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.

Long Term Investments and Inflation Indexed Bonds

Inflation is one of the biggest worries for investors, especially for those who need to invest for a longer term (say 10 years or more) to provide for their retirement and old age.

Imagine redeeming your bank deposit with accumulated interest after 10 years and then finding that the proceeds cannot even buy half the amount of goods and services that the principal amount would have bought 10 years back! Thus, a depositor will have to face a lot of uncertainty on real value of his savings. Therefore, there is a need for instruments which will not only provide return on investment but will also protect the value of the principal against inflation.

Inflation Indexed Bonds are ideal instruments under these circumstances. An Inflation Indexed Bond (IIB) protects investors from the uncertainty of inflation over the life of the bond. while IIBs are similar to conventional bonds in payment of interest at fixed intervals and return the principal at maturity, the fundamental difference is that unlike conventional bonds which make payments at the contracted nominal rate, IIBs make payments that are fixed in real terms (and thus are called real bonds). The interest payment and return of principal of IIBs are adjusted for changes in the rate of inflation from the date of deposit till when these payments become due.

The primary benefit to investors of long-term IIBs is that they would give investors a long-term asset with a fixed long-term real yield that is free from inflation risk.

Historically, investors in long-term conventional bonds or bank deposits have been exposed to substantial inflation risk. In 1955, for example, the US Treasury issued a 40-year bond with a coupon rate of 3 percent. Because the actual inflation rate over the past 40 years was 4.4 percent, an investor who bought this bond at full price and held it to maturity received a negative 1.4 percent yield on this investment ( i.e., 3& – 4.4% = -1.4%).

In this context, the IIBs which Reserve Bank of India proposes to issue might be a good alternative to bank deposits for long term retail investors. Consider these aspects (from RBI Notification):

  1. IIBs of RBI will be having a fixed real coupon rate and a nominal principal value that is adjusted against inflation. Periodic coupon payments are paid on adjusted principal. Thus these bonds provide inflation protection to both principal and coupon payment. At maturity, the adjusted principal or the face value, whichever is higher, will be paid.
  2. Index ratio (IR) will be computed by dividing reference index for the settlement date by reference index for issue date (i.e., IR set date = Ref. Inflation Index Set Date / Ref Inflation Index Issue Date).
  3. Final Wholesale Price Inflation (WPI) will be used for providing inflation protection in this product. In case of revision in the base year for WPI series, base splicing method would be used to construct a consistent series for indexation.
  4. Indexation Lag: Final WPI with four months lag will be used, i.e. Sept 2012 and Oct 2012 final WPI will be used as reference WPI for 1st Feb 2013 and 1st March 2013, respectively. The reference WPI for dates between 1st Feb and 1st March 2013 will be computed through interpolation.
  5. Issuance method: These bonds will be issued by auction method.
  6. Retail Participation: Non-competitive portion will be increased from extant 5 per cent to up to 20 per cent of the notified amount in order to encourage participation of retail and other eligible investors.
  7. Maturity: Issuance would target various points of the maturity curve in order to have benchmarks. To begin with, these bonds will be issued for tenor of 10 years.
  8. Issuance Size: Each tranche of IIBs will be for `1,000 – 2000 crore and total issuance would be for about `12,000-15,000 crore in 2013-14.
  9. Issuance Date: First such tranche will be issued on June 4th 2013 and the same would be issued regularly through auctions on the last Tuesday of each subsequent month during 2013-14.

RBI says that Second series of IIBs will exclusively be for retail investors and will be issued in second half of the financial year 2013-14.

First series of the IIBs will help in determining the coupon rate for the bonds through auction. This will help in benchmarking IIBs. Based on the experience in the initial issuances, second series of IIBs for the retail investors is proposed to be issued around October 2013. RBI says that terms of issuance of IIBs for retail investors would be announced in due course.

So we need to wait for auctions in June 2013 to have an indication on copoun (interest) rates for these bonds.

Added on 21st June 2013:

On 4th June 2013 the Reserve Bank of India sold 10 billion rupees worth of 10-year bonds at a real yield of 1.44 percent over the wholesale price index.

The Reserve Bank of India (RBI) will conduct the second tranche of inflation indexed bonds (IIBs) auction for Rs 1,000 crore on June 25, 2013. These bonds of 10-year tenure (2023) will carry a real yield of 1.44 percent. With a real yield at 1.44 percent, the coupon rate will be around 8.28 percent. Those bonds are linked to the wholesale price index (WPI) based calculations. RBI had earlier mentioned that the monthly final WPI would be used with a lag of four months. Hence, this auction rate is connected to February WPI which was at 6.84 percent.