Negative Interest Rate – What, Why and How

This is something unheard of in our parents’ time – banks charge you for keeping cash in your bank or fixed deposit account. It’s insane, but several of Europe’s central banks have negative interest rates and kept them there since 2014. They say desperate situation calls for desperate measures – since Feb 2016,  Japan is adopting this too.

An Act of Desperation

Negative interest rates is a signal that traditional fiscal options have proved ineffective and new ways need to be explored. With other options to stimulate the economy limited, more policy makers are willing to test the technique.

Impact to banks : Penalize the practice of hoarding cash instead of extending loans to businesses. Clearly,  sub-zero rates can cripple banks’ profitability or lead them to take additional risks in search of profit – like pushing hard on credit card/personal loan sales.

Impact to business & consumers: In theory, interest rates below zero should reduce borrowing costs for companies and households, driving demand for loans. However, there’s a risk that the policy might do more harm than good. If banks charge customers to hold their money, who will want to deposit money into banks? I might as well keep my cash into tin Milo or under the mattress.

europe negative interest rate

But there’s an escalating concern that when banks absorb the cost of negative rates themselves, that squeezes the profit margin between their lending (circa 4.5% for mortgage) and deposit rates (circa 3.0% for FD), and might make them even less willing to lend. The snowball effect is even more tighter lending criteria for mortgage approval. It is just rationale, yes? With dwindling profitability margin, you cannot afford to be hit by Non Performing Lending (Loan).

Wait but Why Negative Interest Rate?

Primary Reason #1 – Lend more for the good of economy

Let’s take Bank of Japan (BoJ) as an example because I have client investment portfolio invested in Japan region 🙂

BoJ wants to force Japanese banks to lend money which it has been supplying through its quantitative easing.

You heard that right.

The BOJ kick started its quantitative easing (QE) in October 2010 to deal with deflation and a slowing economy. The purpose was to strengthen the bank’s balance sheet and to encourage them to lend.

It worked from 2010 to 2013.

But then in mid 2014, recession strike. Due to Abe sales tax hike.

Japanese banks wanted to and can lend more, but they are helpless when faced with the lack of demand for loans due to the recession. Japanese banks were so desperate to lend that they begged companies to borrow. For two years, the massive quantitative easing efforts by the BOJ failed. Japanese banks were still not reaching their lending target,  and so BOJ had to finally resort to negative interest rates.

It must be a nightmare to be a banker in Japan.

Primary Reason #2 – Inflate the Deflated

The BOJ had an official mandate to keep inflation at 2%. Mild inflation of 2% should encourage consumers to spend today instead of saving. This would lead to more investment and employment as companies increase capacity to meet consumer demand. On the other hand, deflation causes consumers to delay their purchases and previous economic weakness in Japan is largely blamed on long-term deflation.

The official inflation rate in Japan for January 2016 was exactly 0.0% and it is at the brink of deflation again. Disinflation has been going on since 2014 and it is apparent that the BOJ needs stronger, albeit untested cure to combat deflation.

Primary Reason #3 – China

China worries pulled down the Japanese stock market too. The Chinese authorities made repeated pledges to stop the market rout after the June and August 2015 crashes. However, further crashes in December 2015 and January 2016 made clear that the Chinese authorities were powerless against the market forces.

So, BOJ introduced negative interest rates to defend the Japanese economy against further declines. China is the second largest economy in the world and Japan’s second largest export market after the United States; 18% of Japanese exports went to China, just behind the 20% that goes to the United States. If China were to have a hard landing, Japan would not be able to escape a recession.

*****

It’s an unorthodox choice that has distorted financial markets and triggered warnings that the strategy could backfire. If negative interest rates work, however, they may mark the start of a new era for the world’s central banks.

Adapted: http://fifthperson.com/5-reasons-bank-japan-introduced-negative-interest-rates/

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