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Tea with AK71: Interest rates and inflation.

Sunday, January 23, 2011

A topic on interest rates seems serious enough. Why have I put it under "Tea with AK71"? Well, it is because I want to talk about it in a more informal tone. It gives me an excuse to ramble and not be too careful in the way I write.

In the last one year, many have been talking about interest rates and how the low interest rates won't last and would go up in time. It seems to be a relatively safe prediction and, in general, I agree but when would it go up and by how much? That's the difficult question.

What goes up must come down one day and what is down would go up too. It is how things in the world achieve equilibrium. There could be exceptions but let's ignore these to keep this chat going.

I might have mentioned this in my blog before. I cannot remember. Think of China and what they are doing. They have increased interest rate more than once in the last few months due to inflationary pressures. Is increasing interest rates the only way to fight inflation? Well, there are many tools available and interest rate is just one tool. Like all tools, it has its limitations.

China has also increased bank reserves requirement in an attempt to reduce money supply. Interest rate and money supply are useful to a point in controlling inflation which are domestically created. They have little impact on exogenous factors.

The Chinese have a huge problem with inflation and much of that is imported. Remember that only a third of the Chinese economy is driven by domestic consumption. This is very different from Indonesia's 60%. How much of the inflationary pressure in China is due to rampant domestic over-consumption, therefore?

Raising interest rates won't help much and could make things worse. The more effective way to reign in inflation is what the Singapore government did: allow its currency to appreciate. Singapore too has a small domestic economy. The Chinese know that they have to let the RMB appreciate and they are just delaying the move.

The RMB is way undervalued and it is the main culprit in causing rampart inflation in China as the booming Chinese economy is heavily reliant on many imports just to keep its industries humming along. Its energy needs is just one such example.

The Singapore government does not use interest rate to control inflation. It uses the Singapore Dollar which floats against a basket of currencies of its major trading partners. If the MAS should hike interest rates (which it can't) to combat inflation, it could have a bigger problem on hand. Why?

Many Asian countries already have a problem of hot money flowing in, money looking for better returns. This money is usually from developed countries which are doing quantitative easing in the hope of jump starting or keeping their economy above water. In these countries, interest rates are more likely than not close to zero.

Money will go to where it is treated best and so, although the interest rates are pretty low in Singapore, a lot of money still find its way to our small island. For example, a 0.8% interest rate plus the prospect of  a 5% appreciation against its country of origin is very attractive for such funds.

The inflows have to be put to productive use and lenders (banks) will mostly offer relatively low interest rates to entice borrowers. More cheap debt and inflation continues. So, combating inflation is not a simple matter of increasing interest rates. If only it was that simple.

Now, one day, when the Chinese government decides to float the RMB more realistically, what would happen to companies with investments in the PRC? What would happen to CapitaMalls Asia?

Another point, since the Singapore government does not use interest rate to control inflation and if an increase in interest rate could be a bad thing instead as it encourages more hot money inflow, what would be the interest rates be like in Singapore for the next 12 months?

To both sets of questions, I have answers. However, seeing that my formal education in Economics ceased at "A" Levels, I shall not reveal what I think. I could be wrong, of course.

I think I need something bracing after this heavy blogging. Tieh Kuan Yin, anybody?

8 comments:

Isaac said...

Hi AK,

you mentioned that Singapore won't raise it's interest rates. Actually it has no control over interest rates, since it controls both FX rates and has free capital controls.

Wiki Link is here: http://en.wikipedia.org/wiki/Impossible_trinity

that's why Australia, having free cap flows and an independent monetary policy, has no control over fx rates, which is why the Aus Dollar has been increasingly appreciating against every currency in the world.


Seeing that China is under such huge pressure to revalue it's currency, might be a good idea to get a RMB FD :P


Anyway thanks for the insight! REITs won't be such a good idea if interest rates were so high, haha

AK71 said...

Hi Isaac,

Thanks for the correction, you are right in that the word should be "can't" instead of "won't". Also, thanks for the link to the Impossible Trinity. ;)

I hold some RMB as a hedge but since the S$ is relatively strong as well, it makes less sense for us to hold more RMB unlike someone in Hong Kong or the USA, for example.

It looks to me that the interest rate in Singapore is likely to stay quite low for a while more and it is a strong reason why I am sanguine about the prospects of S-REITs. :)

Kelvin said...

Incidentally, our SG govt looks set to announce measures to tame inflation (esp food prices). The announcement could be as early as 24 Jan morning before mkt opens?

AK71 said...

Hi Kelvin,

I heard this as well. It seems that the government is gearing up for election again and it has to press all the right buttons.

I hope this is not going to be considered a political statement. I wouldn't want my blog to end up like The Online Citizen which was gazetted as a political association earlier this month. ;p

Temperament said...

Hi,
Some old folks use to say Papaya policy is: "You won't starve to death, you won't grow fat either"
What do they(old folks) mean?
Ha! Ha!
Cheers!

AK71 said...

Hi Temperament,

Papaya? I know a Chinese saying, "Eat not full but won't starve to death." You referring to this? ;)

Temperament said...

Hi Ak 71,
Ya lo, 吃 不 饱 饿 不 死。
Olk folks use to say about the Papaya's policy.
I wonder what they are saying now?

Sorry, Papaya=Pay&Pay; who must press all the correct buttons because of the coming election.
Just for laugh.
Ha! Ha!
Cheers!

AK71 said...

Hi Temperament,

Oh my, you were referring to the PAP? Ahem.. hmmm... the weather good or not in London, I wonder. Lalalala.... ;)

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