Interest in negative rates, at least as can be judged from hyper activity from commentators, has diminished. But a number of European central banks still have negative official rates. The European Central Bank (“ECB”) deposit rate is minus 0.30%. Switzerland’s policy rate is minus 0.75%. Sweden’s policy rate is minus 0.35%. The Bank of Japan (“BoJ”) too has negative interest rates.
Over US$20 trillion of government bonds are now trading at yields of below 1% with over US$6 trillion currently yielding less than 0%. Government bonds in Germany out to a maturity of 7 years are trading at negative yields. Swiss and Japanese government bonds out to 10 years trade at negative yields.
Negative rates are now firmly part of the central bank toolkit, as evident from strange comments from members of the US Federal Reserve that negative rates are an option at a time when official US rates are rising.
Negative yields mean that if an investor places a deposit with a bank at maturity the investor receives back an amount less than the original investment. In effect, the depositor pays to place money with the bank. In the case of bonds, negative yields mean that investors accept an economic loss, as the price paid by the investor is greater than the present value of the interest payments and principal repayment for a security.
Negative real rates entail return on the amount invested but loss of purchasing power because inflation rates are greater than the return. Negative nominal rates involve a guaranteed loss of capital invested.
Since 2008, policy makers have sought to use low rates to boost economic growth and increase inflation in order to bring elevated debt levels under control. Low rates should encourage debt financed consumption and investment, feeding a virtuous cycle of expansion. Higher asset prices increase the collateral value against which banks have lent. They also increase wealth encouraging spending. Low rates and abundant liquidity should drive inflation.
The policies have succeeded in creating a precarious stability. They have not created growth or inflation.
Increasingly, constrained by the zero lower bound of rates, policy makers have found it necessary to innovate. They have used quantitative easing (“QE”) to purchase securities to lower interest rates. They have also directly employed negative rates.
Negative rates work through the same economic channels as low or zero rates. They have extra power in that savers facing the threat of actual loss should increase investment and consumption, helping economic growth and inflation.
Negative rates also target the velocity of money, which has declined sharply since the Great Recession reducing the effectiveness of monetary policy globally. It is intended to increase the speed of circulation of money, as everyone seeks to avoid the loss caused by holding cash (commonly referred to as the ‘hot potato’ argument).
It is also designed to encourage banks to lend aggressively. A key objective is to reduce excess reserves held by banks at central banks. The money is the result of QE schemes which have not flowed into the real economy. Negative rates impose a cost on banks, forcing them to increase loans thereby reducing their excess reserves.
A major unstated objective of negative interest rates is to influence currency values. Negative rates are a methamphetamine boosted form of zero or low interest designed to devalue a currency, as investors move capital elsewhere to avoid loss. Lower currencies increase export competitiveness by decreasing costs. It also decreases the purchasing power of debt denominated in the currency to reduce real debt levels.
Less Than Zero Effect
To date, negative rates have not boosted growth or inflation, instead creating serious economic and financial distortions.
The lack of impact on the real economy reflects the failure of these policies to materially increase consumption and investment. Heavily indebted or increasingly cautious households are reluctant to borrow to fund spending. Low business investment reflects lack of demand, over-capacity and also a reluctance to increase debt in a potentially deflationary environment.
Negative rates may perversely create deflationary pressures. Artificial reduction in the cost of capital may encourage over excessive or mal-investment in excess capacity which in turn drives down prices for goods and services. Lower cost of capital may encourage substitution of labour with capital goods which drive down employment and demand which is turn adversely affects both growth and inflation.
The policies have not increased the velocity of money. Reducing excess reserves, where they exist, has proved difficult because of the lack of demand for new credit.
In part, this reflects the fact that most banks have not passed on the negative interest rates to the majority of customers. In jurisdictions with negative official negative rates, some banks only charge large corporations or fund managers to deposit cash. Most banks do not yet charge retail customers to deposit money. There are limited examples of banks paying customers to borrow.
Banks dependent on deposits are reluctant to reduce rates, fearing the loss of their funding base. Banks which profess engagement with advanced technologies, such as ‘block chains’ and FinTech, also may lack systems which can accommodate negative rates.
Lending rates have not come down in line with official rates. Concerns about profitability compounded by new higher capital and liquidity regulations have reduced bank willingness to lend.
Banks face profit pressures from the mismatch between hard to reduce deposit rates and loans which have interest payments contractually linked to the central bank’s policy rate.
Most economies with negative rates are caught in a credit trap. Credit demand is weak and credit supply is also constrained. Policy measures such as negative rate and additional QE are increasingly ineffective.
Negative interest rates are also increasingly ineffective in managing exchange rates.
Initially, the Euro-zone and Japan benefitted from a weaker Euro and Yen which boosted exports. Switzerland and Denmark limited the appreciation of Swiss Franc and Danish Krone against the Euro. But in a world of limited growth and low demand, the increase is at the expense of competitors. US industry has been affected by a 20% appreciation of the dollar, leading to criticism of currency manipulation. The likelihood of retaliation to restore individual nation’s competitive position is high.
The latest round of rate cuts have not affected currency values as expected. Both the Yen and the Euro appreciated against the US dollar after the announcement by the BoJ and the ECB of more negative rates. Persistence with this policy risks triggering a nugatory race to the bottom for both interest rates and currencies, as tit-for-tat cuts and devaluations vitiate each other.
The understandable desire amongst some investors to avoid a certain loss has underpinned further financial risk taking in the shape of demand for risky assets, such as equities and corporate bonds. Critics fear asset bubbles. The experience is mixed. Some European equity and real estate valuations have become stretched, as investors switch out of cash or safe assets.
A major concern is risky corporate bonds and bank securities, usually hybrid or quasi capital instruments. Investors, particularly individuals, lack the skills to analyse credit and complex structures. The suicide of an elderly Italian investor who lost a substantial proportion of his life savings when a subordinated note was written down to recapitalise the issuing banks highlights the risk.
Negative rates also distort financial markets and the economy.
There are mechanical complications. US money market funds operate under regulations which require them to maintain the capital value of the investment made by savers. Negative interest rates would require either changes in the rules or force these entities to close, effectively disrupting the flow of short term funding to industrial companies, banks and governments. The US Treasury process for the issue of new securities does not permit negative rates and would require change.
There are important fundamental alterations to rate relationships within financial markets and also funding arrangements, which have implications for central bank monetary operations.
Negative interest rates change the role of default or bankruptcy in debt markets. A borrower could only default on principal repayments as there is no interest payment. Covenants such as interest or debt cover designed to provide early warning of distress would have altered significance or none at all. Depending on bankruptcy laws, borrowers may lose and lenders gain in cases of default.
Negative or ultra low interest rates also reduce the risk of default. As shown in Japan, it creates zombie companies and industries by distorting the cost of capital and finance encouraging mal-investment. Businesses do not make necessary adjustments to strategy or business practices. Unproductive investments are not restructured or sold.
Banks do not write off bad loans, relying instead on low or negative rates to allow zombie companies to continue operations. Weakened profitability from negative interest rates discourages banks from aggressively realising bad debts.
In effect, low rates delay essential restructuring to remove the detritus of previous crises. It restricts the supply of credit to the wider economy affecting economic activity. Misallocation of capital deepens the malaise and makes ultimate resolution more costly and difficult.
A prolonged period of negative interest rates would damage the process of saving and investment central to the market system. One troubling historical precedent is the attempts by the German National Socialists to prohibit interest rate being charged on borrowings.
A policy of ever deeper negative interest rates is reminiscent of the strategy of an army officer during the Vietnam War entailing the destruction of a village in order to save it.
Satyajit Das is a former banker. His latest book is ‘A Banquet of Consequences’ (published in North America as The Age of Stagnation to avoid confusion as a cookbook). He is also the author of Extreme Money and Traders, Guns & Money.