Black Wednesday --- Interest Rate Cuts

Stock markets around the world fell as the credit crisis reduced confidence in the banking system leading to questions about the economic prospects with many economists forecasting recession and some even likening the current to the 1929 depression.

For the record, there are a number of similarities in how the crisis came about. No, they did not have sub prime and Alt A mortgages, and they did not have CDO's back then. But what they did have was a period of easy credit. The major difference between then and now is that our central bankers have learned their lessons and have intervened massively. Back then, the US government believed that government should not intervene in the market and kept this up until 1933.

Some may argue that the intervention came too late. Would it have been better to start intervening in 2007 when it became apparent that sub prime mortgages are being defaulted on? I guess we will never know. Still, better late than never.

The Hang Seng Index fell 8% to below 16,000 for the first time in 3 years. The HKMA cut interbank interest rate by 1.5% to 2%. The discount rate is 2.5% which is below the Hibor. In effect the HKMA and other central banks are acting a intermediaries to the banking system Banks with surplus funds are reluctant to lend to other banks and prefer to place the funds with the HKMA which then re-lends to banks needing short term funding.

Yesterday, the China announced that from today interest rates will be cut by 0.27% with lending rate at 6.93% and deposit rate at 3.87% (that's a spread of 3.06%, not bad if you can get it). At the same time, all banks will have their reserves requirements cut by 0.5% to 17% meaning that they will be able to lend more.

Some analysts on the mainland are negative on bank stocks because they believe that by cutting the lending rate this will cut into the banks profitability. Wrong! For banks, the most important drivers of profitability are the spread (i.e. the difference between the deposit rate it pays to depositors and the rate at which it lends to the borrowers) and the reserve requirement (i.e. how much they can lend out). As long as they maintain their spread, they will make more profits by lending more.

In fact, during periods of high interest rates, banks are actually less profitable because borrowers shy away from paying the high rates unless they are desperate (and therefore may be bad credit risks). Bad debts tend to rise when interest rates are high. So, low interest rates are good for the banks. Borrowers are more willing to borrow, investments make more sense because of the lower costs, and failure to repay is less.

By the way, China Construction Bank announced that 98% of their busines is in China and therefore their direct exposure to the credit crisis is limited.