Negative interest rates: where borrowers are paid to borrow!

Today opening a bank account is pretty common to us.

Why do we do it?

For the safety of our money, the convenience of payments, and of-course getting some interest on our deposits.

Now just imagine if instead of getting paid to keep your money in the bank, you have to pay the bank to keep your money.

SHOCKING isn’t it?!

As the coronavirus wrecks havoc on the world economies and people become wary of spending and start to save, the central banks across the world run to provide monetary stimulus in terms of rate cuts and fresh credit infusion into the economies.

How rate cuts promote spending?

Many banks borrow from the central banks of their country at an interest rate fixed by the central bank. When the central bank cuts rates, this borrowing rate, which is termed as repo rate in India, becomes cheaper. It is expected that when banks get credit cheaply, they will extend these benefits of cheaper credit to the customers. Hence, as credit gets cheaper for the retail and institutional borrowers, it is expected that they will borrow more and this will boost the economy.

How did it all start?

The beginning of this can be linked backed to the great recession of 2008–2009. As the world was reeling with the after-effects of the financial crisis, central banks wanted to avoid a global recession. So, they thought the best way would be to flood the economy with abundant cheap credit.

Theoretically, as people would have surplus cash, they would start spending on non-essentials and undertake investments, which could help sustain the economy.

Did it happen like it was intended to?

Inflation

Any central bank’s most important job is to make sure that their inflation targets are met.

(As prices of goods increase over time, the number of goods you can buy with the same amount of money decreases. This depreciation in value of money is termed as ‘inflation’.)

In a recession, the inflation rate takes a hit. As inflation falls, the cost of living goes down but if it persists for a long time then companies may revise their pay structure to incorporate these low inflation rates and also hold on to fresh capacity additions. Now, this may lead to a loss in consumer confidence and people may reduce spending for fear of a recession.

One way of getting inflation up again is by reducing the interest rates to incentivize spending.

Consider the case of the U.K. where the central bank had an inflation target of 2% but the inflation rate went down to 0.8% in 2020 as shown below.

To bring inflation to its target rate, the Bank of England reduced the interest rates to almost zero (0.1%).

Well, it did seem to work for the first few years until some European banks took a step further and introduced negative interest rates. Meaning that central banks were incentivizing borrowers by paying them to borrow money!

Banks use these rates, determined by the central bank, to define interest rates to be paid to depositors on their deposits at the bank. And on the basis of this, banks started giving zero or negative returns to depositors. That is, they either did not pay any interest or started charging a small fee from the depositors.

Why would people place their money in a bank where they would be getting negative returns?

Well, one possibility could be that people don’t understand these policies and are wary of a recession, therefore, they may be willing to keep their money safe in a bank, even if they are not earning any returns on it.

Why do banks keep money with the central bank or other banks if they are earning a negative interest rate?

Storing money isn’t free of cost. Keeping money with yourself also incurs cost- security cost, regulatory costs, insurance cost, etc. These costs may sometimes make keeping money with other banks or the central bank attractive, even if they are giving a negative interest rate.

Why would negative rates not work?

In theory, negative interest rates should help stimulate economic activity. However, this does not come without risks where the move may backfire.

Banks have some assets like mortgages which are closely related to the current interest rate and negative interest rates could squeeze the margins of banks and so the banks may be willing to lend less.

There is also nothing to stop people withdrawing all their money and stashing it in their mattresses.

The drain of cash from the banking system could lead to an increase in interest rate- the exact opposite of what was intended.

According to research, negative interest rates actually hurt the lending of banks as their margins dwindle and banks prefer to store as cash, rather than lend it out to borrowers.

Cross-Country Position

Today many banks have negative interest rates.

These include- Switzerland, Denmark, Japan, Sweden, Spain

Let us see India’s case!

The Reserve Bank of India has recently, in the wake of the novel Coronavirus (Covid-19), reduced the interest rates (repo rate) by 115 basis points to support the economy.

The following chart depicts the cuts in repo rate by the RBI since February 2019.

Bonds

One reason for interest rates to become negative is the central bank policy. Another way that interest rates could dip into the negative is via the bond market.

Bond yields are a function of demand and supply. When people rush to buy a particular bond, its price increases and its yield decreases.

If a bond has a negative yield then does that mean that investors will lose money?

If you buy a bond with a negative yield, and hold it till maturity, then you will lose money. But if you trade it in the secondary market, and the bonds price keeps increasing, then you may be able to make some gains on it.

Why would a person buy a bond with a negative yield?

As is said, all things are relative. Similarly, a negative yield may not always be a very bad thing.

For example, you buy a bond with a yield of -0.5% and inflation remains positive. Then, unless you trade this bond in the secondary market you will lose money.

But in case the inflation dips to -2.5%, then this very bond will give a real return of 2%.

(real return = yield-inflation rate)

Not so bad after all

The Bottom Line

Negative interest rates are rather an anomaly for the financial system. They make it cheaper to borrow and expensive to save in banks. The reason why people would still want to keep money in the banks despite not earning any interest, or incurring negative interest, could be to keep the money safe in uncertain times where people may be fearing a recession-like situation to develop.