A familiar yet unfamiliar concept – interest rate (3)

(Full text count: 1620 words, it takes about 5 and a half minutes to read)

Brothers, sisters, younger brothers and sisters, hello everyone, I am classmate Wang.

I've had a cold these past two days and can't read at all. So this will be a very boring article. If your time is precious, you don’t need to read further. Because it will waste everyone's time, and these few minutes can be used to do other things. If you happen to be free, go ahead.

01 | What will increase the interest rate?

Prices in Beautiful Village have risen relatively high recently, and they are always calling for interest rate hikes. Let’s start from here.

The so-called interest rate increase is the base interest rate. The base interest rate is the core of interest rates. Loan interest rates for businesses, individuals or others are based on the base interest rate plus various factors such as time and risk. The way each country determines its benchmark interest rate is different. Developed economies, especially the United States, the United Kingdom or Japan, all use the interbank interest rate as their benchmark interest rate.

When the Federal Reserve raises interest rates, it mainly increases the U.S. federal benchmark rate (FFR), and its main adjustment is the overnight lending rate. [1] Raising interest rates increases the cost of lending funds to each other among commercial banks. Since the interest rate for corporate entities to borrow money from banks is based on the base interest rate plus time and risk premiums, the cost of capital will definitely be transmitted to the corporate entities, and in turn affect the money flowing in the market.

02 | Principles of interest rate hikes

The Fed’s interest rate hikes or interest rate cuts are not mandatory administrative orders, but are operated through market means. The specific principle is as follows.

First of all, the Federal Reserve itself is the largest player in the interbank market. Assuming that the Federal Reserve cuts interest rates, the Federal Reserve will reduce the cost of borrowing funds between itself and other commercial banks. Other commercial banks will see that it is cheaper to borrow money from the Federal Reserve. They will tend to cooperate with the Federal Reserve. In order to lend money out, other banks have to follow up and cut interest rates, so the cost of borrowing money in the entire market drops.

Conversely, if the Fed raises interest rates, the cost of borrowing money from the Fed will be higher than the cost of borrowing money from other commercial banks. At this time, there are two situations. First, there is very little money in the market, so banks have no choice but to borrow high-cost money from the Federal Reserve. Second, if there is a lot of money in the market, then other banks can choose not to cooperate with the Federal Reserve, borrow money from other cheaper commercial banks, and leave the Federal Reserve aside. However, the Federal Reserve has a backup plan, which is to sell the United States in the Treasury market. National debt reduces the amount of money flowing in the market, forcing commercial banks to borrow from themselves. In the end, the cost of borrowing money will definitely rise.

In short, no matter what the situation is, the Fed has the ability to influence the market. Moreover, all banks believe that the Fed has this ability, so the Fed does not need to use this ability to influence the entire market, as if we know that we cannot beat Tyson, so we will not try at all.

03 | About Shibor

In my country, due to its late start, interest rates like the London Interbank Offered Rate (Libor) or the U.S. Federal Reserve Rate (FFR) have not been fully formed. The refinancing interest rate [2] and the rediscount rate [3] are mainly used as the benchmark interest rate. They are collectively called the deposit and loan benchmark interest rate or the legal interest rate. In our country, people generally use the one-year fixed deposit interest rate as the market benchmark interest rate, while banks use the Shanghai Interbank Offered Rate (Shibor) as the benchmark interest rate. [4]

The current overall situation in my country is that commercial banks have gradually transitioned from keeping a close eye on the benchmark interest rates for deposits and loans to referring to Shibor, and Shibor will gradually become China's benchmark interest rate.

Let’s talk about my country’s benchmark deposit and loan interest rates. Do you think they are only one-year? No. When the central bank sets a benchmark interest rate, it will set each time period, and then commercial banks will set their own deposit and loan interest rates for each time period according to the given standards. Due to the gradual increase in interest rate marketization, the deposit and loan interest rates of each bank are now different, but they all fluctuate within a range set by the central bank and are not fully market-oriented.

That’s all for today. In the next article, we will talk about some of the tools used to adjust interest rates in our country.

May you be brave and diligent, and may all your wishes come true.

Student Wang

2022.7.8

[1] The overnight lending rate mentioned here is not the same thing as the interbank lending rate mentioned above. The lending rates include overnight, one week, two weeks, January, March, June and one year, overnight is just one of them. This interest rate is generally a simple, unsecured wholesale interest rate on funds.

[2] The interest rate at which we borrow from commercial banks is called the lending rate, and the interest rate at which commercial banks lend to the central bank is called the refinancing rate.

[3] The interest rate we discount to commercial banks is called the discount rate, and the interest rate commercial banks discount to the central bank is called the rediscount rate.

[4] Starting from January 2007, 16 banks (four major banks + 6 joint-stock banks + 3 city banks + 3 foreign banks) have summarized the daily fund lending prices of various maturities. Remove a highest price, remove a lowest price, and calculate the arithmetic average of the other prices as the Shibor of each period, which is released at 11:30 on each trading day.