CENTRAL BANK AND THE BASE RATE

I. Central bank.
_ A central bank is an institution that is responsible for issuing currency, managing nations currency and banking activity. By doing so, central banks have the power to regulate the growth of the economy. There are two main kinds of central bank: the one who is independent with the Gorvenor (U.S, Japan, ) and the other is under the administration of the government (Viet Nam, Korea, ) _The functions of central bank: 1) Prints the national currency 2) Bank of the banks + Supervise all commercial banks activities. + Settles the mutual transactions of banks 3) Bankers, Agent and Adviser to the Government + Gives loan to the government. + Advice the government on monetary, banking and financial matters. 4) Controlling the macroeconomy by the monetary policies. It includes some tools: base rate, foreign exchange, required reserves, open market operations... In this paper, we will make a study about the base rate of central bank and its importance in the economy.

II. The base rate and its function:

1. Definition Base rate is the lowest rate set by the Central Bank for lending to other banks. In Vietnam, base rate is a rate which is published by the State Bank

of Vietnam as a basic for credit institutions and businesses to set their interest rate. .2.How Central bank acts on base rate: There are two ways for central banks to infuluence on base rates. -Normally the central bank effects on base rate by indirect way through openmarket operations to increase or decrease total payment method -The second way is direct effect by increasing or decreasing refinancing interest rate and rediscount interest rate. 3. The importance of base rate: It is the most important interest rate in the economy because it influences all the other interest rates. It curbs the inflation rate and promotes the economic growth. It maintains price stability and a state of full employment equilibrium. The Central Bank also uses base rate for orienting credit to banking system.

III. Case study:

In the early 2008, Viet Nam faced high inflation situation and commercial banks in Viet Nam also had problems with liquidity. In this period, the strict monetary policy of the Central Bank of Viet Nam gave a lot of challenges to the commercial banks. Because the Central Bank increased base rate, borrowing rates and lending rates of commercial banks fluctuated strongly. In June 2008, the base rate for VND officially increased to 14% a year (the highest rate in 2008). It also meant that the maximum lending rate that the commercial banks could set was 21% ( 150% of base rate). On 11 June, about 20 commercial banks announced to adjust their interest rate. For example, The Kien Long Bank in HCM set a very high borrowing rate of 20% a year for 12-month period deposits.

In this period, the commercial banks tried to increase the borrowing rates to attract depositors. However, the maximum lending rate which was set based on the base rate charged by the Central Bank was 21 %. Therefore, a lot of commercial banks were in trouble. The spread rate between borrowing and lending rates was very low and thus, the profit they gained from lending significantly decreased. Moreover, because the lending rates were too high, enterprises could not borrow money from banks to develop their enterprises, so the credit growth of commercial banks in 2008 was also low compared with 2007.

Besides, a lot of enterprises that borrowed money from banks had difficulties in repayment, bad debt ratio of commercial banks, therefore, crept up.

Bad debts of Vietnamese banking system in 2008:

The whole banking system State-owned commercial banks Joint-stock commercial banks Joint venture commercial banks and Foreign commercial banks 1.45%

3.5%

4.59%

2.44%

It can be said that the increase in base rate of the Central Bank in this year had strong effects on the commercial banks and economic growth.

VI/ Conclusion:

1. Base rate creates chances for credit institutions and customer to choose an appropriate interest rate. It helps credit institutions expand capital and mid- long term loans. 2.Base rate helps implement well the macroeconomic objectives, increase motivation for economic engine and contribute to the industrialization and modernization. 3. By making an appropriate profit for banks to offset operating costs and risks, base rate contributes to consolidate and develop the banking system.