Wednesday, March 30, 2011

THe Effect of Interest Rate

As an investor, very often we run into a situation whereby we do not fully understand certain economic concepts or economic indicators while reading the Business Section of the newspaper. These economic indicators are important source of information that provides investors with insight into the environment in which financial markets operate that may in turn have a significant impact on our stock market.

For example, I read an article this morning, it said: “EU raised interest rate to boost the Euro”. Many investors only know the relationship between interest rate and stock market, but they do not know why interest rate will affect a country’s currency?

While interest rate has an inverse relationship with the stock market; it has a direct relationship with the currency! This is because when a country raises its interest rate, it will attract short term “hot money” or short term capital into the country to take advantage of the higher interest rate. When this happens, it raises the demand for the currency and thus raises its valuation as well.

During the 2006 – 2008 oil crisis, our official inflation once reached more than 5% but unofficial inflation could be much higher, it was not reflected mainly due to the oil subsidies that we were enjoying. Our inflation problem was much better when we compared to other neighbouring countries since they do not have oil subsidies.

So back to the point, to combat high inflation most countries would raise their interest rates to prevent erosion of purchasing power. The effect? If the economy already in recession due to high inflation, it will go deeper into recession further as the cost of borrowing has increased!

Our Bank Negara at that time did raise interest rate but to a lesser extent. It was a brilliant move by Dr. Zeti, our award winning Governor, that we sacrificed the purchasing power temporary, kept the cost of borrowing at reasonable level to protect the business sectors, so that we can all secure our jobs. In addition, the higher interest rate made our currency stronger, so that we can import cheaper to bring down the imported inflation. As for our exports, not a big problem there because the regional countries all experienced currency appreciation so we did not lose our competitive advantage.

Hence, do not underestimate the effect of the interest rate, it can bring impact onto our daily consumption, firms investment, government borrowing, our Ringgit as well as our Malaysia trade patterns.

Besides our local interest rates, we must also know the level of interest rates in other countries as well. So keep reading! The more you read the better investor you are and you are on your way to successful investing!

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Happy investing,
Pauline Yong


Anonymous said...

Hi Pauline, you highlighted the effect of interest rate on currencey in the post. So my doubt is:

Why America arguing thet China artificially lower yuan while the USD is dropping to a decade low?

Mind sharing?

Pauline Yong said...

THere are many factors affecting the currency. Interest rate is one of them, other factors include economic condition, inflation, government borrowing and many more. For the case of US and CHina, the main factor is their balance of trade.

The US has been having trade deficits with China for years. By right, with the trade surplus the China enjoy (thanks to the US), Chinese Yuan should be appreciating against the US Dollar, but it didn't! According to the Purchasing Power Parity (PPP) in fact Chinese Yuan was under valued by as much as 50%!So obviously, China was manipulating their currency so that the Yuan didn't rise to the actual level. Because China wants to keep their exports competitive.

In short, when US demand more CHinese goods, demand for Yuan rises. But it didn't so that's why the claim is "China artificially lower Yuan".

But "US dropping to decade low" that's because US has been printing too much money, that explain why US Dollar loses its value.