Winners and Losers of Interest Rates in Historical Low

Dumlao is associate professor of economics at the Ateneo de Manila University. This piece was published in the December 20, 2010 edition of the BusinessWorld, pages S1/4 to S1/5.


In the 1980s, the average interbank call loan rate and 31-day t-bill rate were 16 and 17 percent respectively. In the 1990s, these were both 14 percent. In the 2000s, these were 7 and 6 percent, respectively. The year has not ended yet. But so far in 2010, the averages are both 4 percent. As of 30 November, interest rates were generally at their lowest in history. For example, the 31-day t-bill went to less than 1 percent, that is, 0.775 percent. Which investors win and which lose? There are two sides to investing. On one side, there are those who invest by spending on business for profit. On the other side, there are those who invest by lending for interest. For those who invest by spending, the private sector can now borrow at lower interest and spend for business. The government that borrows and spends for public expenditure will also pay lower interest. Therefore, investors who spend are winners.

For those who invest by lending, a stylized example will help to show who wins and who loses. Suppose that the add-on interest is 10 percent per year. This means that a promissory note that will pay P100 next year is worth P90 today and was P80 last year. In other words, the investor who bought the note at P80 last year can sell at P90 today, and the investor that buys at P90 today will collect P100 next year. Both get P10 interest from their investment. This, of course, assumes that interest is constant. But suppose interest is variable. For example, suppose interest goes down from 10 percent to 5 percent. This means that a promissory note to pay P100 next year is now worth P95. In other words, the investor who bought the note at P80 last year can now sell at P95 today, and the investor who buys at P95 today will collect P100 next year. The investor who bought the note last year expected to get P10 but ends up with P15. But the investor today will get P5 instead of P10. Therefore, those who already lent in the past are winners, and those who are lending today are losers.

Investing by lending becomes less attractive. By natural instinct, financial investors will look for alternative investments. Some may opt to invest outside of the Philippines, thus causing capital flight. This is not good. Some may opt to invest in stocks. This will increase the demand for stocks. The prices of stocks increase. For now, the stock market wins.

Some firms have a clear strategy on how to raise productivity or some have real demand for market expansion. Those who invest in these will have their capital infused to either raise productivity or expand business. This will raise profit and will be good for these firms, the stock market and investors. But some firms do not have the vision to raise productivity and do not have the market to expand. Those who invest in these will be eventual victims of a vicious cycle. First, investors buy stocks. Second, prices of stocks increase. Third, the increase of price attracts new investors so that they buy stocks. Fourth, prices of stocks increase again and the cycle begins. The vicious cycle will create a bubble that will inevitably burst. Traditional fundamental investors will be winners and naïve players aka “speculators” will be losers.

What do near-zero interest rates imply on policy? When economies hit recession, reducing interest rates is a standard monetary policy. In doing so, the cost of borrowing decreases; the private sector supposedly spends more; and the increase in expenditure pumps the economy out of recession. The problem is that interest rates are already as good as zero. If recession hits the economy, there is no more room for reduction of interest (unless the central bank reduces interest to negative rates). This is a lesson learned from the recent US financial crisis. The Federal Reserve (Fed) had successfully lowered interest in the past. But when recession hit the US, the Fed failed to help the economy. It failed not because it affected the interest wrongly. Rather, it failed because it had no room to affect interest.

In the 1980s, the average interbank call loan rate and 31-day t-bill rate were 16 and 17 percent respectively. In the 1990s, these were both 14 percent. In the 2000s, these were 7 and 6 percent, respectively. The year has not ended yet. But so far in 2010, the averages are both 4 percent. As of 30 November, interest rates were generally at their lowest in history. For example, the 31-day t-bill went to less than 1 percent, that is, 0.775 percent. Which investors win and which lose? There are two sides to investing. On one side, there are those who invest by spending on business for profit. On the other side, there are those who invest by lending for interest. For those who invest by spending, the private sector can now borrow at lower interest and spend for business. The government that borrows and spends for public expenditure will also pay lower interest. Therefore, investors who spend are winners.

For those who invest by lending, a stylized example will help to show who wins and who loses. Suppose that the add-on interest is 10 percent per year. This means that a promissory note that will pay P100 next year is worth P90 today and was P80 last year. In other words, the investor who bought the note at P80 last year can sell at P90 today, and the investor that buys at P90 today will collect P100 next year. Both get P10 interest from their investment. This, of course, assumes that interest is constant. But suppose interest is variable. For example, suppose interest goes down from 10 percent to 5 percent. This means that a promissory note to pay P100 next year is now worth P95. In other words, the investor who bought the note at P80 last year can now sell at P95 today, and the investor who buys at P95 today will collect P100 next year. The investor who bought the note last year expected to get P10 but ends up with P15. But the investor today will get P5 instead of P10. Therefore, those who already lent in the past are winners, and those who are lending today are losers.

Investing by lending becomes less attractive. By natural instinct, financial investors will look for alternative investments. Some may opt to invest outside of the Philippines, thus causing capital flight. This is not good. Some may opt to invest in stocks. This will increase the demand for stocks. The prices of stocks increase. For now, the stock market wins.

Some firms have a clear strategy on how to raise productivity or some have real demand for market expansion. Those who invest in these will have their capital infused to either raise productivity or expand business. This will raise profit and will be good for these firms, the stock market and investors. But some firms do not have the vision to raise productivity and do not have the market to expand. Those who invest in these will be eventual victims of a vicious cycle. First, investors buy stocks. Second, prices of stocks increase. Third, the increase of price attracts new investors so that they buy stocks. Fourth, prices of stocks increase again and the cycle begins. The vicious cycle will create a bubble that will inevitably burst. Traditional fundamental investors will be winners and naïve players aka “speculators” will be losers.

What do near-zero interest rates imply on policy? When economies hit recession, reducing interest rates is a standard monetary policy. In doing so, the cost of borrowing decreases; the private sector supposedly spends more; and the increase in expenditure pumps the economy out of recession. The problem is that interest rates are already as good as zero. If recession hits the economy, there is no more room for reduction of interest (unless the central bank reduces interest to negative rates). This is a lesson learned from the recent US financial crisis. The Federal Reserve (Fed) had successfully lowered interest in the past. But when recession hit the US, the Fed failed to help the economy. It failed not because it affected the interest wrongly. Rather, it failed because it had no room to affect interest.

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