The Conundrum of Negative Interest Rate Policy

A few days ago, I came across something known as the ‘Bizarro World’. While I’m not a big DC fan, avid followers of Superman comics may be familiar with it, a cubed planet far out in space that is inhabited by imperfect duplicates of Superman. In the ‘Bizarro World’, up is down, hot is cold, good is bad, and beautiful is ugly. They go to bed when the alarm clock rings. They eat only the peel of a banana. They earn degrees by failing subjects. And they invest in “bizarro bonds” that are “guaranteed to lose money”.


But why are we discussing it? Because of how bizarre it is. In today’s world, a bizarro bond is no longer a comic-book fantasy. Base interest rates have been negative in countries like Switzerland, Denmark, Japan, etc. for years now. The base interest rate set by a central bank plays a dual role. It influences people’s decisions on whether to save or invest their money. At the same time, interest rates influence a country’s exchange rate. The higher the interest rate, the higher the value of the currency.


Why is NIR adoption on the rise?


Setting interest rates to <0 is often viewed as unusual but is a continuation of the perfectly normal monetary policy practice which is moving the short-term interest rate in response to fluctuations in the economy.


The idea behind having a negative interest rate (NIR) for excess reserves is that banks will be forced to squeeze them and lend instead of incurring costs, which in turn will boost domestic demand. Thus, NIRP could be termed as an extreme form of easy monetary policy exercised by central banks to increase spending, stimulate inflation, reinvigorate the economy and boost its growth.


Some countries embrace NIR to stimulate exports by devaluing the currency. Another reason for implementing NIRP is related to the indebtedness of the national government. When national governments are in severe debt, low-interest rates make it easier for them to afford interest payments. In summary, NIRP shows the bleak state of the economy and the government’s desperation to prevent the economy from falling into a deflationary trap.


Side Effects of NIRP


(i) In theory, low/negative interest rates are supposed to stimulate spending. But the opposite has happened in the past. Since negative rates increase uncertainty about the future, consumers are worried about saving for retirement and other goals and spend less.


(ii) As seen in Eurozone countries that implemented NIRP, negative rates led to increased household debt and led to money flowing into riskier assets, such as real estate.


(iii) NIRP weakens the country’s banking system. If the negative policy rates cannot be passed on to lending rates, they can’t increase the demand for loans. Again, if the negative policy rates translate into lower lending rates, but not lower deposit rates, they erode bank profits and, over time, probably weaken the banks’ ability to lend. If the negative policy rates get passed on to both lending and deposit rates, banks stand to lose their retail deposit base, making it challenging for them to attract funds. In this whole process, the intermediary function of banks, which are at the very centre of monetary policy mechanisms, could be jeopardized.


(iv) Moreover, countries with negative rates have less flexibility to respond to an economic downturn with monetary stimulus.


Where does India stand?


While rates in India are way above the zero mark, they are at a decade low. Nonetheless, irrespective of India’s interest rate policy, India is indirectly impacted by the policy regimes of other economies as well.


With the increasing interconnectedness of economies and the attractive positioning of India concerning other emerging economies, low-interest rates and low profitability for banks in NIRP nations could motivate them to shift more activities into India. NIRP adopting countries with limited avenues to earn healthy returns in their home countries, often look out to invest in Indian startups, driving up valuations.


Sustained low-interest rates in other regions may even encourage foreign borrowing by Indian financial institutions. Cheap foreign financing could increase the profitability of Indian banks, but it could also lead to problems if lending became excessive.


However, our reality isn’t a Bizarro replica. Examples of countries like Japan, Denmark, and Switzerland have made practical limits of pushing policy rates below zero quite evident. Though low/ negative rates might increase consumption and investment in the short run, history has shown that an economic model fueled by excessive borrowing is unsustainable and leads to much greater problems. Hence, there is a need for greater reliance on fiscal policy, structural reforms, and improved financial sector policies to increase aggregate demand.



References:


https://theconversation.com/negative-interest-rates-will-not-fix-the-global-economy-just-ask-switzerland-130718


https://theconversation.com/guaranteed-to-lose-money-welcome-to-the-bizarro-world-of-negative-interest-rates-119994


http://aswathdamodaran.blogspot.com/2016/03/negative-interest-rates-unreal.html?m=1


https://www.investopedia.com/terms/n/negative-interest-rate-policy


https://www.financialexpress.com/opinion/negative-interest-rates-a-new-unnerving-normal/1403636/