WHY AN INCREASE IN THE US’S INTEREST RATES COULD AFFECT YOU BUSINESS ON THE OTHER SIDE OF THE WORLD

This week’s top news story in the business world is that the Federal Reserve (that is the Central Bank of the USA) has announced an increase in interest rate by 0.25%. This announcement was accompanied by a similar rate hike by the Central Bank of the UAE. But how does the increased interest rate affect you, especially if it is the Fed’s increase and you live on the opposite side of the world?

The direct effect of an increase in interest rate by a Central Bank is that it increases the interest rate at which commercial banks borrow money from them. These Central Banks regulate the flow of money in the economy and the business of commercial banks to make sure that they are stable. However, there is a ripple effect to the increase in interest rate (if you are already familiar with this, skip down to the third paragraph). When Commercial banks have to borrow money from the central bank at a higher interest rate, they shift these interest rates unto people who are coming in from loans at their branches.

With higher interest rates, companies that have already taken out loans that have variable interest rates should note that the interest they are paying on their loan has increased. At the same time, some people who intended to take out a loan may no longer go forth with it because it has become more expensive to take out a loan. Ultimately, the mechanism is meant to decrease the amount of money circulating in the economy to control inflation rates as they rise. Since the economies of the world are interconnected and certain economies like the US’s are powerhouses, the decision by the Fed can lead to affect even in the economy of a country farther away.

That said and done, how does this situation apply in the UAE with the major difference of Islamic Banking to also take into consideration. In many countries where there is Islamic banking (like the UAE), the currency is “pegged” to the dollar and the country operates a dual financial system where Islamic banks operate on “conventional” interest rates. Pegging a currency means that the country stocks up on foreign reserves that make it possible to fix the rate of its currency to a more stable one like the dollar so that the rate of exchange remains the same even if the other currencies value changes. The long and short of it is, though interest rates were also raised in the UAE, because of this dual financial system, the increase will only be felt by non-Islamic banks immediately. If there is to be any effect at all, it will be a bit sluggish and will take time. (More on Islamic banking and monetary regulation)

The Fed intends to increase interest a few more times this year as the American economy grows. However, we cannot be sure of what will happen next because this growth could be affected by policy decisions but thus far, things have been improving and we are hopeful it remains so.