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The Factor Of Inflation And Interest Rates That Many May Have Neglected
Malaysia Perspective | 22 April 2013

By Chong Kok Wai

Lately, there has been euphoria in the Asian property markets, as prices have risen sky high.  Many  own a few houses nowadays, some even accumulated more debt than they will ever be able to pay in their lifetime hoping that their owned house rental can automatically settle their debt obligation. The question we should ask is what really makes people so optimistic enough that they rent out several of their purchased houses? Why are they so confident that the property prices will rise perpetually? The reason could be due to the worries about central banks worldwide trying to outdo each other in printing money to debase their currency to such that it becomes worthless. People are betting for a rise in inflation and against low interest rates, which they believe, will remain perpetual.

Three factors that affect interest rates are government monetary policies, inflation and deposits. With government’s pushing towards lower interest rates, people can now borrow money at times almost at no cost to buy everything they can get their hands on, as long as their credit situation allows them. The other factor that people often neglect is the ability of governments and banks to borrow. With the economy not improving, governments worldwide have resorted to spending to spur the economy and to reduce unemployment. This causes budget deficits, as there will be a need for governments to find avenues to fund the habit. Governments usually do that through the issuance of bonds and they will pay a rate based on the ratings on the government’s ability to pay its obligations. If the deficits are too large, local and foreign parties will be reluctant to lend money to them. To pay their dues, governments will resort to other means, by printing money. These are however, not without their consequences. Inflation will shoot up sky high and the currency will be debased leading to chaos in the country similar to one extreme, that of Zimbabwe where its inflation sky rocketed to over several thousand per cent. Therefore, responsible governments should not just print money as they wish. To borrow more money, they will need to increase interest rates, accordingly. When interest rates increase, inflation will be curtailed. As we may see from this, government policies and actions often affect interest rates and hence, it will have effect on inflation too but mostly on a controlled situation.

Confidence In The Banking System Shattered
There is also neglect in the banking side of the equation because many people have never encountered a run in the bank before as most trust the banks to return money deposited with interest accumulated to them. A major business of a bank is to lend money in a higher interest rate than they pay their depositors. Therefore, demand and supply sets in. With demand for loans increasing due to the fear of rising inflation, banks will normally demand higher interest rates to generate more profit. With low rates paid to depositors and higher lending rates, banks particularly in Asia, which are shielded from the western financial crisis, are making record profits year by year. It will last as long as people are still depositing money into these banks and have the confidence that their value will not drop even though the rate of return is lesser than inflation. However, the turning point would appear when confidence in the banking sector is shattered. Recently, a situation such as this happened in Cyprus, when not only did depositors not see their savings increase; many had their savings reduced by no less than thirty per cent. This was due to a decision by none other than European Union (EU), which is one of the biggest policy makers in the world. In an instant, people all over the world began  to worry  that their hard earned money will be robbed by those they had trusted so much to protect them.  The fear may be contained by now as there is no run in banks worldwide. People elsewhere are not rushing to withdraw their money as they believe this is an isolated case happening in a country far away from them. I fear now that governors in the EU may feel that their strategy is a success and the damage, well contained. This might also encourage them to duplicate the same strategy to the next troubled state. This will inevitably cause fear and anxiety. Once sparked off, it could be a fire that would be difficult to douse.

In this situation, deposits in banks will dwindle and they will have lesser money to lend out. As this is the major source of income and working capital for banks, they will have to increase interest rates to attract people to put their money with them in order to survive. Interest rates in affected countries may have to rise to the level where people will feel comfortable placing their savings, in return for greater returns.

As the world’s economy is intertwined, and free flow of capital is easy in an open economy, a rise in the EU’s interest rate will inevitably cause Malaysia to be less competitive in attracting investment capital. If the central bank in Malaysia does not increase its interest rates in line with its major trading partners, the country will suffer a net capital outflow. To retain investment and capital in the country, Malaysia’s central bank will be forced to increase interest rates to be competitive with the others. So think about the above scenario and imagine what would happen to the properties that you own, if such a banking crisis happens? Also ask yourself, what will happen to the debt you have accumulated thus far? Please do ponder on that thought!

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