Interest rates are going up. But what does that mean, and how does the UAE make it happen?
The basic idea is that central banks create an option for financial institutions that is too good to refuse.
If a central bank sets an interest rate of 2 per cent, it commits to buying an unlimited amount of financial institution assets, and then giving them back to the banks plus 2 per cent.
Banks can always earn a nominal rate of return of 2 per cent by parking cash at the central bank. So they have no incentive to do anything that earns them less money – that 2 per cent is risk-less and guaranteed. So banks set the price at which they are willing to lend funds above (or equal to) 2 per cent.
This affects companies. If a company cannot borrow funds for less than 2 per cent, it will always make a loss on debt-financed investments with a rate of return below 2 per cent. And if a company has cash reserves, it can earn 2 per cent simply by placing cash into the short-term money market – it no longer needs to invest in products that earn less than the minimum rate of return.
Across the economy, the central bank interest rate determines the minimum rate of return on investment. Anyone who puts their money into an investment, project or loan with a lower interest rate could generate a higher return by simply parking their cash at the central bank, or in a short-term debt market.
This effects the overall amount of investment and credit in the economy – lower rates mean more investments are profitable, and that credit is cheaper.
But how does the UAE Central Bank set the interest rate?
The main tool used by the UAE’s central bank is the certificate of deposit.
These are short-term deposits of funds by financial institutions at the central bank, on which the central bank pays interest.
Banks submit bids every weekday morning to the central bank, allowing them to decide what value of CDs they would like to buy and over what time period.
Now that the UAE Central Bank has raised interest rates, these CDs pay 1.25 per cent, not 1.0 per cent.
That means financial institutions can earn a guaranteed return of 1.25 per cent on deposited capital – and discourages them from issuing any finance that earns them less than this.
To see the impact of the rate change, imagine an investment that had a rate of return of 1.1 per cent.
Before the rate change, a bank had an incentive to invest its money in this project, since it generated a higher return than the back would otherwise have got from the Central Bank.
But now, the bank can earn more money just by putting its cash in the Central Bank – it is no longer sensible for the bank to invest in this project.
If you imagine that this project is a new housing development in Dubai, for instance, you can see how changing the interest rate affects the real economy.
After 2008, the central bank introduced a new tool to help panicking banks find funds in a pinch – the marginal lending facility.
Banks could temporarily lend the central bank assets in exchange for emergency funds – plus a 1 per cent haircut.
This affects the bank’s minimum short-term cost of capital – when all other funding avenues have been exhausted, the cost to the bank of raising new funds is the interest rate it pays on emergency funds (the interest rate plus 1 per cent.)
Similar logic then applies – it does not make sense for the bank to invest in projects that earn a rate of return below this price, since banks will record a loss on these.