4/25/2008

econs faq

decided to outline the basic economic theory behind some questions i've been asked, to provide a more complete answer.

if savings rates are higher in the united states/united kingdom, why shouldn't i put all my money in fixed interest accounts over there instead of the measly rates here.

First, let's look at this empirically, is this true? Did I make money on my GBP interest bearing accounts? First, take a look at this chart, a history of GBP-SGD exchange rates

http://www.exchange-rates.org/history/SGD/GBP/T

Let's assume I had indeed changed 2982 SGD into £1000, and put it into a fixed deposit in the UK starting 28/10/07, and I took my money out today, 25/04/08. This is a roughly 6 month period. On HSBC's online saver (UK), i have been earning an average rate of 6% AER (Annual Equivalent Rate, basically it means continually compounded interest), while for an equivalent small sum of money in Singapore, I can get a rate of about 0.57% for a 6 month fixed deposit. To be fair, the Singapore interest rate I have quoted is on the low end because there are other products out there with higher interest rates, but different terms and conditions... the best case scenario would be an average of 1.25% AER (You can find this at UOB, but you need $50,000)

2 strategies:
1. Keep my money in Singapore
2. Change it to pounds, keep it in the UK, change it back to SGD.

1000£ * 1.03 (taking a lazy arithmetic average) gets me £1030. Changing it back at today's SGD rates would get me £1030 * 2.7 = 2781 SGD. My net return is -201.00 SGD

if i kept it in singapore, i would have 2,982 * 1.0050 = 2,996. 14 SGD profit. Peanuts, but I didn't lose my shirt in the exchange rate market. Basically, the 5% gain I made on the interest rate was not enough to compensate me for the 10% depreciation in the pound. Bear in mind that the interest rate differential is usually not as high as 5% (the UK was in a boom and they had high rates, which are being lowered now, and the pound usually doesn't depreciate that much).

lesson 1: when you invest overseas, you have to worry about one thing: exchange rate risk. the starkest example: Indonesia has 9% interest rate. Would you put your money there?

As economists say, there is no such thing as a free lunch (otherwise, everyone can make money out of nothing. only traders can do that, haha, and they make money out of other traders).

So, what is the link between exchange rates and interest rates?

The numbers I have given you above are an example of the interest-parity condition. This is what finance people call a no-arbitrage condition, meaning that if opportunities for making crazy profit exist, people would have jumped onto it already. this is true (broadly) in theory, but we can examine examples later where this is not really true

the magic formula:

i - i* = (Ee(t+1) - E(t))/E(t)

In English:
i = domestic interest rate
i* = foreign interest rate
Ee(t+1) = expected future exchange rate, SGD/£ from a local perspective. you can replace this by the forward price on the market, which is the contract price to buy £ 1 year later, and is the official measure of expectation in the future and allows you to lock in at 0 risk what the future price will be.
(more later on how expectations are generated)
E(t) exchange rate now.

So RHS basically is expected depreciation (if positive) or expected appreciation (if negative). So local interest rates needs to be higher to compensate for expected depreciation, and lower if expected appreciation. This is a no-arbitrage condition, no economics involved so far.

2 caveats:
1. when there are expectations involved, this is a mean value. so you will find you could still make a profit/loss if on a particular day, the exchange rate happened to be higher/lower than usual due to some other factors. however, this profit for you would be a loss for someone else, so on average, people will make 0 profit. of course, if you are vigilant, then you could make money... but the expectations will indicate the general trend for the currency.

2. This is a static formula predicting the general trend. For the actual path movement, you need some dynamics, which take a little more time to explain, but still pretty intuitive. difficult without a graph though.

For example, a popular trade is the yen carry trade
http://en.wikipedia.org/wiki/Carry_trade#Currency

You borrow at low interest rate from countries like Japan and lend it at a higher rate to countries overseas. How is this possible? Well, you make money but you bear the risk if you are holding on to some of these assets when the trade unwinds. Basically, don't get caught holding shit.

http://www.moneyweek.com/file/20635/why-is-the-carry-trade-so-dangerous.html

Okay economics time

so, isn't the british citizen so lucky, he/she doesn't worry about exchange rate risk, but can benefit from higher interest rate?

firstly, you have to check the real interest rate. japan has 0% nominal interest rate, but they have price deflation, so they have positive real rate of interest (because when you get your money back in 1 year, prices have changed). so you check by subtracting inflation from interest rate, which is a good approximation. so the uk has higher inflation than singapore, for example, and they have correspondingly higher interest rates. singapore is also suffering from a bout of inflation now, but this is largely imported inflation. singapore has to strengthen the sgd even more to fight this (which is how we do it, we're small economy so we take the interest rate as given... more on this later).

let's say real interest rates are still low. then what do you do? you borrow. interest rates are the price of savings. everyone just wants to leave their money there to grow interest for nothing, so you borrow their money, buy property, start a business, some asset, generate returns on them, and you get less knocked off your profits. low interest rates are business friendly. they reward people for borrowing money to take risks to generate excess return.

if you want to save, go to a place where everyone is in debt. yeah, true, maybe the US. haha. the US is a net borrower from the rest of the world, running a deficit. also, the long term trend for currencies like the sterling and USD is downwards (with regards to less inflationary currencies, such as the Singapore dollar and the Euro). This is because they generally print more money each year and have a higher rate of inflation. (they do this because they believe in lubricating the economy and growth. europe, on the other hand, is scared of inflation, because germany suffered hyperinflation. inflation is generally bad for savers, good for borrowers). Go look at the historical data on USD and Sterling, and it has been a long-term downward slide.

However, note though that the US can sustain such large deficits because it basically prints the money the world uses as a reserve currency. This is a form of seignorage (or money the government gains by printing money, net the inflationary effects of money). this will change as USD keeps losing its value and people switch to Euro or multiple reserve currencies.

What causes inflation?

Big country (Endogenous)

MV = PY

Flow equation. velocity of money flow * quantity of money = price level * output
any increase in the flow of money (e.g. greater credit access) or money supply (printing money, banks loan out more money as they have lower reserve ratio) leads to an increase in price level, if output is constant. anglo countries like to raise money supply slightly faster than output to prevent any liquidity bottlenecks from occuring in the economy, slowing growth down.

i
n countries like singapore, though, we do not have that much power to set prices because they are determined in foreign currencies, so our rates are pretty much determined by the arbitrage conditions above, while we control inflation by adjusting our exchange rate. this is a balancing act. too strong, and our exports cost more and are less competitive. too weak, and things we import cost a lot. so it depends on whether you want growth or inflation. same trade-off as big countries, just different mechanisms.

so why doesn't a singapore bank offer marginally higher interest rates to attract customers?

I'm not a banking expert. The rates we experience in general are influenced by SIBOR (Singapore interbank offer rate). This is the rate at which banks lend to each other (because every day out of the millions of clearances, some will owe more than others to another bank because of a transaction between a party from this bank and another bank, and they need to settle the outstanding balance.

this is the same in the UK, where LIBOR is used. strangely enough, SIBOR takes its cue from the US Fed Rate. Let me present a basic schematic of the banking sector

Central Bank:

Assets (Foreign Reserves FX + Loans to Government LG)
Liabilities (Monetary Base (Printed Money) MB)

Commercial Bank:
Assets (MBb, Reserves at the Central Bank, L Loans to Public)
Liabilities (Deposits)

So a bank's deposit rate will be influenced by the rate it can get on its reserves and the loans, and the costs of borrowing from other banks.

do banks offer different interest rates? well, there are a wide variety of savings products and loan products with differentiated rates and terms, which is how they like to compete (differentiate, compete by getting a niche or suiting a certain group's niche). but it's also the reason why petrol companies don't charge different prices at the pump. because the product (savings deposits) are roughly homogenous. if one bank raises rates to get all the customers, the others will follow suit to avoid losing all of them. so there's no point being destructive to their profits, especially since there is not much competition. the last bout was when singapore liberalized and allowed more foreign banks in.

let me end with a game that michelle told me was played with her kids. basically, the game was to bid for a 2 dollar note. the highest bidder would get the note, while the second highest bidder would have to pay for the bid. so, the smartest thing would be for someone to say 2 dollars, or not to say anything at all. their profit will be 0. if someone said 1.99, you just have to say 2 dollars and you will get the note for free, so it's irrational to set anything less than 2 dollars. if you bid to 2.01 and then someone has an incentive to outbid you, then you have an incentive to outbid him, and him to outbid you, because there is no point finishing second once you're at that stage. so the bids will go to infinity. this is why the price of the 2 dollar note will settle at 2 dollars, and it is the same thing with most homogenous commodities with a price. it's bertrand competition, redux.

more next time... please correct me where i'm wrong





1 comment:

huifang said...

hey jesse, i am impressed! haha. a nice summary of the real world application of the EC315 models :)