Monday, December 25, 2006

The role of interest rates in the market

From time to time readers ask me about the effect of interest rates on the economy. This curiosity comes from the fact that interest rates have been a main consideration in the Jamaican economy since the 1990s, and hence have seen numerous commentaries in the press. This is justified, as the high level of interest rates have been the main cause of not only the economic problems we face, but also our social issues.

An easy explanation would be that when interest rates are high enough people will invest in interest earning assets, such as high yielding government paper. The effect this has is that it diverts money from competing investments, such as manufacturing, once the return on the paper is comparable, that is considering the risk-return relationship of each investment type. When interest rates are reduced, so that based on the risk-reward relationship, the return on say manufacturing is comparable to or higher, then the investor will shy away from paper and invest in real assets.

This is similar to the way in which the Fed uses interest rates to manage the pace of the US economy. So regularly we hear of the Fed raising or reducing interest rates to control inflation and growth (economic activity). When the Fed wants to keep inflation low or slow down the growth of the economy, e.g. consumer spending levels, which drives inflation, then they will raise interest rates, usually in increments to gradually slow down the economy. Similarly when they want to stimulate economic activity they will reduce rates, which will encourage consumer spending. This spending may take the form of consumer or business borrowings as interest rates on loans will be lower. This in turn encourages manufacturing to satisfy the increased demand, and leads to more jobs.

Paper investments
This is how every market will operate, given that other factors such as social conditions are stable and is why the suggestion to use moral suasion to reduce interest rates is impractical, as it assumes that the market is not rational. What has happened to Jamaica over the last ten to thirteen years is that the government has kept interest rates on paper investments high, so this has had the effect of diverting money from the real economy. And just as all other markets do the Jamaican market similarly moved money from the productive sector to investments on paper (deposits), which does not create wealth.

This contributed to the decline of the productive economy, and since no wealth was being created we had to borrow money to keep the country going. This in turn aided in the ballooning of our debt and resulted in us having to today use 70% of each tax dollar to service debt, instead of having it to invest in our people and infrastructure. This lack of funds and infrastructural investment has led to the decline in social conditions, as health and other social services are compromised, and real investments declined as monies were transferred from productive enterprises to paper investments, and real investments made difficult with a deteriorating infrastructure.

So if we want to stimulate economic growth, then certainly one tried and proven method of doing it is to reduce interest rates. The marginal interest rate reductions we have been seeing since the start of the year is already having a positive effect on productive investments. As interest rates come down then the relationship between paper and real investments changes. Real investments begin to become more attractive and debt financing becomes a little more affordable. This results in a move of money from investment in government paper to wealth creating businesses.

The varying of interest rates therefore has the effect of increasing or decreasing production, as it affects demand. In turn this also affects the currency markets, and exchange rates, as it means that if interest rates in the US are reduced then holding US$ is less attractive to investors as one would receive a lower return (interest rate) on the US$ when compared to say the Sterling. For this reason when the Fed cuts interest rates then it devalues the US in comparison to other currencies. A weaker US$, however, means that the relative price of US exports is cheaper in relation to exports from other countries, such as the UK. This will in turn have the effect of increasing the demand for US exports, in other countries, and reducing the demand for imports into the US from other countries against which the US$ has revalued.

When Jamaica was increasing interest rates we did not see any increase in value against the US$, however. In fact we still saw devaluations of the J$, although not at the rate it would have been if interest rates were lower. We sometimes got an indication of this as any attempt to reduce interest rates would lead to an increased demand for the US$, which shows that the Jamaican market acts rationally also.

Jamaica’s productive capacity
The reason why we did not see an increase in the J$ versus US$ is because at the base of a currency’s value is the productive capacity. In other words the only demand for J$ was because of higher interest rates, which meant that when persons wanted to convert the principal and interest to US$ there was no increased earnings to pay it from, as our productive capacity was on the decline. This means that we were using paper to pay paper, and not earning new monies to pay the high interest rates, while at the same time using the principal for non-productive activities.

This caused an increase in the “production” of high yielding J$ paper, which was being paid by the Government in turn increasing the “export” of money (high interest rates) not goods. So the behaviour pattern caused from interest rates does work in Jamaica. The problem is that it has the effect of increasing what one has the productive capacity to increase, which in our case was high yielding government paper.

The problem with Jamaica, therefore, has always been productive capacity. Logically when one varies interest rates, the objective is either to increase / decrease demand for goods or services. Our productive capacity was replaced, however, because interest rates were increased so high that non-productive investments provided a higher rate of return than productive activities. In addition, the loss of jobs because of increased interest rates also caused deteriorating social conditions further eroding the investment climate. So the rational behaviour of investors led them to invest primarily in high yielding government paper, rather than productive enterprise.

What has been happening recently, why commentators like myself are upbeat about our economic prospects is (1) interest rates have been coming down marginally, thus reducing the relative return of paper investments versus real investments; and (2) improvement in the crime levels creating a stable environment for investment. The primary threats to this fragile state are that with the upcoming elections (1) there is an increase in crime levels, or (2) irresponsible pubic spending. Both these conditions can have the effect of reducing investor confidence and pulling back any gains we have made.

I hope that this explains to my readers how interest rates affect underlying economic activity and their understanding that at the base of Jamaica’s problem is one of productive capacity.

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