Near-zero interest rates and their impact

I was brooding over the question as to why the US, Japan and Germany have near-zero interest rates and how it impacts the global financial markets. The following post is the answer to this question by Mr.Harshil Dave, one of my seniors at SDMIMD, Mysore. He is an MBA Finance guy working as a consultant at Oracle Financial Services. I agree with whatever he wrote about this topic on Facebook and I would welcome comments from my readers as well.

"In order to spur the GDP growth rate and reduce unemployment in their economies they need to provide incentive to businesses to borrow money from banks. By having near zero interest rates, the central bank is trying to encourage existing businesses and budding entrepreneurs and luring them by cheap credit. In theory, near-zero interest rates are supposed to help increase GDP growth rate (By capacity expansion and increased spending by businesses and households) and reduce unemployment (which stands at 9.8% in the US at present). After the crisis when major economies across the world were dragged into recession (which is characterized by multiple negative GDP growth rate quarters according to NBER definition of recession) the monetary policy makers had to cut down the interest rates to bring back the economy on positive GDP growth track. Near zero interest rates are also meant to restore confidence in the dried up inter-bank money market lending. This was in context of the US.

Coming to Japan, they have been a zero interest rate regime since a long time, you can refer to 'Yen carry trade' and 'Asian currency crisis' to go to the origins of the same!

Germany, had to follow France's footsteps of lowering the interest rates after Sarkozy accused Merkel of not taking adequate measures to combat recession!

Low interest rates increase liquidity in domestic economy, as in the case of the US what has happened is that since you can borrow money at virtually zero interest rates from commercial banks, the proprietary trading arms of big multinational banks have borrowed from their commercial banking arm and invested money in emerging economies like India, China and Brazil. Because of this we observe a surge in FII inflow led by prop trading desk activities and also by 'Dollar carry trade' (Selling short dollar against other currencies expecting dollar to depreciate on account of slow growth and more dollar bills being printed, and then investing that money made by shorting the dollar contract into other asset classes in Emerging economies).

Consider it as a tap of water (liquidity) opened by the Fed to aid the domestic economy, but the water (liquidity) spilled more in other places (Emerging Economies)! We see benchmark indices go up by 10-15% in matter of few months because of such liquidity. When the interest rates in the US will go up there is very high likelihood of reversal in this fund flows which can cause markets to crash in matter of few weeks!"