Your Money: Know how currency markets effect interest rates

For that matter, our own Mumbai has a MIBOR. These rates are, however, not as widely used as LIBOR.

By Sunil K. Parameswaran

Interest is the rent paid by borrowers of capital to the lenders, for giving them permission to use funds available with the latter. Capital is a factor of production like land and labour. Just the way rent is paid for borrowed land, and wages for borrowed labour, interest is payable for borrowed capital.

Banks are dealers in capital. Like dealers of other assets, they too will quote two rates, one for borrowing and the other for lending. The difference between the lending rate and the borrowing rate is called the Net Interest Margin and is equivalent to the bid-ask spread in securities markets. The borrowing rate is called the ‘Bid’ while the lending rate is called the ‘Ask’ or the ‘Offer’.

LIBOR refers to the London Inter-bank Offer Rate. It is the rate at which a bank in London is willing to lend to another. The rate at which a bank in London is willing to borrow is called the LIBID.

Both LIBID and LIBOR can be used as benchmarks, as can their average, which is termed as LIMEAN. Of the three, LIBOR is the most commonly used benchmark. Other financial centres have offer rates associated with them, such as NIBOR in New York City, SIBOR in Singapore and TIBOR in Tokyo. For that matter, our own Mumbai has a MIBOR. These rates are, however, not as widely used as LIBOR.

Interest rates
The central bank of a country has various ways of influencing interest rates. Decades ago, interest rates were largely set by central banks. These days, in keeping with the prevailing economic mantra of free markets, the practice is to let interest rates be determined by demand and supply factors in the market. Central banks, however, influence rates by influencing the money supply level, which is a key determinant of interest rates.

Central banks can alter the reserve ratios for banks. The lower the reserve ratio, the greater is the percentage of a deposit that can be lent by the bank. This will bring down the net interest margin, for the banks have more money to play with. Consequently, they can afford to offer better, which means higher rates, to depositors, and attractive, which means lower rates of to borrowers. Open market operations too are a way of influencing interest rates. The central bank can increase the money supply by buying government securities from the market.

Supply of money
This will cause the supply of money to increase. If the supply goes up, the price must come down and consequently interest rates will decline. If the central bank were to, however, sell government securities, the supply of money will decline, and consequently interest rates will rise. The RBI in India also sets the Repo and Reverse Repo rates. The former is the rate at which banks can borrow from it, while the latter is the rate at which RBI can borrow from banks.

There is a close linkage between interest rates and currency markets. If the rupee is rapidly depreciating, RBI can prop it up by selling dollars and euros to the market. This will reduce the domestic money supply and cause domestic interest rates to go up. However, if RBI intervenes to prevent the rupee from appreciating by buying foreign currencies from the market inventory, domestic money supply will increase and interest rates will come down.

The writer is CEO, Tarheel Consultancy Services