Negative interest rates – what does it mean?

There are an increasing number of media mentions about negative interest rates as more developed countries across the globe are entering a negative interest rates territory. The question now is how effective can this approach be as there is great uncertainty about consequences and the behaviour of commercial banks and other institutions.

Five central banks – the European Central Bank (ECB), the Denmark's National bank, the Swiss National Bank, Sweden's Riksbank and the Bank of Japan – so far have adopted negative rates on commercial banks' funds held on deposit at the central bank. In effect, commercial banks have to pay to hold their money at central banks. The key goal of these decisions is to stimulate economic growth and to fight with low inflation and growing threat of deflation. But is it so?

Why use negative interest rates?

Simply put, when rates are negative, a depositor, for instance a commercial bank, has to pay a central bank for the benefit of holding cash at the nation's central bank. The theoretical aim of such policy is that since banks would have to pay to store their cash, they would be motivated to lend any extra cash to businesses and individuals, fuelling the economy. Another example could be a depositor (i.e. large company) who has to pay for holding cash at commercial bank if latter one applies negative rates. In this case one of the aims would be to encourage companies to use money for business investments, again to boost growth in economy. Or put another way, negative rates mean lenders pay borrowers for the privilege of lending. However, it would be an extreme case at commercial banks level as an economic logic of lending is receiving an interest as a trade-off of assuming borrower’s credit risk. Though, borrowing costs are squeezed down by adopting negative interest rates and the aim is to promote consumption, which is one of the main drivers of economic growth. Yet, above named aims and intentions of adopting negative interest rates are very theoretical and there is uncertainty how it fulfils in practice.

Eurozone’s example

In Eurozone, the aim of the central bank is to stimulate economic growth and to raise inflation. The ECB has a mandate to ensure price stability by aiming for an inflation rate of below but close to 2% over the medium term (currently inflation in Eurozone is a bit below zero). Like most central banks, the ECB influences inflation by setting interest rates. If the central bank wants to act against too high inflation, it generally increases interest rates, making it more expensive to borrow and more attractive to save. By contrast, if it wants to counter too low inflation, it reduces interest rates.

Since Eurozone’s economy is recovering at a very slow pace and inflation is close to zero and is expected to remain considerably below 2% for a prolonged period, the ECB has judged that it needs to lower interest rates. All three rates have been lowered since 2008 and the most recent cut was made in March, 2016. The base interest rate was cut from 0,05% to 0% and the deposit rate was cut more deeply into negative territory from -0,3% to -0,4%. ECB is justifying that is a part of a combination of measures designed to ensure price stability over the medium term, which is a necessary condition for sustainable growth in the euro area.

The deposit rate which is now even more negative means that Eurozone’s commercial banks that deposit money in the ECB have to pay more. The question may rise – isn't it possible for banks to avoid the negative deposit rate? For example, can't they simply decide to hold more money in cash? If a bank holds more money than is required for the minimum reserves and if it is not willing to lend to other commercial banks, it has only two options: to hold the money on an account at the central bank or to hold it as cash (of course the most anticipated option by central banks is that banks increase lending to businesses and individuals). But holding cash is not cost-free either − not least since the bank needs a very safe storage facility to warehouse the cash. So it is unlikely that any bank would choose to do this. The more likely outcome is that banks either lend money to other banks or pay the negative deposit rate. Between these two options the second one is more realistic as currently majority of banks hold more money than they can lend and borrowing from other banks is unnecessary.

Positive and negative effects of negative interest rates

While central banks intend to boost growth and inflation by adopting negative interest rates, such policy becomes more unconventional and brings concerns that worth to consider. Below few major pros and cons are described.

First, taking into account that intensions of central banks is fulfilled and negative interest rates stimulate the economy, this would be a positive sign for the banking sector. If markets believe that negative interest rates improve long-term growth prospects, this should raise expectations of higher inflation and higher interest rates in the future, which is positive for banks' net interest margin (commercial banks make money by assuming credit risk and charging a higher rate of interest on loans than they pay on deposits – they have a positive net interest margin). What's more, in a stronger economy banks should be able to find more worthwhile opportunities to lend and borrowers are more likely to be able to repay those loans. On the other hand, negative interest rates may harm the banking sector. If the rate charged on loans is being squeezed ever lower by falling interest rates, and commercial banks are unwilling or unable to set the rate paid on deposits below zero, banks' net interest margin is compressed tighter and tighter.

Second, the negative interest rates policy should encourage commercial banks to lend more to avoid charges from central banks on funds in excess of mandatory reserves. However, for negative rates to boost lending, commercial banks must become willing to lend more, and at lower potential income. As negative interest rates are introduced to counter slow economic activity and deflation risks, it means that businesses are facing challenges in such environment and, as a result, in lending banks face increased credit risk and squeezed profits at the same time. If profits suffer too much, banks may even reduce lending. Even more, difficulties in imposing negative rates on depositors may mean debt costs rise for consumers.

Third, negative interest rates also have the potential to weaken a national currency, making exports more competitive and boosting inflation as imports become more expensive. However, negative interest rates may provoke so called currency war – a situation where a number of nations seek to deliberately depreciate the value of their domestic currencies in order to stimulate their economies. A weaker exchange rate certainly appears to be a key channel through which monetary policy easing is acting. But overall currency devaluation is a zero-sum game: the global economy can’t engineer a currency devaluation against itself. In worse case, competitive currency devaluations may give way to protectionist trade policies, which would be negative for global growth.

Fourth, from investors’ perspective, negative interest rates should, in theory, function the same way as the lowering of rates to zero – it should benefit stocks as the relationship between interest rates and the stock market is fairly indirect. A decrease in interest rates means that those people who want to borrow money can enjoy lower interest rates. But this also means that those who are lending money, or buying securities such as bonds, have a decreased opportunity to make income from interest. If we assume investors are rational, a decrease in interest rates will prompt investors to move money away from the bond market to the equity market.

Fifth, negative rates may complement other easing measures (like quantitative easing) and signal central bank resolve to tackle economy slowdown and below-target inflation. On the other hand, negative interest rates may be symptomatic of central banks reaching the limits of what monetary policy can do. Markets appear to be increasingly concerned that central banks are out of measures, and are fretting about how policy makers would tackle another downturn in economy.

Bottom line

Central banks are determined to do what it takes to boost growth and inflation. With interest rates already at zero, more central banks have been resorting to negative interest rates to fulfill their objective. However, it is a relatively new tool for central banks and the main opportunities and risks of such policy have not yet been realized. Therefore, it is worth to examine and monitor potential unintended consequences more closely of this increasingly popular policy. So far, in Eurozone economy is picking up slowly, inflation is very low, commercial banks are not in hurry to lend more and instead are seeking how to mitigate potential harm on profits in other ways, willingness from businesses and individuals to borrow more at cheaper rates are increasing at quite slow pace, investors are not in hurry to take more risk in investing, bond yields remain at record lows. More time is needed to realize the true impact of negative interest rates.

Gunta Simenovska,
Sales support manager of SEB bank Business Development Department 

Sources: European Central Bank, World Bank, Bank for International Settlements, Nasdaq, Investopedia, Bloomberg, BBC, CNBC