Warning: Long read and it’s really for econs wonks.


gold link pocket watch

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Last Sunday, I wrote about how interest rates in Singapore have to go up because of rising interest rates in the U.S. I suspect many people don’t know the mechanism behind this so I thought I’d explain how it works for Singapore.

But first, we need to know what interest rates are.

Interest Rates

It’s the rate that banks charge you when you take a loan. Similarly, they are also the rates that the banks pays you in order to deposit money at the bank and keep it there.

Of course, the rates that the bank pays a depositor and the rates that banks charge borrowers cannot be the same but they are related. This describes the most fundamental way a bank makes money — by borrowing money from depositors and lending out most of the deposited sums at a rate higher than the rate that the bank pays a depositor.

How Banking Works

However, the fundamental issue with making loans with depositors’ monies is that if a sufficient number of depositors all want their money back at the same time, the bank will be in trouble because the money has been lent out and the loans may not be due for some time. This is known as borrowing short and lending long.

Usually, there aren’t problems because most depositors don’t close their accounts all at once and as long as you have enough depositors that are convinced that the bank is going to be able to return their monies when they want it, the bank will be fine.

The bank will also be fine as long as the monies that they’ve lent out gets repaid with interest included. This is where the basic job of a banker is to ensure that the borrower is credit-worthy and/or has collateral that the bank can seize in the event that the loan goes sour. Of course, sound bankers will make sure that they aren’t overexposed to any one industry so that the bank can’t be brought down by any downturn in any one industry.

However, what’s described in the preceding two paragraphs doesn’t erase the fact that banks still face the problem of “borrowing short and lending long”. This is where the banks can borrow in the credit markets to overcome any short-term liquidity needs. The rates that banks have to pay to borrow in these markets are the Singapore Interbank Offered Rate (SIBOR) and Swap Offer Rate (SOR). (see here for an explanation of the difference between the two.) More importantly, you have to understand that SIBOR and SOR represent the cheapest rates that a bank can borrow money for and if these rates are the cheapest, then if these rates go up, then all other rates (the rate paid to depositors and the rate charged to borrowers) will tend to increase as well. In Singapore, the rate quoted on housing loans are typically pegged to SIBOR or SOR and therefore, the SIBOR or SOR will directly affect the interest rates paid on housing loans.

Why Interest Rates in Singapore tend to follow the U.S.

Lately, the U.S. federal reserve has been making headlines for raising rates and how they’ll probably raise interest rates a few more times in 2019. The Federal Reserve is the Central Bank of the USA and effectively acts as the lender of last resort. This effectively means that any bank under the Fed’s jurisdiction can borrow (or be forced to borrow) from the Fed to cover their short-term liquidity needs. The interest rates charged by the Fed are essentially what SIBOR or SOR is to banks in Singapore.

At this point, some people (and this happens for many of my students) wonder why can’t the Monetary Authority of Singapore (MAS), Singapore’s central bank just hold interest rates in Singapore steady or independently of what the Fed in the U.S. is doing.

The answer to this lies in what we call ‘The Trilemma” or “The Impossible Trinity”.


red triangle

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The Impossible Trinity

In economics, the impossible trinity says that any economy has to choose between:

  • Controlling the exchange rate
  • Free flow of capital
  • Independent Monetary Policy (i.e. controlling interest rates)

In Singapore, we’ve chosen to allow free flow of capital and to have some control over our exchange rates which is why interest rates in Singapore are greatly influenced by interest rates outside of Singapore.

Before we look at why this happens, let’s look at why we in Singapore would want free flow of capital and to control the exchange rate.

Free Flow of Capital

First of all, Singapore is a financial hub for South-East Asia. This means that money has to be able to flow in and out of Singapore with very little to no restrictions. This is important for a few purposes but mainly it’s important for investor confidence and trade.

If you want foreign investors to put their money to work in your country, you have to reassure them that their money won’t be at risk of sudden confiscation, suspension or devaluation. This is why free flow of capital is necessary to attract foreign investors.

The second reason is trade. For the buying and selling of goods to take place, money needs to exchange hands. Since Singapore is a global trans-shipment hub, we need to ensure that money can exchange hands here to facilitate the buying and selling of goods. Once again, if we don’t have free flow of capital, that can’t happen.

Controlling the Exchange Rate

The issue of trade also leads us to the point on exchange rates. Buying and selling of goods typically happen in local currencies. In order to a company in China to sell something to Singapore, the company in China needs to receive Chinese Yuan (RMB). That means that whoever is buying the good in Singapore needs to exchange their Singapore Dollars (SGD) for RMB before the trade can take place. Similarly, if we’re exporting things to the USA or elsewhere, an exchange of foreign currency needs to happen.

If the value of the SGD fluctuates greatly, no one would be willing to accept SGDs in exchange for goods. Therefore, a highly unstable currency leads to a breakdown in trade or the use of alternative currency (e.g. the highly inflationary environment in Venezuela right now has lead to Venezuelans using alternative currencies like the US dollar).

Trade, being such a huge component of Singapore’s GDP, requires that the SGD remains relatively stable. Furthermore, as we import quite a lot of goods and resources to our daily living, having control over our currency means that we can retain some control over inflation as well. Controlling interest rates won’t be much of a lever on inflation since most of our inflation will be ‘imported’ i.e. our inflation rate depends greatly on the price of the goods and resources that we’re importing.

Why We Have to Give Up Control Over Interest Rates

Since we choose to have free flow of capital and control over the exchange rates, the impossible trinity says that we have to give up control over our interest rates. Let’s look at what happens when monetary policy between Singapore and another country, for example, the USA, diverges. In fact, this is exactly what’s happening in the world today.

As the Fed raises interest rates in the U.S., it becomes more attractive for investors/depositors to deposit money in the U.S. Investors in Singapore (assuming rates haven’t moved relative to the U.S.) will tend move their capital from Singapore to the U.S. Remember, in Singapore, we have free flow of capital so this can happen.

However, in order for this movement of capital to happen, investors need to exchange their SGD for USD. Selling the SGD to buy USD causes a depreciation (appreciation) in the SGD (USD).

Singapore, or rather, the MAS, in wanting to retain control over the exchange rate will then have to buy these SGD being sold in order to prevent the SGD from depreciating too far. And what does MAS buy SGD with? Why with foreign currencies of course. The question is where does MAS get their foreign currency from?

The answer is that foreign currency first enters the country’s financial system either for the purposes of trade or foreign investment. MAS facilitates the conversion of these foreign currencies to SGD. The excess foreign currency held by MAS is placed in our foreign exchange reserves where they are used to control the exchange rate as described in the preceding paragraph.

The problem is that if such a scenario continues, MAS will eventually run out of foreign currency and will have to let the SGD depreciate greatly. This is exactly what happened to the pound (which Soros is famously known for betting on) in the early 90s and other Asian currencies during the Asian Financial Crisis.

Therefore, MAS cannot allow there to a difference in interest rates for too long. Specifically, if rates outside of Singapore are much higher than the rates here, MAS has to either allow the SGD to depreciate or interest rates in Singapore have to rise in tandem with rates in the U.S.


In sum, it’s been a long, long post but if you’ve read this far, I hope you’ve gotten a better understanding of why rates in Singapore have to follow rates outside of Singapore (particularly the U.S. as financial markets there are huge). If you understand this, I’d say that you already have a better working knowledge of SGD and interest rate movements than even some people working in the banks.