Negative Interest Rates!

Where this world is headed? Negative interest rates? Do I have to pay banks for letting them have my money?

Yes and why not? Are you not paying parking fee while you park your car at public places? Are you not paying a fee to keep your things at Cloakroom?

That’s fine but banks are not keeping my money with them like the car I left in the parking slot! They make use of my money and earn income on my money!

But the income they earn on your money is increasingly becoming less and less and risks they assume for doing that are increasing day by day!

This can go on and on…but the truth is that negative interest rates are being talked about these days pretty frequently.  In early May 2013, President of European Central Bank (ECB)  Mario Draghi told reporters that the ECB might actually charge banks for the privilege of depositing cash with it overnight. That’s a sign of how weak the European economy is. The demand for cash is so weak that Mario Draghi might not even take it from the banks when it’s free. The ECB doesn’t want more cash because it can’t lend it out profitably.

Within a few days after Mario Draghi’s statement, President of Swiss National Bank (SNB), Central Bank of Switzerland Thomas Jordan gave a statement that a shift in its ceiling on the franc or a negative rate on commercial banks’ excess deposits was in the SNB’s toolkit.

Also, in February 2013 The Bank of England’s Deputy Governor had floated the idea of negative interest rates being applied to commercial banks’ deposits in an effort to force them to increase lending.

Negative interest rates are not new. One Central Bank in Europe is already charging negative interest rates.  Denmark, which has its own currency, has kept overnight interest rates negative for some time to discourage an influx of hot money that would drive up the value of the krone and make Danish goods and services uncompetitive in world markets. As reported by Bloomberg News, the Danish central bank’s deposit rate has been below zero since last July. It’s currently a negative 0.1 percent.

Switzerland made aggressive use of negative interest rates during the 1970s, when it was trying desperately to dissuade capital from flooding the country as investors sought a safe haven from the ravages of global inflation and fears of instability. Netherlands and Germany also had a brush with negative interest rates during this period.

Why negative interest rates?

When there is ample liquidity in the system and yet there is no growth in credit (i.e., lending), regulators think of ways to incentivize the lenders (i.e., banks) to perk up their lending. But many a times, banks are reluctant to lend as they fear about the safety of funds lent. They prefer the safety of parking the funds with their central banks. Under such circumstances, charging of negative interest rates is expected to make banks look elsewhere to deploy their funds and banks will be compelled to increase their loan book or investments.

Negative interest rates are also used when a currency appreciates to undesirable levels, perhaps due to its safe haven status. Such a strong currency will have adverse impact on exports and will make imports pretty cheap. This will result in dampening the economic growth.  Negative interest rates, under these circumstances, will provide a strong disincentive for hot money flows.

What kinds of negative interest rates central banks have?

Central banks can reduce interest rates below zero in two ways. The first one is to reduce the interest rates paid on excess reserves of banks held with central bank to below zero. The second one is to reduce the policy rate i.e., the rate at which central banks will lend to banks against collateral to below zero.

Negative interest rates – do they work?

Negative interest rates do have some desired impact when a currency becomes too strong and appreciates to undesirable levels. By assigning cost to holding of home currency, central banks are able to discourage undesirable inflows. This has been the experience of some European countries. This is true when negative interest rates applied to excess reserves the banks hold with the central bank.

When negative interest rates are applied to policy rates, the impact may be far reaching and may not be said to be too desirable.  Main functions of money are to serve as a medium of exchange, a unit of account, a store of value (i.e., purchasing power). Negative interest rate policy strikes at the root of one of money’s main functions i.e., its role as a store of value.  In fact, negative interest rate policy reverses money’s role as a store of purchasing power, and turn money into a drain on purchasing power.

Unwillingness to hold currency may not necessarily stimulate the economy by encouraging productive activity and investment. It is likely to encourage people to convert their money into other assets, preferably with good liquidity such as gold, a foreign currency and even a digital currency! During the period of ultra low interest rate regime in USA, Gold and Emerging Market currencies had a field day. Now, when US Fed started giving indications of reducing QE and easy money policy, Gold and Emerging Market currencies started wobbling and saw pretty steep decline! Bitcoins (a digital currency – see my earlier blog) made news in the recent times precisely for this reason (i.e., ultra low interest rates in US).

In this context, it is worthwhile to have a look at Japan. Japan has spent almost twenty years at almost zero interest rates and had multiple rounds of quantitative easing and stimulus. Yet Japan’s economy remains sluggish.