The European Central Bank (ECB), the Danish National Bank (DN), the Swiss National Bank (SNB), Sweden's Riksbank and the Bank of Japan (BoJ) are among the big central banks that implemented negative interest rates from 2014 on. While all were products of their macro-economic environment, their motivations differed somewhat. Some banks used it to counter a subdued inflation outlook while others - SNB notably so - were more focused on currency appreciation pressures.
Implementing a negative interest rate policy (NIRP) faces a big obstacle in the form of a zero lower bound (ZLB), which comes out due to the at-par value of paper currency. Breaking through the ZLB effectively will mean that the policy should be imposed on both electronic and paper currency. The implementation on the electronic route should be easy once the proper regulation and technological frameworks are in place. The real problem is with paper currency. The dream of a world in which currency is fully electronic has some way to go, and during the transition, central banks would have to discourage the storage of paper currency and at the same time ensure below-par value of paper currency.
Central banks can attack the problem by either restricting withdrawal of currency or by taxing the storage of paper currency or redepositing paper currency. Taxing storage doesn't seem to very retail-friendly and could encourage black markets, which is a very undesirable outcome. Of the other two, placing a negative deposit rate on the paper currency that a bank deposits with its central bank is more preferable. This would lead to the development of an exchange rate mechanism which would determine the pricing of the paper currency below par, which would in turn be the applicable rate that a bank charges its customers.
The biggest and most immediate effect that negative rates have had until now has been on the global bond yield curve. More than $10 trillion of sovereign debt is now trading below zero levels. Negative yield debt is now 35 per cent of the total G10 debt. If the United States is excluded, this number would be much higher. What this has done is to push yields across the world lower, as money has flowed to currencies where the carry is better and the exchange rate has some semblance of stability.
Thus, inflows into the US have been good because, despite expectations of a Fed rate hike, we have seen a flattening of the curve and a sharp drop in yields. Global rates in totality are at all-time lows. One interesting consequence of this has been that DM bond funds have had their best year in the last 30 years in terms of returns.
Until now, in four European jurisdictions that have a significant experience of negative interest rates, retail investors have been shielded from negative interest rates and hence have not yet faced the question of ZLB. Therefore, they have not yet seen an abnormal jump in demand for cash. In Switzerland in particular, banks have taken extra care to ensure that negative rates are not passed on to retail investors, and they have effected this through adjustments in lending margins, which has actually led to an increase in lending rates on mortgages even as government and corporate bond yields fell in line with money market rates.
This would however run counter to the objective of the NIRP. However, if the NIRP continues long enough or goes deeper than current levels, then central banks would have to find a way to break the ZLB. There will most probably be a huge backlash from the general public to such measures. The notion of paper currency holding its value is strong, as this has been ingrained in the public psyche.
A big problem would be faced by insurers, who would struggle to find instruments yielding a positive rate, as they struggle to meet their liabilities. There is thus a risk that they would resort to a higher term or credit risk kind of structure. This thus exposes them to greater risks.
A positive implication of the negative interest rate regime is the flexibility it affords to central banks in terms of setting inflation targets. At present a central bank is constrained, as it is forced to set its rate away from the ZLB, so that it has sufficient room to conduct policy during a period of recession. Removal of the ZLB can theoretically mean that a central bank can set its inflation target at zero levels. A zero inflation target would send a very effective signal from a central bank to the general public. This can in turn increase the efficiency of central bank policies.
Another benefit is that even for people in the financial markets, there are ample instances of confusion between real and nominal rates. The real rate of return is a concept not easily understood and the general public finds it even harder. However, in a zero-inflation target kind of scenario, these difficulties are circumvented. Thus it is easier for the general public to understand how they have been impacted by public policies in terms of their income and wealth.
The option of a NIRP thus appears to be good for central bank policy-making, as it removes some constraints. The negative connotation of NIRP, I think, is not from the negative interest rate per se, but the fear of being stuck at zero levels, as has happened in Japan. In fact, if the constraints of the ZLB are removed, it would mean that central banks can cut rates to levels that are low enough to provide stimulus to an economy trapped in recession. If we take this to its logical extreme then a deeply negative rate can eventually be the route to higher rates. But, as with anything new in our complex and volatile world, we will have to wait to see how things pan out.
The writer is Chief Executive Officer, Financial Services, Aditya Birla Group
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
