Manipulation of Interest Rates in India by Central Bank

Introduction

(McKinnon, 2001) found that, interest rates are manipulated by central banks that intervene with a limited enforcement power. Central bank is a monetary authority and has the responsibility to control monetary policy for its particular country as well as a group of states who are members under the control of the central bank. The major role of central bank is to ensure the stability of its national currency as well as its supply. However, central bank has other active duties such as regulating loan interest rates and lending money as the last resolution to other banking sector especially during financial crisis. Private Banks also benefit from the services. Central bank also supervises the interest rates of other financial institutions to ensure that they are not offered recklessly and to avoid such institutions are not fraudulent. In more developed countries, the central banks are “independent” in the sense that, they are not interfered by the political trend as they operate under strict rules specifically designed for them. Such central bank includes European central bank and US Federal reserve. Such banks can be owned by the public for example Reserve bank of India where it is governed by Indian government or they can be private. However, public or private ownership of bank makes no difference in the manner in which they control interest rates of other banks as well as other financial activities. All the profits made by both private as well as private banks are remitted to the government in form of tax.

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Interest rate intervention by central bank

(Lovell, 2000) argued that, it is the role of central banks to control both short and long-term interest rates and this in a great way influence stock as well as bond markets including mortgages. An example is illustrated by the European central banks where the interest rates are announced when the governing council is convening their meeting, and if it is the case of a federal reserve, during the meeting of the board of governors. There exists at least one central body making up either the Federal Reserve or European central bank. The role of such a central body is to make decisions regarding interest rates as well as the size of open market operations. Central banks also control the functioning of its various branches that enable it to implement its policies. These central bodies perform the role of the local Federal Reserve banks while in the case of European central banks they act acts as national central banks.

Limits of central banks in controlling interest rates

According to (Haussmann, 2004), the central bank of India known as reserve bank of India is not as powerful in effecting its policies as many people perceive. It is important to note that, majority of Indian think that the central bank manipulates all the interest rates as well as currency rates contrary to the economic theory. There is enough empirical evidence that illustrates how it is not possible for the central bank of India to perform both duties at the same time, especially if the banks are operating in an open economy. One formulation known as “impossible trinity” by Robert Mundell is famous in explaining such limited powers. The formulation argues that, it is not possible to target interest rates under monetary policy and at the same time target exchange rates through a fixed rate while at the same time the central bank is maintaining free movement in its capital. Majority of economies in the western world have adopted open economy and operate on a free capital movement. It is therefore possible for the central banks to target interest rates as well as exchange rates with enough credibility but it is difficult to target both at the same time. Even when the central bank decides to target on the interest rates, it may be limited in influencing such rates expected from private individuals as well as companies. Research demonstrates an example of such a policy failure by George Soros who arbitraged the relationship between the sterling pound and the ECU. George made a $2 billion by himself and made the UK to defend the pound thereby spending not less than $8 billion. However, he latter forced the UK to abandon the policy and considered that a great lesson in implementing bank policies. Since then, George has been criticizing bank policies that are clumsy and advices people to be careful in making such decisions as it is difficult for anyone to reach the far he went in implementing the policy.

(Bhattacharyya, 2000) argued that, in order to facilitate the operation of open market, central banks operate with foreign exchange reserves through government bonds as well as official gold reserves with some influence on official and mandated exchange rates. Some of these rates are managed by the central banks while others are market based and therefore floats freely. Other such rates are in between the two forms. Control of market interest rates is commonly the visible as well as the obvious power perceived by most people regarding the roles of the central banks. That popular belief is a misconception because central banks only set fixed rates in rare circumstances. Research has shown that, the mechanisms through which interest rates are arrived at are different in various countries. However, in most cases, there is similarity whereby, there is minimal influence by the central banks on the setting of fixed interest rates.

According to (Olney, 2002), Central banks normally adopt a mechanism to influence market towards achieving ‘target rate’ and it does this using any specific rate. This is done through borrowing or lending of money that in theory is in unlimited amounts till the market rate is almost equal to the target. Central bank does that by lending to, as well as borrowing from qualified banks within specific limits. It can also achieve this target by trading in bonds. Bank of India influence overnight interest rates using such mechanism within a band of ± 0.25%. Those banks that qualify are allowed to borrow each other within this range but never outside these limits. The central bank ensures that, it has lent to these banks at the top of the range and borrows from them at the lowest extreme of the band. Central bank therefore has unlimited capacity to lend to as well as borrow from these banks. Various other central banks including the central bank of India have a similar mechanism. Research indicates that, the target rates set by the central banks are generally offered on short-term basis and are not very much related to the rate extended to the borrowers or lenders at the market.

(Delong, 2002) found that, the actual market rates are largely influenced by perceived credit risks at that particular time. The rates also depend on maturity as well as other factors. Central bank for example may decide on 4.5% as a target rate meant for overnight lending. However, equivalent risk may influence rates for five-year bonds to be 5% or even 4.75%. For inverted yield curves, the rates might even be lower than the short-term rates set. Majority of central banks operate on a single ‘headline’ which refers to the rate quoted specifically for central bank. On the ground, central banks make use of other tools as well as other rates but generally ensure that, only one target that is rigorously enforced. When central bank lends money to other banks, it can choose on the rates at will and these rates are the one that make financial headlines. In general, central banks operate on a variety of interest rates as well as tools for monetary policy in influencing markets interest rates. It can use marginal lending currently rated at 4.25% in Euro category. This is a fixed rate at which central banks lends money to other banks and is referred to as discount rate in the United States of America. The other type of interest rate is known as main refinancing rate which in Euro zone; it is rated at 3.75%. This interest rate is regarded as visible to the public because it is announced by the central bank. The rate is also referred as minimum bid rate and acts as a guide for other banks for refinancing loans. This rate is known as federal funds rate in USA. The other category for interest rates for central banks is the deposit rate which in Euro zone is rated at 3.25%. All these rates affect money market rates directly regarding short-term loans.

Interest Rates in India

According to (Benson, 2003), interest rates in India follow a trend that is largely influenced by key determinants as well as policies in the liberal financial and credit markets. Both internal and external factors have been influencing short-term and long-term interest rates. The relationship between the exchange rates and interest rates also plays an important role in determining the interest rates. Research about India liberal market reveals that, there has been a relationship between nominal commercial paper rates as well as certificate of deposit rate and the increase in money supply, world interest rate, industrial production as well as expected inflation. All these variables also relate with real certificate of deposit. Short-term nominal interest rates are influenced positively by world interest rates and growth rate of money supply as well as forward premium. On the other hand, in India, short-term real interest rates are influenced by variables such industrial production and world interest rates as well as forward premium. Study also shows that, theories of both covered and uncovered interest parity do not exist in India.

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(Shah A. (2003) argued that, the extent to which short-term real interest rates respond to world interest rates has relatively been more compared to nominal interest rates. In India during pre-reform period, GNP’s growth rate and fiscal deficit as well as world interest rates have positively influenced long-term interest rates. During the post- reform period, major determinants of interest rates appear to have been fiscal deficit and inflation expected in the market. Contrary to the expectation of the majority, variable such as money supply, world interest rates as well as GNP’s growth rate have not had a significant role in determination of long-term interest rates during the period of post-reform. Further research shows that, structural break for long-term nominal interest rates has existed but this has not been the case with the real interest rates for the period 1970-2000. Study has also revealed that when exchange rates undergo an appreciation, it influences interest rates to be high. This is advantageous to the liberal market in India because when the exchange rates appreciate, the benefits are usually more compared to the cost that is incurred in raising the interest rates so as to defend the currency. Since 2001, India has experienced a lower actual level of interest rate compared with the natural rate of interest which is considered more stable. Such a difference between the two clearly indicates that, there is inflation in the country’s economy although this may largely be attributed to the savings-investment gap.

According to (McKinnon, 2001), the major influence of interest rates in India has been the liberalization of the market; an idea that was welcomed by majority but which caused soft interest rates policy to give rise to various adverse economic as well as social consequences. From evidence, higher interest rates encourage savings while lower interest rates discourage saving on one hand while on the other hand, the change of interest rate does not encourage or discourage investment. When the interest rates are low, the savers especially the rural savers are harmed. Research has shown that the variables that are currently influencing interest’s rates in India are not likely to cause any reduction in the interest rates. The recommended interest rates in India are targeted to be slightly higher than the current rates as long as they are controlled in a flexible manner.

Central bank of India

(Lovell, 2000) found that, Contrary to believes of many people, Saudi Arabia monetary agency; abbreviated as SAMA and which is the central bank of India has many other roles other than just controlling the country’s interest rates. The survey of an interview with the governor of the central bank reveals that, SAMA’s role has been changing to match the change in the domestic financial market. Although SAMA is not the only variable that influences the trend in the interest rates in Indian market, it undertakes various steps in providing sound as well as effective banking system and therefore providing a stable economy. It also maintains prices in the domestic market at a level that is stable and of real value as far as Saudi riyal is concerned. SAMA is the sole agency that formulates policies on monetary transactions and uses a number of liquidity instruments in influencing conditions regarding money markets. As a supervisory authority, it has a framework on supervision as well as regulation that meets codes according to the requirement of international financial standards. It makes the market prices stronger and more transparent therefore protecting the consumer as well as investors. In case a customer forwards a complaint regarding a particular bank, SAMA intervenes and provides a resolution between the two parties. As one method of monitoring interest rates, SAMA has utilized the modern technology to develop sophisticated payments as well as settlement systems and this has improved efficiency in the manner in which the financial markets functions.

Indian interest rates have remained unchanged

(Haussmann R. (2004) argued that, Indian central bank sometimes during extra ordinary circumstances, exercises its authority and goes beyond many people’s expectations. For example at the moment, it has made the interest rates to remain at 7.75% and this has disappointed quite a number of investors who hoped for a cut. Economists have argued that, if the prices of food and fuel go up, the situation will impact negatively on the reserve bank of India even than the consequences of sub-prime crisis that have occurred in US. Interests rates in India increased by a factor of five between mid 2006 and March this year where they have stagnated since then. Some economists expected that, a cut was likely to occur especially because the United States Federal Reserve has reduced the rates but the central bank of India has maintained interest rates at a constant. This shows how influential the central banks sometimes can be on the market interest rates making them not to reflect the reality on the ground.

Concern for rupee

According to (Haussmann, 2004), reserve bank of India has agreed to reduce the interest rates after it has observed any likelihood of slowdown. The reserve bank said that, more intensified monitoring as well as swift responses using all adequate instruments would be warranted by developments in financial markets globally as far as sub-prime crisis are concerned. This will be in order to preserve as well as maintain stable macroeconomic and stability in financial flow. Research has shown that, the difference between the interest rates in the United States and that in India is the largest in a period of three years. This is creating concern because the disparity is likely to push higher the rupee and consequently, Indian export will be less competitive among other currencies on the world market.

(Delong, 2002) found that, prominent central banks such reserve bank of India are focusing on price stability as the main objective of their single monetary policy. It leaves the moderation of long-term interest rates as an objective for the open market. This concern was a consequence of financial crisis that occurred in1990s. The process of transmitting changes by central banks through monetary policy to achieve objectives commonly referred to as monetary transmission mechanism influences exchange rates. Although customers as well as investors do not know with certainty how this objective is achieved, transmission channels that are known in literature such as the interest channel are used somehow effectively. The functioning of the interest rate channel in Indian economy like in other states is largely influenced by the extent of development of the country’s economy as well as its respective financial structure.

Weakness of the central bank of India in influencing interests rates

According to (Delong, 2002), research has shown that, the forecast made by the banks can never be perfect and even comparing forecast of the great-7 central banks in the year 2008 supports that conclusion. When these forecasts are made against those of India, each central bank has been found to project growth; in its interest’s rates below the actual performance in the market. When the actual performance of the economy in India differs from the forecast initially made by the central bank, a change is required on the policies regarding rates as this may end up in the country relying on interest rates that are not genuine. From that reasoning, if growth in Indian economy is faster than initially expected, interest rates would rise to unexpected inflationary levels. Conversely, a question arises on whether central bank of India would be willing to lower the rates if their expectations seem too optimistic. Study shows that, the eventual interest rates’ level does not appear to depend on whether the forecast made by the central bank of India on the country’s gross domestic product is right or wrong. A lesson should be learnt from the mistakes that are done by the central banks in such predictions. For example, when the central bank of India makes changes in the interest rates, it can take between 12 and 18 months for the change to be effected in the country’s economy. During this period, individuals as well as business alter spending together with saving patterns. They are therefore forced to reset their rates in order to catch up and as a result, forecast that are guided by the economy are important as they provide a guide to the central banks during their rates setting decisions at such times.

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Commonly asked questions regarding interest rates

  1. What is the relationship between price and Yield?
  2. What are interest rate swaps?
  3. What are Overnight Interest Swaps?
  4. What are Money Market Instruments?
  5. What is Commercial Paper?
  6. Who Regulates Indian G-Secs and Debt Market?
  7. What factors determine interest rates?
  8. What are G-Secs?
  9. What do you mean by “Cum-Interest” and “Ex-Interest”?
  10. What are interest rate risk, re-investment risk and default risk?

Conclusion

The findings of the research agree with the conclusion that, interest rates are manipulated by Central Banks and have no connection to reality. the central bank of India through it errors in making its forecast maintains interest rates that are not reflecting the current trend of the country’s economy in regard with the interest rates required by its liberal markets. Formulation of an effective monetary policy by the central bank of India to influence interest rates in the country’s economy is also a complex process. This is because the emerging markets in the country are on transit progressing from relatively closed to an open economy (Benson, 2003).

References

  1. McKinnon R. (2001): REASSESSMENT OF INTEREST-RATE POLICIES IN ASIA: Oxford University Press pp. 23-34
  2. Lovell S. (2000): Central Banking in Undeveloped Money Markets: Book land pp. 45-53
  3. Haussmann R. (2004): Exchange rates and financial fragility: Elsevier pp. 25-34
  4. Bhattacharyya A. (2000): European Journal of Operational Research: Elsevier pp. 19-27
  5. Olney P. (2002): Saving, Investment, and Growth in India: Oxford University Press pp. 56-67
  6. Delong J. (2002): Macroeconomics: McGraw-Hill/Irwin pp. 43-49
  7. Benson M. (2003): The Foreign Exchanges: Theory, Modeling, and Policy: Palgrave Macmillan pp. 34-42
  8. Shah A. (2003): Interest Rate Risk in the Indian Banking System Indian: Oxford University Press pp. 78-95
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