Interest Rate Disparity between RBA and Major Australian Banks - Case Study Example

Interest rate disparity between RBA and major Australian Banks Student’s name Course Institution Date Letter of Transmittal RBA is responsible in executing monetary policy that are geared towards promoting economic growth, reducing inflation rate, lowering unemployment rate, and reducing inflation rates. The objectives are achieved through monetary policy such as interest rates or exchange rates. The report provides an explanation on interest rate disparity between RBA and major Australian banks, and the highlight factors the RBA take into account when determining interbank interest rates. In addition, list and explain the reasons given by banks for not matching the interest rate cuts together with the reasons why the treasurer believe that banks should be passing rate cuts on to the public. The report also investigates and reports the situation to similar changes of central/federal bank interbank lending cuts in other countries such as China, India, and Europe over the last year. Lastly, a brief conclusion is provided. Executive Summary This report seeks to explore the presence of interest rate disparity between RBA and major Australian banks. Since last year, there has been extensive media coverage on the state of Australian economy, as well as the role of RBA in promoting consumer confidence. Australia has a desirable, well-built economy with its GDP per capita equivalent to that of four leading west European economies. Stressing on policy and structural reforms, near to the ground persistent rise in price, a housing boom in the market and growing strong relations with China forms the basis of the economic expansion that Australia has recorded over the past fifteen years. The Reserve Bank of Australia as one of the G20 was the initial country to constrict monetary policy right after the financial crisis through the central bank of Australia that increased its cash rate in October 2009. Monetary policy refers to the actions pursued by the central bank of a country to normalize the sum of currency supply in the economy. The actions can be either on interest rates or on exchange rates. Monetary policy can be either expansionary or contractionary policy. Therefore, a target is also referred to as an objective. It is the aim of any economic policy and it can be measured in reference to an economic variable like unemployment rate, growth of Gross Domestic Product (GDP), or rate of inflation. The main objective of RBA is to boost economic growth and investment. This can be achieved by lowering cash rate that translates to a decline in lending rate by commercial banks. The report also outline factors such as inflation, exchange rates and economic growth as the main determinants considered by RBA in calculating cash rates. As inflation pressures loosen, it is prudent for the central bank to cut on interest rates. In addition, the exchange rate should be considered because commercial banks source huge amounts of their funding from overseas. In the same line of thought, a slow down in economic growth necessitates a monetary policy such as interest rate cut in order to stimulate growth. The interest disparity between RBA and Australian banks is because of a number of reasons such as local banks huge borrowing costs, global environment, and profit protection. Other countries including China, India, and Europe also undertake the same monetary policy as an instrument to boost economic growth and investment. The monetary policy adopted is interest rate cut by central bank. The intended objective is not attained because commercial banks do not pass on the changes in interest rates to consumers. Table of Contents Letter of Transmittal 2 RBA is responsible in executing monetary policy that are geared towards promoting economic growth, reducing inflation rate, lowering unemployment rate, and reducing inflation rates. The objectives are achieved through monetary policy such as interest rates or exchange rates. The report provides an explanation on interest rate disparity between RBA and major Australian banks, and the highlight factors the RBA take into account when determining interbank interest rates. In addition, list and explain the reasons given by banks for not matching the interest rate cuts together with the reasons why the treasurer believe that banks should be passing rate cuts on to the public. The report also investigates and reports the situation to similar changes of central/federal bank interbank lending cuts in other countries such as China, India, and Europe over the last year. Lastly, a brief conclusion is provided. 2 Executive Summary 2 4 Table of Contents 4 Introduction 5 India 9 China 10 Europe 11 References 12 Introduction All through 2011 and since the start of the year 2012, there has been extensive media coverage about the state of the Australian economy and RBAs role in promoting public confidence. The RBA tries to influence the economy by raising and lowering the cash rate with a view to keeping some economic parameters in a narrow range: such as unemployment, inflation etc. Despite the RBA lowering interest rates by 25 basis points many times, the commercial banks have not reduced their interest rates by a similar amount. In this context, monetary policy in an economy lies on the relationship between the sum of cash and the rate of interest in the economy. Monetary policy employ a number of tools in controlling the amount of money supplied and the interest rate to influence variables like unemployment, inflation, exchange rates and economic growth. Where only the central bank is vested with the sole power of issuing currency, the bank will have the power over the amounts of money that should be in circulation. With the ability to change the amount of money supply it will also affect the interest rate. It is essential for policymakers to come up with realistic announcements, and protest against interest rate targets since they are irrelevant and not essential in relation to monetary policies (Woodford, 2003). Factors considered in determining interbank interest rates The main objective of Australian government is to boost economic growth. Therefore, the country policy makers will have to adopt a growth targeting monetary policy. Under this monetary policy, the target is to improve economic performance. The growth target can only be attained through the central bank periodical adjustment on the interest rate target. The economy will adopt a contractionary monetary policy where the amount of money supplied in the economy is increased through interest rates cut leading to growth and increased investment. With the open market operations, the interest rate can be kept constant for a particular period. The policy committee on a quarterly or monthly basis reviews this interest rate target. The changes made on the interest rate target occur in response to a number of market indicators in an effort to foretell economic patterns. This will ensure that the key objective of an economic growth target is achieved. When cash rate is lower than the expected, the commercial banks are likely to increase interest rates. This is a contractionary policy since it will ensure a just economy and a low interest rate. On the other hand, in the event of low cash rate far below, the local banks will respond by lowering the interest rate. This will increase the amount of money in circulation; hence, the inflation will be steadily increasing (Dowrick, Pitchford & Turnovsky, 2004). The other factor used by RBA to determine interbank interest rate is economic performance. Australia’s economy is recorded as one of the strongest and fast growing economy in the world. The economy has recorded a fall in unemployment and economic growth. With the economy, engaging in vigorous policy and structural reforms the economy has turn out to be resilient, flexible, and well integrated with worldwide markets. In the recent years the economy has be able to overcome both internal and external milestones such as a housing boom, major drought and the economic and financial crisis that had hardly hit the Asian community. The market forces determine interest rates and as such, the economy faces the risks of uncertainty because prices fluctuate on a daily basis. Therefore, it brings confusion among importers and exporters since they are not sure of the exact price. In addition, it may act as an impediment to investment, and the economy is at risk of lacking investment both internal and foreign investment. The other risk is that an economy is vulnerable to high inflation rates, and as a result, an economy will face adverse economic times. Furthermore, an economy will be exposed to the risks of speculation; this will destabilize and damage the economic performance of the country. An economy will also face the risks of mounting deficits in relation to balance of payment deficits. As such, the RBA use the prevailing conditions in the market in order to determine interbank interest rates. Reasons Given By Banks for Not Matching the Interest Rate Cuts The chief reason provided by Australian banks is profits protection. The commercial banks increased interest rates in order to protect profits. They maintain that during the global financial crisis commercial banks incurred high borrowing costs. Commercial find the interest rates charged on borrowers as appropriate since it cushion their profit. Australians banks faced high total funding costs because most of their funds are sourced from overseas. The competition among banks in Australia in seek of new borrowers, as well as the uncertainty of lending money during global economic crisis affects the funding costs of local banks. Uncertainty in the global environment is another reason given by local banks. Local banks in Australia still nurse the effects of the global financial crisis, and they fear a repeat of the same may adversely affect their operations. In addition, banks in the global market are still undergoing difficult times, and as such, it will make local banks overseas borrowing costs to increase. The basis of determining lending rates is also another reason for banks not to match their interest rates with those of RBA. Despite banks using that changes in RBA's cash rate as a basis for setting corporate borrowing rates, they also link the loans other money market rates and bond prices or fixed rates. As a result, customers on market rates benefit when the rates decline, even early than the move taken by RBA. Therefore, the move to pass on rates changes should not be blanket-like, but in relation to loans that are referenced to the reserve bank of Australia cash rate (Walsh, 2003). Whenever there is a cut on interest rates, commercial banks should pass on the changes in rates to the public. The treasurer should ensure that rate cuts are passed to the public in full. This is because local banks should be forced to adhere to new changes, otherwise consumers may not benefit from interest rate changes. On the contrary, when interest rates are increased by RBA, commercial banks pass on the increase in full to consumers, but when the rates are lowered borrowing costs for banks is not affect because they source more than one-thirds of their lending money from overseas (Gramont, 2001). The decrease in interest rates will help homeowners to pay their mortgage prices easily, and pay low than expected. Further, it will prevent other customers from switching their loan to other loan providers with favourable terms such as families. In addition, the number of loan borrowers will decline since it is expensive to service a loan. In that connection, banks will have less demand for loans; hence affecting the amount of money in circulation. The economy faces the problem of low money supply during a sub-prime crisis. The problem of low money supply is associated with low growth rate due to reduced investment because of high interest rates. The impact of high inflation is also experienced during such as situation. The resulting effect of reduced money supply can be tackled by the monetary policy. Tools of monetary policy such as open market operations, reduced cash rates, and reduced reserve requirements will lower the rate of interest of the economy. The government through reduced cash rates will advance loans to banks at a lower rate. This implies that the money held by the banks can be increased. As a result, banks will have money to advance to consumers at a lower rate so that investment options can be taken. As a result, high investment rate will boost economic growth (Jadhav, 2006). The expansionary monetary policy has a positive effect on the challenges that an economy is going through in a sub-prime crisis. The challenges include low growth rate and skyrocketing interest rates. The policy will reduce the interest rate which is a recipe for increased capital investment, hence an improvement in economic growth. The use of discretionary monetary policy is suitable for the reserve bank of Australia in control of the prevailing economic crisis.The result of a sub-prime crisis is ballooning inflation rates; the households find it difficult to meet their daily needs. To reduce the high inflation rates that are closely related with the deficiencies within the financial sector is to adopt monetary policies that are geared towards reducing the interest rates and stability of commodity prices (Ferrero & Nobili, 2008). Situation in Europe, India and China India In India, the Reserve Bank India cuts interest rates as an effort to boost economic growth. The country's growth and investment was stagnating, and needed a stimulus in order to improve. The objective of the monetary policy is to stimulate investment and economic growth. The RBI lowered the repo rate by 50 basis points to eight percent. The RBI in the last two years has increased the interest rates more than thirteen times. The move taken by Reserve Bank of India reflects a shift in the policy of the bank from exclusively focus on bridling in inflation to reviving the slow performance of the country. The move is meant to stimulate investment and growth after controlling inflation. The other policy improvement was to increase borrowing limits for local banks to 2 per cent. This will increase liquidity in the economy; hence shielding the country from the debt crisis in Europe (Mishkin, 2007). Furthermore, lending rates will be reduced but industrialists are sceptical that local banks will pass on the changes in interest rates. The policy adopted by RBI will take time to trickle down to businesses and consumers. Locals banks fail to match the cut in rates with their lending rates because global financial environment remained challenging (Bofinger, Reischle & Schachter, 2001). China People's bank of China as a monetary policy to revive and boost economic growth decided to cut interest rates to 6.06 percent by 25 basis points in the second and third quarter of 2012. The poor economic growth experienced in China is because of US and Euro zone slowdown. The monetary policy was adjusted because there was a gradual ease in inflation pressures as indicated by low external demands, appreciation of renminbi, as well as home economy slow down. The Central bank of China will also reduce the reserve requirement ratio by 50 basis points. The fall in consumer price index to 3.33% in 2012 as compared to a 5.4% in 2011 offers leeway for the People's Bank of China to relax its monetary policy as the local economy register poor performance. It is indispensable for the central bank to relax its policies in order to boost growth. Furthermore, the China's economy in the last two years has experienced negative real interest rate. This implies that deposit interest rates should remain constant, but the loan interest rate should be cut. This will encourage investment and boost domestic demand (Mercier, 2011). Europe European Central Bank (ECB) undertook monetary policy especially interest rate cut in order to counter the effects of financial and economic crisis. It is also meant to save the euro. The nations that constitute the euro zone have experienced stagnant growth since 2008 when it was hit by the economic and financial crisis. The zone cuts interest rate to 1 % by 25 basis points. The move is meant to save the depreciating currency, that is, euro. Low interest rates will boost growth and investment, hence translating to appreciation of the currency. It is evident that the nations have a strong political goodwill to ensure that macroeconomic policies are implemented to the later. This will ensure that the intended objective is achieved. It is also a long due solution to be delivered by ECB. The action will also ease the Euro zone absolute debt pressures (Fendel, 2007). Conclusion The use of interest rate cuts as a monetary policy by RBA is the best action in ensuring economic growth and increased investment. However, the move cannot achieve its intended objective because of interest disparity between RBA and local banks. Banks fail to pass on the change in interest rates to consumers. It is essential for the economy to use other actions such as political reforms in order to achieve the intended objective of economic growth and increased investment. In addition, it will increase consumer confidence because of minimal uncertainties. Commercial banks should match their lending rates with cash rate in order to protect consumers from high cost of borrowing and living. References Bofinger, P., Reischle, J., & Schächter, A. (2001). Monetary policy: goals, institutions, strategies, and instruments. Oxford: Oxford University Press. Dowrick, S., Pitchford, R., & Turnovsky, S. J. (2004). Economic growth and macroeconomic changes. Cambridge, U.K.: Cambridge University Press. Fendel, R. (2007). Monetary policy, interest rate rules, and the term structure of interest rates: theoretical considerations and empirical implications. Frankfurt am Main: Peter Lang. Ferrero, G., & Nobili, A. (2008). Short-term interest rate futures as monetary policy forecasts. Roma: Banca d'Italia. Gramont, C. A. (2001). Monetary policy, interest rate rules, and inflation targeting: some basic equivalences. Cambridge, MA.: National Bureau of Economic Research. Jadhav, N. (2006). Monetary policy, financial stability, and central banking in India. New Delhi: Macmillan India. Mercier, P. (2011). The concrete Euro: implementing monetary policy in the Euro area. Oxford: Oxford University Press. Mishkin, F. S. (2007). Monetary policy strategy. Cambridge, Mass.: MIT Press. Walsh, C. E. (2003). Monetary theory and policy (2nd ed.). Cambridge, Mass.: MIT Press. Woodford, M. (2003). Interest and prices: foundations of a theory of monetary policy. Princeton, N.J.: Princeton University Press. Read More