My Piggybank’s started charging me: Experiments with Negative Interest Rates
In 1960, DC Comics introduced the “Bizarro” planet of “Htrae”. Created with a duplicating ray, the planet’s inhabitants are all imperfect versions of Superman and Lois Lane, doing “opposite of all Earthly things”.
They go to bed when the alarm clock rings. They eat only the peel of a banana. They earn degrees by failing subjects. And they invest in “bizarro bonds” that are “guaranteed to lose money”.
In today’s world, a bizarro bond is no longer comic-book fantasy.
The clamor for negative interest rates is now more than ever. Base interest rates have been negative in Switzerland, Denmark, Japan etc for years. A few months ago, Britain sold bonds with negative yield for the first time. Trump, and now some economists have called on the Fed to take rates negative.
Aswath Damodaran, the revered finance professor, wrote in his blog in 2016 — “In the years since the 2008 crisis, there is no question in finance that has caused more angst among investors, analysts and even onlookers than what to do about “abnormally low” interest rates. In 2009 and 2010, the response was that rates would revert back quickly to normal levels, once the crisis had passed. In 2011 and 2012, the conviction was that it was central banking policy that was keeping rates low, and that once banks stopped or slowed down quantitative easing, rates would rise quickly. In 2013 and 2014, it was easy to blame one crisis or the other (Greece, Ukraine) for depressed rates. In 2015, there was talk of commodity price driven deflation and China being responsible for rates being low. With each passing year, though, the conviction that rates will rise back to what people perceive as normal recedes and the floor below which analysts thought rates would never go has become lower.”
With the impact of the Covid pandemic being larger than what most countries had anticipated, countries are jostling to get back on their feet. Negative interest rates are being regarded as the messiah. But have negative rates achieved their intended outcomes in the countries which have had a Negative Interest rate Policy (NIRP) since years. In December 2019, Sweden decided to exit NIRP by raising the rates back to zero. What has been the country’s experience with NIRP. What are the second and third order effects of negative interest rates, not only on the global macro economy, but also on India and our the startup ecosystem. In this article, I attempt to answer some of these questions.
Has NIRP achieved its intended outcomes in Japan and Europe?
Before I attempt to answer whether NIRP achieved its intended outcomes, let me lay out the reason of implementing negative interest rates in in the first place.
Interest rates turn negative when the rule of preference for current consumption over future consumption is violated and you expect deflation in a currency. NIRP is intended to stimulate borrowing, investment and spending, since if people have to pay for storing cash, they will rather spend than save. Some countries resort to negative interest rates to devalue their currencies to stimulate the export sector. Another reason for implementing NIRP is related to the indebtedness of the national government. When national governments are in severe debt, low-interest rates make it easier for them to afford interest payments. An ineffective low-rate policy from a central bank often follows years of deficit spending by a central government. In summary, NIRP shows the bleak state of the economy and government’s desperation to prevent the economy from falling into a deflationary trap.
Coming to Japan, the country implemented NIRP in 2016 as the last resort to get back to economic prosperity. However, NIRP hasn’t led to an economic revival since it fails to address the broader structural issues in the economy –
- Aging population — which is not going to stop saving despite negative interest rates
- Declining birth rates
- Stalling export engine threatened by the emergence of other Asian technological hubs
- High government debt-to-GDP ratio (230% as of 2019 — highest among Fitch rated sovereigns) — restricting the government’s ability to invest in widespread structural changes to its economy
Moreover, NIRP has weakened the country’s banking system. Japanese banks have experienced a severe compression of lending margins since the introduction of the NIRP, as they have a structural surplus of deposits over loans and there is little room for the deposit rate to decline even while lending rates are dropping, given the degree of competition in the market.
Similarly, in the Eurozone, NIRP has failed to propel the economy. Though the impact has been varied across countries, in general NIRP has hampered the business model of financial institutions, with banks having paid over €20 billion in negative interest fees to ECB. Moreover, there appears to be an asymmetry between lending rate adjustments and deposit rate adjustments. Whereas lending rates have generally declined, only some banks in Switzerland, Denmark, and Germany have been found to apply negative deposit rates, that to only to large deposits — leading to declining spreads for banks. As margins contract and profits decline, banks raise fees or turn to other revenue measures to boost earnings. This keeps actual borrowing costs relatively high, undercutting the whole point of a negative rate policy.
In Switzerland and Denmark, NIRP has put pressure on the pensions industry, since negative interest rates led to negative bond yields, affecting the amount paid to pensioners. Hence, they have sought riskier investments such as real estate. Property prices have increased sharply, taking Switzerland to the brink of a housing crisis. To mend the situation, Swiss banks are now increasing the lending rates on fixed ten-year mortgages — irrespective of the negative base rate.
The unintended effects of negative interest rate
Now that we’ve established that NIRP is implemented as the last resort to propel a struggling economy, let’s see what have been the (side) effects of NIRP vs what was theorized:
(i) In theory, low/negative interest rates are supposed to stimulate spending. But the opposite has happened: The savings rate has gone up. As interest rates on deposits declined, consumers felt that now they had to save more to earn the same income. Moreover, since negative rates increase uncertainty about the future, consumers worried about saving for retirement and other goals, spend less.
(ii) As we’ve seen in cases of Eurozone countries that implemented NIRP, negative rates increased household debt and led to money flowing into riskier assets, such as real estate, increasing real estate prices and creating property bubbles. Cash locked up in property does not increase the velocity of money and creates wealth disparity.
(iiii) NIRP weakens the country’s banking system, setting off a dangerous feedback loop in credit markets and real economy (see left)
(iv) Some countries resort to negative interest rates to devalue their currencies to stimulate the export sector. But other governments will do the same, and in the end all countries will experience lowered consumption & a higher savings rate.
(v) Moreover, countries with negative rates have less flexibility to respond to an economic downturn with monetary stimulus
How is India impacted by global NIRP regimes?
While rates in India are way above the zero mark, they are at a decade low level at 4.4%. Nonetheless, irrespective of India’s own interest rate policy, India is indirectly impacted by the policy regimes of other economies.
With the increasing interconnectedness of the Indian economy and global economies, and the attractive positioning of India vs other emerging economies, low interest rates and low profitability for banks in NIRP regimes could motivate them to shift more activities into India. Such a shift could bolster efficiency, innovation, and stability in India. Further, negative rates elsewhere might lead to capital flows across asset classes in India, benefitting Indian FDI/ FPI flows. But with a depreciating Rupee, they would expect to be compensated higher to make up for the currency effect. Moreover, sustained capital flows without fundamental asset growth would push up asset prices. We have seen this play out in the startup valuations of late. With limited avenues to earn healthy returns in their home countries, foreign investors (read: Softbank) borrow cheap at their country’s low rates, invest in Indian startups, driving up valuations to unsuitable levels.
Sustained low interest rates in other regions may encourage foreign borrowing by Indian financial institutions. Cheap foreign financing could increase the profitability of Indian banks, but it could also lead to problems if lending became excessive or unduly risky, or if access to global markets were suddenly cut off. Problems could also arise if funding were denominated in foreign currency, as corporations with unhedged exposures may experience repayment difficulties in the event of INR depreciation.
Finally, though low/ negative rates might temporarily increase consumption and investment, history has shown that an economic model fueled by excessive borrowing is unsustainable. Lower rates, which are ineffective and weaken the financial system and ultimately the real economy, are merely a mechanism to wriggle out of solving the structural issues crippling the economy.
Sources:
https://voxeu.org/article/swedish-experience-negative-central-bank-rates
http://aswathdamodaran.blogspot.com/2016/03/negative-interest-rates-unreal.html?m=1
https://www.adb.org/sites/default/files/publication/317926/adbi-wp740.pdf
https://www.bis.org/publ/cgfs61.pdf
https://theconversation.com/negative-interest-rates-will-not-fix-the-global-economy-just-ask-switzerland-130718
