Since our childhood we have saved our pocket money to buy chocolates and toys. As we grew up, we started saving our pocket money for subtler gift-giving ceremonies. We have always been told by our parents that saving our money is good and that saving it in a bank account is essentially better as it pays you interest. But what if there was a bank that wanted to be paid just to keep your money deposited with them? Enter the concept of “Negative Interest Rates”.
In a developing country like India, a savings deposit account is a norm for every good household. However, if global trends are to be followed savings is not the best option in many countries like Japan, Denmark, and Switzerland where the banks have taken the extreme measure of introducing negative interest rates.
As crazy as it may sound, the banks now get paid when investors deposit their money. This policy seems to defy the very logic of deposits, however there is a rationale behind it. During the times of deflation, people tend to save money which in turn reduces the capital in the economy and leads to further deflation. To prevent this cycle from continuing, the banks try to encourage people to invest by charging depositors on their savings. This way people find it more attractive to invest elsewhere rather than hoard money in banks. Negative rates do not necessarily mean that the borrowers will get paid for the loans but the interest on loans will decrease substantially to encourage borrowing. The banks will have to adjust their policy to ensure that borrowers do not get paid interest on mortgages.
Additionally, in some countries, their respective central banks introduced negative rates not to overcome deflation but to increase exports. The banks realized that their currency was over-valued and this over-evaluation was directly linked to the decrease in exports. Thus these banks prevented the appreciation of the local currency by charging negative interest rates.
The concept of negative interest rates emerged in the year 2014, when the European central bank started paying -0.1% interest on deposits held in its vault. Today, this concept is wide spread not only in Europe but also Switzerland and Japan where central banks have been extremely aggressive and charged rates up to -0.75% on deposits. In Japan and Europe this policy was introduced to ward off deflation, whereas in Denmark and Switzerland it was adopted to devalue the currency and boost exports. The success of this policy depends on how well the local banks manage their customers. In Europe, it was found that the local banks had to change their legal systems, computation software and redo spreadsheets to comply with the central bank policy. These adaptations took a heavy toll on the banks’ balance sheet. In a very peculiar case, a Spanish bank, Bankinter SA had to pay some customers interest on their mortgage. Some others were reluctant to charge customers for deposits and were sacrificing their own profits by paying the central bank from their pockets. If this continues then the very purpose of negative interest rates is lost. The central banks still believe that there will be an initial resistance to this change but eventually local banks will adapt and begin charging the customers on deposits and find a suitable policy for mortgages.
Policy-makers justify the need for negative interest rates by claiming that inflow of money was required to reduce deflation, and rate cuts would provide the required inflow. It is too early to judge the impact of this policy. It might work as envisioned by its creators or can have severe repercussions. If we reflect back on the 2008 crisis, the root cause of it was bad mortgage. To encourage people to borrow, the fed reduced the rates on borrowing and loans were given without any precautionary measures. These loans were called NINJA loans (No Income, No Job or Assets). Thus people who did not have the ability to pay mortgages also bought loans and fulfilled their dream of ‘owning a house’. To gain profits all these loans were converted into MBS (Mortgage backed securities) with AAA rating. When people started defaulting on loans, all the investors holding MBS and derivatives related to MBS lost money. This caused a domino effect and the entire economy collapsed. The lynch pin to this catastrophe was bad debt. The policy of negative rates which aims at increasing borrowing might encourage banks to invest in riskier assets which might lead to another asset bubble like in 2008.
Despite severe criticism central banks have defended their move of negative interest rates. Several policy changes have been implemented to check the adverse effects. Thus whether the negative interest rates will pull Europe out of deflation, boost Denmark’s trade or cause another economic catastrophe – only time will tell.
This article was written by Apurva Kulkarni (PGDM, Batch 21, XIME-B)