in their risk models and what makes it worse for developing countries is that they tend to be primary based economies which are the most susceptible to climate change. Moody’s, the credit rating agency, has suggested that of the 37 countries that are most vulnerable, farming accounts for 44% of employment on average.

For developing countries to counter the impacts of climate change sovereign parametric insurance has been prevalent. This insurance is pooled amongst countries in close proximity and makes the premium more affordable. This insurance relies on risk modeling rather than on-the-ground damage assessments to estimate the cost of disasters. Parametric insurance policies pay out automatically when certain pre-agreed conditions, such as wind speed, rainfall or modeled economic losses, meet or exceed a given threshold. Examples of areas where countries have pooled insurance are:

  • Caribbean Catastrophe Risk Insurance Facility
  • African Risk Capacity
  • Pacific Catastrophe Risk Insurance Company
  • Southeast Asia Disaster Risk Insurance Facility – under development

Like any insurance although it might be under used it does mean that countries can access money to recover and rebuild their economies – ideally with greater resilience.

Source: The Economist – ‘Costing the earth’ – 17th August 2019

A2 Revision – Liquidity Preference

With the A2 multiple choice tomorrow here is a mind map on liquidity preference. The liquidity preference or the demand for money is the sum of the transactionary, precautionary and speculative demand for money. Only the speculative demand is inversely related to interest rates. It is the speculative demand that students find difficult to understand. This is money not held for transaction purposes but in place of other financial assets, usually because they are expected to fall in price.  Demand is interest elastic – i.e. is affected by changes in interest rates. Below is a mind map and some notes.

Adapted from CIE AS A Level Revision Guide by Susan Grant

Bond prices and interest rates are inversely related – Interest Rates ↑ = Bond Prices ↓ and Interest Rates ↓ = Bond Prices ↑. If a bond has a fixed return, e.g. $10 a year. If the price of a bond is $100 this represents a 10% return. If the price of the bond is $50 this represents a 20% return, i.e. the lower the price of the bond, the greater the return.

At high rates of interest, individuals expect interest rates to fall and bond prices to rise. To benefit from the rise in bond prices individuals use their speculative balances to buy bonds. Thus when interest rates are high speculative money balances are low.

At low rates of interest, individuals expect interest rates to rise and bond prices to fall. To avoid the capital loses associated with a fall in the price of bonds individuals will sell their bonds and add to their speculative cash balances. Thus, when interest rates are low speculative money balances will be high.

AS and A2 Macroeconomics: Internal and External Balances

In explaining the differences between internal and external balances I came across an old textbook that I used at University – Economics by David Begg. It was described as ‘The Student’s Bible” by BBC Radio 4 and I certainly do refer back to it quite regularly. Part 4 on macroeconomics has an informative diagram that shows the impact of booms and recessions on the internal and external balances.

Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.

External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.

In the diagram right the point of internal and external balance is the intersection of the two axes, with neither boom nor slump, and with neither a current account surplus nor a deficit.

The top left-hand quadrant shows a combination of a domestic slump and a current account surplus. This can be caused by a rise in desired savings or by an adoption of a tight fiscal policy and monetary policy. These reduce AD which cause both a domestic slump and a reduction in imports.

The bottom left-hand corner shows a higher real exchange rate, which makes exports less competitive, reduces export demand and raises import demand. The fall in net exports induces both a current account deficit and lower AD, leading to a domestic slump.

In a downturn a more expansionary fiscal and monetary policy can hasten the return to full employment eg. Quantitative easing, tax cuts, lower interest rates. However one could say that today it doesn’t seem to be that effective.

Monetary Policy in New Zealand – what the OCR means.

The Monetary Policy Committee of the Reserve Bank of New Zealand (RBNZ) operates monetary policy in New Zealand through adjusting the official cash rate (OCR). The OCR was introduced in March 1999, and is reviewed 7 – 8 times a year. The recent amendment to the Reserve Bank’s legislation sets up a Monetary Policy Committee that is responsible for a new dual mandate of keeping consumer price inflation low and stable, and supporting maximum sustainable employment. The agreement continues the requirement for the Reserve Bank to keep future annual CPI inflation between 1 and 3% over the medium-term, with a focus on keeping future inflation near the 2% mid-point.

Through adjusting the OCR, the Reserve Bank is able to substantially influence short-term interest rates in New Zealand, such as the 90-day bank bill rate. It also has an influence upon long-term interest rates and the exchange rate. In theory this is what the impact should be:

Higher interest rates = contractionary effect which leads to lower inflation and less employment growth

Lower interest rates = expansionary effect which can lead to higher inflation but more employment growth.

However the Reserve Bank of New Zealand acknowledge that it is a very complex mechanism as interest rates impact the aggregate demand through various channels – C+I+G+(X-M) – and over varying time periods.

On a normal day consumers, producers, government etc undertake financial transactions involving the commercial banking system. At the end of each day they need to ensure that their accounts balance but some registered banks may find that they are short of funds following the net aggregate result of these transactions, while others may find that they have substantial deposits.

Commercial banks that are have positive balances can leave this money with the Reserve Bank overnight. They receive the OCR on deposits up to a threshold level, and then receive the OCR less 1% for the remainder. Commercial banks that have a negative balance can borrow overnight from the Reserve Bank at an overnight rate of the OCR plus 0.5%. Therefore if you use the current OCR rate of 1% you get this situation. Remember that 50 basis point = 0.50% and 100 basis points = 1.00%.

Banks have the option (and incentive) of borrowing from each other, and using the Reserve Bank as a last resort. In doing so, both parties gain as the lending and borrowing rate tends to mirror the OCR (given the level of competition in the banking market). Those banks with excess deposits can then receive an overnight rate close to one percent (rather than a zero interest rate on any funds over the threshold level). Those banks who need to borrow funds can do so at around the OCR rate, rather than at 1.50 percent. The interest rate at which these transactions take place is called the overnight interbank cash rate see graph below.

Source: Grant Cleland – Parliamentary Monthly Economic Review – Special Topic – October 2019

What is a recession?

Here is another very useful video from CNBC which focuses on what actually is a recession. By definition it is two consecutive quarters of negative GDP. Between 1960 and 2007 there were 122 recessions in 21 advanced economies although those economies were only in recession around 10% of the time. The video is well worth a look and presenter Tom Chitty does a good job explaining things.

Should Central Banks still be independent?

Video from CNBC looking at why central banks became independent and if it still should be the case – very informative and they use the Phillips Curve in their explanation. WIth the ongoing inflation problems in the 1970’s and 80’s it was thought that giving central banks independence of government control should be implemented. It was argued that policy makers would struggle to convince the public they were serious about containing inflation if politicians retained a say on setting interest rates. In 1989 New Zealand become the first country to introduce an independent bank with the 1989 – Reserve Bank Act. The mandate was to keep inflation between 0-2% but later changed to 1-3%.

With the GFC in 2008 it was central banks who slashed interest rates and implemented several rounds of quantitative easing to stimulate demand. However the GFC could have been prevented if central banks intervened to stop the biggest asset-bubble in history instead of focusing purely on keeping inflation low. Furthermore the European Central Bank were slow to act and the recovery was stymied. The fact that Germany is under the threat of deflation means that the ECB have cut interest into negative territory and are relaunch another round of quantitative easing – they are running out of options. Economists are focusing on fiscal stimulus – tax cuts and government spending. Therefore monetary and fiscal policy should be working together. According to Larry Elliott of The Guardian. central bank independence is a product of the neoliberal Chicago school of economics and aims to advance neoliberal interests. More specifically, workers like high employment because in those circumstances it is easier to bid up pay.

50 basis points cut by RBNZ – are they going negative?

The 50 basis points of the OCR (Official Cash Rate) by the RBNZ took everyone by surprise. Cuts of this magnitude generally only occur when significant events happen – 9/11, the GFC, the Christchurch earthquake etc. However the US China trade dispute have significant implications for global trade and ultimately the NZ economy. The idea behind such a cut is to be proactive and get ahead of the curve – why wait and be reactionary.

The Bank has forecast the OCR to trough at 0.9 percent, indicating a possible further interest rate cut in the near future. The RBNZ believe that lower interest rates will drive economic growth by encouraging more investment but you would have thought that such low rates wold have been stimulatory by now. I don’t recall the corporate sector complaining too much about interest rates and according to the NZIER (New Zealand Institute of Economic Research) latest survey of business opinion only 4% of firms cited finance as the factor most limiting their ability to increase turnover. The problem seems to be an increase in input costs for firms which is hard to pass on to consumers.

Lower interest rates have a downside in the reduction in spending by savers and this could also impact on consumer confidence. Any hint of further easing seems to encourage financial risk-taking more than real investment. Central bankers have thus become prisoners of the atmosphere they helped to create. There is still a belief amongst politicians that central bankers have the power by to solve these issues in an economy and politicians keep asking why those powers aren’t being used.

Are negative Interest rates an option?

The idea behind this is that if trading banks are charged interest for holding money at the central bank they are more likely to make additional loans to people. Although this sounds good negative interest rates on those that hold deposits at the bank could lead to customers storing their money elsewhere.

The European Central Bank sees that negative interest rates have an expansionary effect which outweighs the contractionary effect. An example of this is Jyske Bank, Denmark’s third-largest bank, offered a 10-year fixed-rate mortgage with an interest rate of -0.5%. for a ten-year mortgage – in other words the bank pay you to take out a mortgage.

However negative interest rates is seen as a short-run fix for the economy. Getting people to pay interest for deposit holdings may mean that banks have less deposits to lend out in the long-run and this may choke off lending and ultimately growth in the EU.

How George Soros almost broke the Bank of England and pocketed $1bn

Today I was teaching  exchange rates with my AS Level class and couldn’t get away from the events in Britain on the 16th September 1992 – known as Black Wednesday. On this day the British government were forced to pull the pound from the European Exchange Rate Mechanism (ERM). The video below explains the drama that unfolded very well.

Background

The Exchange Rate Mechanism (ERM) was the central part of the European Monetary System (EMS) and its purpose was to provide a zone of monetary stability – the ERM was like an imaginary rope (see below), preventing the value of currencies from soaring too high or falling too low in realtion to one another.

It consisted of a currency band with a ‘Ceiling’ and a ‘Floor’ through which currencies cannot (or should not) pass and a central line to which they should aspire. The idea is to achieve the mutual benefits of stabel currencies by mutual assistance in difficult times. Participating countries were permitted a variation of +/- 2.25% although the Italian Lira and the Spanish Peseta had a 6% band because of their volatility. When this margin is reached the two central banks concerned must intervene to keep within the permitted variation. The UK persistently refused to join the ERM, but under political pressure from other members agreed to join “when the time is right”. The Chancellor decided that this time had come in the middle of October 1990. The UK pound was given a 6% variation

Black Wednesday

Although it stood apart from European currencies, the British pound had shadowed the German mark (DM) in the period leading up to the 1990s. Unfortunately, Britain at the time had low interest rates and high inflation and they entered the ERM with the express desire to keep its currency above 2.7 DM to the pound. This was fundamentally unsound because Britain’s inflation rate was many times that of Germany’s.

Compounding the underlying problems inherent in the pound’s inclusion into the ERM was the economic strain of reunification that Germany found itself under, which put pressure on the mark as the core currency for the ERM. Speculators began to eye the ERM and wondered how long fixed exchange rates could fight natural market forces. Britain upped its interest rates to 15% (5% in one day) to attract people to the pound, but speculators, George Soros among them, began heavy shorting* of the currency. Spotting the writing on the wall, by leveraging the value of his fund, George Soros was able to take a $10 billion short position on the pound, which earned him US$1 billion. This trade is considered one of the greatest trades of all time.

* In finance, short selling is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to that third party. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than it received on selling them. Wikipedia.

Modern Monetary Theory vs Mainstream Monetary Theory

Although not in the A2 syllabus we have had some great discussions in my A2 class on Modern Monetary Theory – MMT. It has its roots in the theory of John Maynard Keynes who during the Great Depression created the field of macroeconomics. He stated that the fact that income must always move to the level where the flows of saving and investment are equal leads to one of the most important paradoxes in economics – the paradox of thrift. Keynes explains how, under certain circumstances, an attempt to increase savings may lead to a fall in total savings. Any attempt to save more which is not matched by an equal willingness to invest more will create a deficiency in demand – leakages (savings) will exceed injections (investment) and income will fall to a new equilibrium. When you get this situation it is the government that can get the economy moving again by putting money in people’s pockets.

MMT states that a government that can create its own money therefore:

1. Cannot default on debt denominated in its own currency;
2. Can pay for goods, services, and financial assets without a need to collect money in the form of taxes or debt issuance in advance of such purchases;
3. Is limited in its money creation and purchases by inflation, which accelerates once the economic resources (i.e., labor and capital) of the economy are utilised at full employment;
4. Can control inflation by taxation and bond issuance, which remove excess money from circulation, although the political will to do so may not always exist;
5. Does not need to compete with the private sector for scarce savings by issuing bonds.

Within this model the only constraint on spending is inflation, which can break out if the public and private sectors spend too much at the same time. As long as there are enough workers and equipment to meet growing demand without igniting inflation, the government can spend what it needs to maintain employment and achieve goals such as halting climate change.

How does it differ from more mainstream monetary policy – see table below.

Those against MMT are dubious of the idea that the treasury and central bank should work together and also concerned about the jobs guarantee. They argue that if the government’s wage for guaranteed jobs is too low it won’t do much to help unemployed workers or the economy, while if it’s too high it will undermine private employment. They also say that trying to use fiscal policy to steer the economy is a proven failure because politicians rarely act quickly enough to respond to a downturn. They can’t be relied upon to impose pain on the public through higher taxes or lower spending to quell rising inflation.

Below is a video from Stephanie Kelton, an MMTer who was the economic adviser on Vermont Independent Senator Bernie Sanders’s presidential campaign in 2016.

Sources:

The Economist – Free Exchange – March 16th 2019

Wikipedia – Modern Monetary Theory

A2 Economics – Liquidity Trap

Just covering this with my A2 class and have gone through the theory with them. The liquidity trap is a situation where monetary policy becomes ineffective. Cutting the rate of interest is supposed to be the escape route from economic recession: boosting the money supply, increasing demand and thus reducing unemployment. But John Maynard Keynes argued that sometimes cutting the rate of interest, even to zero, would not help. People, banks and firms could become so risk averse that they preferred the liquidity of cash to offering credit or using the credit that is on offer. In such circumstances, the economy would be trapped in recession, despite the best efforts of monetary policy makers.

The graph below shows a liquidity trap. Increases or decreases in the supply of money at an interest rate of X do not affect interest rates, as all wealth-holders believe interest rates have reached the floor. All increases in money supply are simply taken up in idle balances. Since interest rates do not alter, the level of expenditure in the economy is not affected. Hence, monetary policy in this situation is ineffective.

Policies to overcome a liquidity trap

Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. Governments and central banks like there to be “just enough” growth in an economy – not too much that could lead to inflation getting out of control, but not too little that there is stagnation. Their aim is the so-called “Goldilocks economy” – not too hot, but not too cold. One of the main tools they have to control growth is raising or lowering interest rates. Lower interest rates encourage people or companies to spend money, rather than save.

But when interest rates are almost at zero, central banks need to adopt different tactics – such as pumping money directly into the economy. This process is known as quantitative easing or QE.

Helicopter Drop. Milton Friedman  advocated bypassing the commercial banks and money could be paid directly to consumers . This policy was termed a ‘helicopter drop’ to indicate the idea of a central bank dropping money from a helicopter. If deflation is a real problem, the Central bank could give money credits which have to be spent by a certain date – to stop people just saving the extra money.