Understanding Negative Interest Rates

Negative interest rates have been creating a buzz over the past few months. Paying interest for deposits, instead of earning interest, is coming into vogue. The world of central banking and economics is becoming more confounding by the day.

An overview of the inflation across some of the major economies of the world in 2015 is as below. Near zero inflation is one of the key driving factors behind the Negative Interest Rates.

Inflation in 2015

The emerging economies are struggling with a high inflation rate. Prices are on the rise across the BRICS countries, causing a lot of pain among consumers. High inflation, as seen in Brazil and Russia, is considered to have a negative impact on the economy.

On the other hand, the advanced markets are dealing with a near zero or subzero inflation rate. In 2015, most of the economic powerhouses in Europe and the USA have recorded an inflation rate less the healthy benchmark of 2%. This has the Central Banks across the advanced economies worried.

Meanwhile, the US Fed increased the base rates for the first time in a decade in December 2015. The oil prices are below 40 US Dollars a barrel. The slender inflation, and even deflation in some countries, is impacting consumer growth in the advanced economies. This in turn is impacting exporting countries like China. China is in a slowdown.

In such challenging and evolving economic conditions, central banks across the world are increasing adopting a Negative Interest Rate Policy to manage the economy.

The Actions by the Central Banks

It will be worthwhile to understand the actions related to negative interest rates by different central banks across the world.

The Danish National Bank (DNB) was the first central bank in the world to adopt the Negative Interest Rate Policy in July 2012. The DNB has currently set the deposit rate at minus 0.65% (-0.65%) as on 11^th March 2016. The certificates of deposit (typically a 7 day deposit) sold by the DNB will attract a rate of -0.65%. With this, a bank placing a Certificate of Deposit with the DNB will need to pay interest at 0.65%.

The next one to adopt this policy was the European Central Bank (the ECB). The Deposit Facility Rate was 0% between May 2013 and Jun 2014, while it has been in the subzero territory since Jun 2014. On 10^th March 2016, the ECB reduced the Deposit Facility Rate to minus 0.4% (-0.4%), as against the earlier rate of -0.3%. This rate will be applicable when the banks make overnight deposits within the Eurosystem.

Thus, commercial banks placing a deposit with the ECB would need to pay interest at 0.4%, rather than earn interest for the deposit.

The Central Bank of Sweden (The Riksbank) is also using this policy. It has set the overnight deposit rate at -1.25% since February 2016. The deposit rate is in the negative territory since September 2014.

The Bank of Japan (BOJ) and the Swiss National Bank (SNB) have also reduced the deposit rates below 0%. In late January 2016, the BOJ set the benchmark rate at -0.1%. The SNB has set the deposit interest rate at -0.75%, a historical low. With this measure, banks need to pay interest for the deposits placed with the central bank.

It can be seen that negative interest rates are being increasingly used as a central bank policy tool in major economies across the world.

Why Negative Interest Rates?

It will be critical to understand the key reasons behind the negative interest rate policies.

Improving Credit Growth

Many central banks (though not all) across the world implement a Minimum Reserve Requirement. It is the minimum portion of the customer’s deposits which the banks must maintain as deposits with the central bank.

The Central Bank pays interest to the commercial banks for the deposits placed with it. This rate is often referred to as the Deposit Facility Rate or the Reverse Repo Rate.

The Central Bank of the country can also extend loans to the commercial banks in case of any shortfalls or liquidity crunch. This rate is referred to as the Repo Rate or the Lending Rate.

These rates are extremely powerful tools for managing an economy. The rates directly control the liquidity in the financial system, and the rates at which the bank will lend to its borrowers.

Usually, the interest rate offered by the Central Banks for overnight deposits or 7 day deposits is much lower than the interest rate at which banks lend to consumers and businesses. To maximize the profits, the banks tend to keep the deposits with the Central Bank close to the required minimum and utilize the excess for lending.

However, in the throes of difficult economic conditions, banks usually take a risk-averse position. The opportunities for lending reduce in light of the stagnating economic weather, due to reduced business opportunities or due to an unfavorable assessment about the quality of the credit.

In such circumstances, instead of lending to consumers and businesses, the banks prefer to park their excess funds with the Central Bank. The funds available for lending are thereby reduced. This leads to increased cost of borrowings, a credit crunch and may lead to a downturn in the economy.

Central Banks are using Negative Interest Rates to resolve this deadlock.

The move by the ECB and other Central Banks is expected to encourage banks to lend money to borrowers to earn interest rather than placing those funds in the safe havens of the Central Bank. The negative interest rate policy is being used as a tool to prompt banks to lend to businesses and corporations. The idea is to make the funds available to enterprises needing them. The Central Bank is expecting to kick start the economy and trigger a cycle of spending.

The SNB has implemented an interesting variant of this policy. The SNB has a minimum reserve requirement. The banks placing funds with the SNB in excess of 20 times of the minimum reserve requirement (referred to as the exemption threshold) need to pay interest at the rate of -0.75%. In short, central banks are implementing a tiered model of deposit interest rates to penalize commercial banks for placing additional deposits with the central bank.

In effect, to improve credit growth and increase the inflation rate near the stable levels, negative interest rates are being adopted by central banks.

Improving Consumption and Investments

The commercial banks continue to be cautious with respect to lending to businesses, in spite of these nudges by the central bank. They continue to keep their excess funds with the central bank. However, since the bank needs to pay interest rather than earn interest on such deposits, the bottom-line of the banks are getting impacted.

Banks are devising ways and means to cushion against such reductions in profit. One of the techniques is to the charge customers who save their money or place a deposit with the bank. The customers would be expected to pay interest for their savings and deposits.

Paying for their own savings is not an attractive option for the customers! This is worrying the banks too, since customers may withdraw funds from the bank. However, the central banks are keen to see this happening. They want to the consumers to spend instead of save, and once again, kick start the economic cycle. Increase in consumption is expected to help the inflation rise to the required levels.

In addition, due to lower interest rates, it would be easier for corporations to finance their business operations. This would lead to an increase in investments from such organizations, which in turn is expected to trigger an increase in the demand across the economy and a higher inflation.

Some banks are trying to avoid a direct impact to the customers. Such banks are increasing the rate of interest for loans and mortgages. This is increasing the cost of borrowing in the market, much to the disappointment of the central banks. After all, the central banks wanted the loans to be easily available for businesses, at affordable costs of borrowing.

Another interesting theme which is coming to fore recently is the concept of paying interest to the borrower for borrowing money. Yes, you read it right – interest will be paid to the borrower, instead of the usual norm of the interest being paid by the borrower.

Promoting credit growth is one of the key aspirations of the central banks in the advanced economies struggling with stunted inflation. Under a new scheme being evaluated by the European Central Bank, the ECB could pay banks to borrow money from it, if they extend significant loans to consumers.

This is related to the four year loans being granted by the ECB under the new targeted longer-term refinancing operations (TLTRO II) scheme. With this, the banks can get refinancing from the ECB at 0% (the main refinancing rate was set at 0% on 16^th March 2016). The banks can also earn interest at rates up to 0.4% (the Deposit Facility Rate is set at -0.4%) for refinancing from the ECB.

To sum up, using the tool of negative interest rates, the central banks are expecting to increase consumption, improve spending, increase investments and trigger a cycle of growth.

Moderating the Currency Exchange Rate

The world is experiencing tough economic conditions. The markets are in turmoil. The price of oil is hovering below 40 USD a barrel, down from 80 to 100 USD price range prevalent in the last 5 years. The last time the oil was below 40 USD a barrel was in Nov 2003. The world has changed significantly in the last decade.

In such challenging circumstances, stable markets like Switzerland see a sizeable inflow of funds. The continued buying of the currency increases the value of the currency vis-à-vis the US Dollars and other major currencies. This in turn leads to increase in imports, reduction of exports, making the exports costlier and the economy less competitive.

One of the intentions of the SNB for reduction of the deposit rate below 0% is to discourage investors from buying the Swiss Franc, avoid the over valuation of the Franc, and thereby keep the Swiss economy competitive.

Nevertheless, customers continue to keep deposits with the banks, even though the rate of interest is below zero. As an illustration, foreign investors would be happy to place deposits with banks in economically strong countries like Switzerland and Germany even though the deposit rate is less than 0%. Such investors expect the exchange rate of the Swiss Franc against other currencies to rise favorably, thereby favorably offsetting the negative yield on the deposit.

The Swiss Government recently borrowed money from the market at a rate of interest of -0.26%. Needless to say, the investors did not shy away from such bonds. After all, the Swiss Government bonds are considered to be absolutely safe, and the probability of the Swiss Government defaulting is negligible, if not zero. Add to it, the currency valuation of the Swiss Franc vis-à-vis the other major currencies is expected to rise. All these positives make such bonds attractive.

In spite of a slew of measures related to negative interest rates, the Swiss Franc continues to be strong, causing worry in the SNB. To address this situation, the SNB is also contemplating the reduction of the exemption threshold. The reduction of the exemption threshold will make it increasingly difficult for banks to keep the savers insulated from the negative interest rates. Savers might also be expected to pay interest for savings.

Similar currency exchange rate reactions were seen in Japan after the Bank of Japan announced negative interest rates in late Jan 2016. The Japanese Yen has risen by almost 6.5% (instead of the expected fall) against the US Dollars since February 2016. The BOJ, too, has implemented a tiered system for negative interest rates.

Recently, the rate of interest on the 10 year German Government bond was hovering around 10 basis points, very close to the historical low of 7 basis points. The fact that the bond is a safe government debt makes it an attractive investment option. It would not be wrong to assume that investors would even subscribe to such high quality debt even if the interest rate yield was negative.

Summarizing, in some markets, though negative interest rates have been implemented to control the valuation of the currency, the results are not in line with the expectations of the central bank. This makes the situation more interesting and ambiguous, and more incisive action can be expected from the central banks in the coming months.

Summary

The Repo Rate (The Lending Rate) and the Reverse Repo Rate (The Deposit Facility Rate) have been long used as a tool to manage and control the economy by the central banks. Given the evolving market conditions, rock bottom oil prices, slowing growth in China and Europe, and significant deflationary pressures across the leading economies, central banks in these economies are using a previously unheard concept of negative interest rates.

Countries like Sweden, Denmark and Switzerland have seen early benefits of this policy. Denmark has managed to keep the inflation rate within 1% in the last two years. Conducive conditions have been created in neighboring Sweden to increase the inflation rate near to the stable levels. Switzerland too is also seeing the economy move from deflation towards inflation.

On the other hand, in Europe, the inflation is reducing progressively in the last 4 years, with a strong risk of Euro Zone slipping into deflation. ECB has increased the negative interest rates in this background, to prevent the Euro Zone from slipping into deflation.

The recent results are a mixed bag. The overall effects of this new policy tool on the respective economies and the world as a whole will be more evident in the coming years.