Thursday, January 15, 2015

The case for an independent rate

[An article from almost 2 years ago.]

May 02, 2013

An unnaturally low interest rate encourages inequality, worsens inflation and jacks up property prices.

By Soon Sze Meng And Tan Tien Leong

For The Straits Times

SINCE independence, Singapore's interest rate has followed the United States'.

This interest rate is regarded as risk-free - it provides a price for savings and investments and is often described as the market rate of interest.

At the same time, however, there is also a natural rate of interest (Federal Reserve Bank of SF). This is set when individuals with savings they do not immediately need lend them to borrowers. Singapore's natural rate of interest (Moneyness) lies between its inflation rate and economic growth rate, which is around 3 per cent.

An appropriate rate protects bank depositors from the corrosive effect of inflation.

Australia's central bank, among others, sets the market rate of interest as close as possible to the natural rate of interest.

Singapore's central bank does not.

In recent years, the US interest rate has declined to near zero, forcing Singapore's market rate of interest to the same level.

If Singapore's market interest rate followed its natural rate, it would be much higher: at around 2.75 per cent, which is the midpoint between the latest 2013 gross domestic product (GDP) forecast of 2 per cent and 3.5 per cent inflation forecast.

This divergence between Singapore's natural and market interest rates has remained for longer than expected. In previous recoveries, Singapore's recovery was tied closely to the US', with corresponding increases in its interest rate. Now, however, our country's growth rate has recovered while US growth remains in the doldrums.

Social impact

THERE are three unintended social implications to this divergence between the market and natural interest rates.

First, inappropriately low interest rates encourage and entrench inequality.

Wealthier individuals are able to borrow cheaply at artificially low interest rates and leverage their wealth to enjoy high-yielding investments.

Given their limited asset base, poorer individuals do not have this option. This is true even if their intrinsic creativity, drive and value creation abilities are similar to their wealthier counterparts'. Singapore's Gini coefficient, a measure of income inequality, has risen constantly in the past decade.

Second, excessively low market interest rates drive up inflation by stimulating aggregate demand. Fixed-asset investment increases due to low discount rates. Meanwhile, demand for consumer durables such as cars rises due to cheaper loans.

Higher spending also occurs due to the wealth effect as share prices rise. High inflation is a regressive tax on those that earn less. Meanwhile, the purchasing power of their savings is eroded as banks pay close to zero interest.

Finally, there is the fact that high housing prices discourage household formation. When the market interest rate is lower than the natural interest rate, potential bank depositors will choose to put their wealth into property instead. In other words, property becomes a store of value.

The growth rate of resale Housing Board flat prices has been consistently higher than the growth rate of median salaries since 2007. In some years, the difference has reached 9 per cent. Because couples cannot afford to purchase their own homes, potential marriages and childbearing are deferred.

[While the authors have a point about how low interest rates encourage investment in housing which drives up property prices, I believe the housing pricing is more complicated than that. ]

Relook rate regime

IN THE light of these adverse social effects, why not recalibrate our interest-rate regime so that interest rates are allowed to follow the natural rate and are not artificially depressed from being linked to the US interest rate?

One reason is the fear of uncontrollable capital inflows if interest rates here rise above those in the US. The Singapore dollar would also appreciate rapidly, as people would want to hold Singdollars for the higher interest offered.

Most economists argue that Singapore, as a small and open economy with net exports close to a quarter of our GDP, has to manage its exchange rate to ensure competitive exports. Arguably, since price inflation is mostly imported, a managed exchange rate should reduce the impact of inflation.

However, these arguments need to be re-examined.

With our interest rate in lockstep with that of the US, Singapore is already attracting significant capital inflows. Capital flows are not determined by interest rate differentials alone. Other factors include a desire for a safe haven, and regional investor preferences.

Moreover, Singapore's economy is now large and resilient enough to adopt an independent market interest rate with a significant savings pool to intermediate borrowers and savers.

Our GDP of US$240 billion (S$294 billion) in 2011 is similar to Australia's at US$1,370 billion when population is taken into account. Singapore's level of bank deposits per capita is also significantly larger than that of the US or Japan. Our GDP per capita is around US$51,000 and is nestled above Japan's and Finland's.

[The important thing to note is "per capita". SG's per capita income is among the highest in the world. But when comparing economies, it is the total economy. That is why China is now the largest economy in the world, even though their per capita GDP is a fraction of SG. But capital inflows will flow into the overall economy, and a large economy like China is less affected, whereas a small economy like SG could be deluged. Which is why though SG may be equivalent to Australia on a per capita basis, $240b is still less than 1/5 of $1370b.]

Furthermore, net exports do not appear to be adversely affected by a rapidly appreciating currency. From 2006 to 2011, net exports have averaged around 27 per cent of GDP with a 6 per cent deviation, even though our currency has strengthened by 23 per cent.

[Because exports are not simply the results of weak currency. The point to be made is that despite our strengthening currency, our economy and market were still competitive enough to increase net exports. ]

Finally, an appreciating currency has not been very effective in reducing inflation recently.

Since March 2010 our currency has strengthened by 12 per cent against the US dollar. But inflation has been consistently higher than the Monetary Authority of Singapore's 2 per cent informal target. This suggests that inflation is more domestically driven and less sensitive to imported inflation. Significantly, oil prices have remained unchanged at around US$100 per barrel since March 2010.

[Jan 2015 update. It is now below US$50.]

Price inflation is now driven by cars and houses, which together account for 40 per cent of our consumer price index basket. Policy measures such as higher stamp duties and curbs on car loans cannot overcome the root cause - the unnaturally low interest rate which spurs demand for car and housing loans.

[Jan 2015 Update: Cuts in COEs have managed to curb car sales and car loans. Other "cooling" measures have curbed the rise in housing markets.]

Short-term pain

HAVING an independent interest-rate framework would be a monumental step in Singapore's economic development. Such a policy change, however, would not be without cost.

Small and medium enterprises would face higher financing costs, and lower housing prices would affect the profitability of local developers. The exchange rate of the Singapore dollar would also become more unpredictable. Bank profits may be affected in the short run.

The long-run benefits, however, outweigh these short-run costs. Having a market interest rate close to the natural interest rate would help the majority of Singaporeans maintain the value of their savings. In addition, we would no longer be fostering an investment environment which disadvantages the poor. Inflation would also be better managed.

In the long run, bank profits would rise due to higher interest rates for corporate loans. Rising bank profits would also encourage banks to issue more loans to small businesses.

Lastly, because house prices will fall, married couples would find it more affordable to buy a home. It might seem a long stretch, but a higher interest rate might just have a positive impact on the country's flagging fertility rate.

[Yes it is. A long stretch, I mean. ]

Soon Sze Meng is a regional director working in a multinational corporation. Tan Tien Leong is chief investment officer of a local investment company.

[This article is being "re-presented" because of the salience of the need to fight inequality. I am not saying that higher interest rates WILL make the difference, but we should and can consider it.]

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