Negative Interest Rates Explained
By Uphar Gandhi, General Manager at SunTec Business Solutions
The outbreak of the COVID-19 pandemic disrupted global business and economies at a scale barely ever seen before. Governments and central banks across the world have responded to the emerging crisis with aggressive fiscal policies in a bid to address the economic impact of the pandemic. Record low interest rates was one of the key tools deployed by most central banks. But by now, it is evident that COVID-19 will remain with us in some form or the other for a long time to come. While vaccinations can help to stave off serious illness, emerging variants will keep the disease circulating in the population as it hopefully will become endemic like the flu. Given this long-term perspective there are growing calls for central banks to move the negative interest rates (NIR). Most central banks and even the International Monetary Fund (IMF), however, say that NIR has eased financial stress and supported growth and inflation.
NIR first emerged in 2012 when central banks of Denmark, Japan, Sweden, and Switzerland adopted the policy to address below target inflation rates that were impacting jobs and economic growth. This move was in response to a situation where interest rates had dipped to a very low neutral rate that was neither contractionary nor expansionary. While they were envisaged as short-term booster shots for the economy, they have been in use for a while now.
But what are negative interest rates? To put it simply, it refers to a policy where one is paid to borrow money from banks, or one is made to pay money to keep money in bank accounts. The idea is to encourage people to borrow more money and spend more money, which will in turn boosts a flagging economy. Given the current economic impact of the pandemic, a policy that encourages spending and getting money into circulation is a sound move. There is no question about why this is being strongly proposed as a tool to stimulate financial growth the world over right now, but does it make sense to continue with this even after the pandemic is over?
NIR essentially means that banks are charged money to maintain excess liquidity in the system. The system disincentivizes banks to maintain excess deposits and forces them to lend more money. Customers can borrow money at very low rates and may even be rewarded for borrowing. In Denmark where NIR has been in play for many years, banks don’t pay cash to the customer when they take out a mortgage. Instead, they adjust the monthly outstanding mortgage amount by more than what the customer has repaid and shorten the overall mortgage payback period. The objective here is to encourage a real estate boom as customers can pay off their mortgages easily and be open to further investments. It is likely to then have a spiraling effect on the economy by boosting spending on related products and services like insurance, home décor and more.
With an NIR policy, customers with existing loans are encouraged to consolidate all their outstanding debts at a lower rate. The money saved can then be spent on other items – which puts the money right back into the economy. But this system discourages savings with banks by not providing any interest on savings or even charging them a fee. Banks in Denmark, Switzerland, Sweden, Japan, where negative interest rates have prevailed for some years now, give no interest to their customers who save with them. In fact, they charge a fee for savings beyond a certain threshold. NIR is bad for anyone trying to save money. With no returns on their bank savings and with ongoing inflation, they stand to lose money by keeping it in their banks. Risk averse investors may end up gravitating towards risky assets in search of returns that will not be available in traditional savings modes. Senior citizens especially stand to lose out under such a system, as they will not receive any interests on their saved income at a time when they can’t earn like before. Such a system is likely to have long term societal impacts as well, as the traditional conservative savings approach is replaced by blatant consumerism, senior citizens push their retirement and rethink retirement plans, investment strategies and pension funds.
Banks will need to rethink their strategies as NIR has a significant impact on their bottom lines. Prolonged ultra-low to negative interest rates, can affect the overall health of the banks and financial institutions, and they would have to find new ways to increase their margins and improve profitability. They may even hold off lending altogether which would adversely impact the economy. And as depositors shy away from saving their money in banks, there may be widespread cash hoarding, last heard of during the Great Depression of the 1930s. One way of surviving and thriving in a NIR driven economy is to change banking product and service offerings. Greater personalization, and innovation, such as interest earnings on deposits tied to certain cash flows – can be a good start.
From having observed NIR policies in play in Japan and the EU, I think one can safely conclude that cheap money does not always spur business expansion and economic activity. It just takes the cost of money out of the equation. Having said that, economists around the world feel that there is enough merit in the system to implement and sustain this policy for some time to come. Whether they will indeed boost world economy will have to be evaluated at a later time.