Keeping on the right side of interest rate changes

This article appeared originally in Gulf News: link to original article

The US Federal Reserve projects further hikes in 2019, and the central bank in the UAE will follow because of the peg. Interest rates, with multiple associations and interlinkages with many economic and financial factors, are also at the core of spending in an economy, via liquidity, as well as attracting investments into it.

To better understand rate hikes and its implications, such a relationship needs to be dissected into its effect on spending and investments. The relationship between rates and spending, or liquidity, is the more complex one. When rates are hiked, the direct result of such an action is decreased consumption by households as well as by corporations, with such an action affecting households and corporations differently.

For households, it means more expensive financing for unsecured loans, such as credit cards and personal, and secured ones, such as cars and mortgages. As for corporations, whose financing sources are either equity, ownership of stake in the corporation, or debt, a higher rate for the latter could diminish a corporation’s net income or profits.

For both cases, and in such times, cash is king. Choosing the source of spending is subject to how costly that source is. Therefore, a household with cash reserves could manage until interest rates reverse direction.

Similarly, corporations can opt for selling additional stocks if the return offered on those to stock holders is more manageable than interest paid on debt financing.

The net effect of curbing household and corporate consumption, or spending, is lower liquidity in the market that could be eased by government spending, which was witnessed through different direct and indirect initiatives by the different emirates in the UAE. Another way to supplement liquidity in the economy is by attracting foreign direct investments, made more attractive by higher interest rates and subject to how attractive those rates are in comparison to other economies or investment options.

The relationship between rising interest rates and attracting investments is a more straightforward one. As rates go up in a country, and financing becomes costlier, investing or even keeping cash at the bank could be more rewarding especially in times when cash is most sought after.

Investments into an economy will be conditioned upon multiple factors that determine the overall economic, financial, and business attractiveness of the country, and in the context of alternative options in proximity or elsewhere.

For instance, and since the Fed started hiking its interest rates in 2017, investing in the US became more appealing since it’s considered a natural safe haven due to the dollar’s role in the global economy. For countries, corporations, and individuals seeking modest returns from very safe investments, rising rates in the US favour its bonds to other available investments.

This is partly the reason behind the economic and financial woes faced by various countries that were somewhat attractive investment destinations when Fed rates were close to zero. Such countries include Turkey and Pakistan, with the latter’s stock market being the latest victim of higher Fed rates.

In the UAE’s case, less available liquidity can be balanced out with increased government spending without such spending leading to higher debt levels for the government. While investments into the economy have always been crucial for the UAE’s economic growth and prosperity, such investments are even more vital when rates are higher.

Investments into the economy would allow it to grow in times similar to those, when the cost of financing is more expensive than it used to be in the past few years, and is going to continue going up in the foreseen future. Attracting more investments will also keep government spending in check so that such spending can be garnered for other priorities rather than economic stimulation.

The last thought that I want to leave you with: how important is government spending to attract foreign direct investments?