Asset bubbles may be the unintended result of a negative interest rate regime, an increasingly common monetary policy in some developed nations.
Interest rates are generally assumed to be the price paid to borrow money. Negative interest rates refer to the case when cash deposits incur a charge for storage at a bank, rather than receiving interest income.
When financial institutions have excess money, it does not make sense to incentivise deposit taking by giving interest to depositors. By the same logic, it does not make sense to lend money to borrowers and having to pay interest to them. That is the basic theory in an economy that has too much money. In this region, we have not seen this happening, although for a long time Singapore has been under a very low interest climate due to its strong currency and stable environment. For example, an annualized 2% interest rate on a $100 loan means that the borrower must repay the initial loan amount plus an additional $2 after one full year. On the other hand, a -2% interest rate means the bank pays the borrower $2 after a year of using the $100 loan. And it’s also unusual because the lender will have to bear the risk of a loan default on top of having to pay interest on the loan it is giving.
THE SITUATION IN EUROPE AND JAPAN
Central banks, however, in Europe, Scandinavia and Japan, from 2015 have implemented a negative interest rate policy (NIRP) on excess bank reserves in the financial system. This unorthodox monetary policy tool is designed to spur economic growth through spending and investment as depositors would be incentivized to spend cash rather than hoard it and incur a guaranteed loss. It has yet to be seen if this policy will work in practice, and whether negative rates will spread beyond excess cash reserves in the banking system to other parts of the economy.[ihc-hide-content ihc_mb_type=”show” ihc_mb_who=”1,2,3,4,5″ ihc_mb_template=”1″ ]
But let us look at the European situation and perhaps we could learn something from there. The European Central Bank (ECB) became the first when its deposit rate declined to 0.2% in September, 2014. A number of other European nations turned to negative interest rates so that over one quarter of Eurozone government-issued debt had negative yields by the end of March 2015.
Negative interest rates are a drastic measure that show policymakers are afraid that Europe is at risk of falling into a deflationary spiral. In harsh economic times, people and businesses have a tendency to hold on to their cash while they wait for the economy to pick up. But this behaviour can serve to weaken the economy further as the lack of spending causes further job losses and lower profits, thus reinforcing people’s fears and giving them even more incentive to hoard.
As spending slows, prices drop creating another incentive for people to wait for prices to fall further. This is precisely the deflationary spiral that European policymakers are trying to avoid with negative interest rates. By charging European banks to hold reserves at the central bank, they hope to encourage banks to lend more.
In theory, banks would rather lend money to borrowers and earn at least some kind of interest as opposed to being charged to hold their money at a central bank. Additionally, however, negative rates charged by a central bank may carry over to deposit accounts and loans, meaning that deposit holders would also be charged for parking their money at their local bank while some borrowers enjoy the privilege of actually earning money by taking out a loan.
Another primary reason the ECB has turned to negative interest rates is to lower the value of the euro. Low or negative yields on European debt will deter foreign investors, weakening demand for the euro. While this decreases the supply of financial capital, Europe’s problem isn’t supply but demand. A weaker euro should stimulate demand for exports, hopefully encouraging businesses to expand.
In theory, negative interest rates should help to stimulate economic activity and stave off inflation, but policymakers remain cautious because there are several ways such a policy could backfire. Because banks have certain assets like mortgages that, by contract, are tied to the interest rate, such negative rates could squeeze profit margins to the point where banks are actually willing to lend less.
Also, there’s nothing to stop deposit holders from withdrawing their money and stuffing the physical cash in mattresses. While the initial threat would be a run on banks, the drain of cash from the banking system could actually lead to a rise in interest rates – the exact opposite of what negative interest rates are supposed to achieve.
While negative interest rates may seem paradoxical, this apparent intuition hasn’t kept a number of European central banks from giving it a try. This is no doubt evidence of the dire situation that policymakers believe is characteristic of the European economy. When the Eurozone inflation rate dropped into deflationary territory at -0.6% in February 2015, European policymakers promised to do whatever it takes to avoid a deflationary spiral. But even as Europe embarked into unchartered monetary territory, a number of analysts believe negative interest rate policies could have severe unintended consequences.
UNINTENDED CONSEQUENCES
1. Hoarding of Cash
We have discussed this above. The purpose of a negative interest rate policy is to penalize the hoarding of money, and to encourage those funds to be lent out, invested or spent instead. Ironically, however, one consequence of negative rates is to hoard physical cash, which has an implicit yield of 0%, rather than submit to pay a fee on deposits at a bank. Hoarding cash can have a deleterious effect on spending by creating deflationary pressure, and could lead to destabilizing bank runs if bank customers withdraw large amounts of cash all at once.
In fact, there is already evidence that Japanese consumers are now purchasing safes to keep cash. The possibility of the same happening in Europe has prompted the ECB to announce that it will be abandoning the €500 bank note, and led others to call for the elimination of the Swiss CHF1,000 note and the $100 bill. Monetary authorities are saying that this “war on cash” is intended to stop money laundering and terrorist financing, but many observers see this as a way to make withdrawing and transporting large amounts of cash more difficult as high-denomination bank notes are phased out of circulation.
2. Changes to Spending Behaviour
Many people and companies buy things on credit and wait as long as possible to pay those invoices. If cash has a positive yield, this is rational as it can accrue a small amount of compounding interest income in the intervening period. If cash has a negative yield, suddenly the incentive is to flip this behaviour on its head. Cheques received as payment may be deposited only at the last minute before they are no longer valid.
People may even draft certified bank cheques to themselves and then hold them in safety deposit boxes until needed. People may begin to favour pre-paid debit cards or gift cards rather than traditional debit and credit cards. The option to pay a recurring subscription may become less favourable than to pay a one-time upfront fee. Similarly, businesses may opt to pre-pay their expenses including leases, bills and vendor invoices.
Businesses and some people may also begin to pre-pay their tax bills instead of waiting until the end of the year. Taxes may even be over-paid in advance, in order to shift the negative fee incurred to the taxing authority, and then receive the overpayment due back at a later time. In fact, in Switzerland this may already be happening as the canton of Zug has urged its citizens to cease pre-payment of taxes and instead wait as long as possible to file.
3. Asset Bubbles as Banks “Pay Your Mortgage”
Many have suggested that low interest rates and quantitative easing have encouraged the formation of asset bubbles as people are able to take advantage of cheap money. If rates are so low as to become negative, this means that borrowers are actually paid to go into debt. Mortgage rates are typically pegged to overnight lending rates such as the Fed Funds Rate, LIBOR or Euribor. If, for example, LIBOR becomes sufficiently negative, it is certainly possible that mortgages could eventually carry negative yields as well. This is bound to hurt profitability for lenders; however, they could still earn a credit spread if the bank borrows from the central bank. For example, the bank could take out a central bank loan at -4% on a mortgage issued at -1%. Here, the “borrower” is still credited 1%, but the bank is able to lock in a 3-point spread.
If people can receive money by borrowing, it can cause a rush of borrowers to go as deep into debt as possible with little fear of having to service those debts with income. Instead, the financial system could enable a rentier class who earns passive income while the money being borrowed does little for the economy. Worse, the money borrowed can be spent on frivolous or non-productive pursuits and then the borrower simply gets paid to borrow even more.
4. Currency Wars
Denmark and Switzerland first adopted negative rates to deter foreign investors from buying up their currency, which was perceived as a safer haven than the euro during the sovereign debt crisis. Buying up this “safe” currency bids up its price, potentially hurting exporters and causing economic problems at home. Also, a rational investor in a global economy will prefer to invest in a country with a positive yield rather than a negative one. This will also have the effect of bidding up that currency.
If a country has a mandate for an expansionary monetary policy, foreign inflows of capital which strengthen the domestic currency can undermine this policy. As a result, countries may devalue their currencies through other mechanisms in a race to the bottom to deter such foreign intervention.
CONCLUSION
Negative interest rates in practice are a very new and uncertain monetary policy tool. Whilst its intention to spur economic growth and prevent recession is certainly valid, policy makers ought to be aware of the unintended consequences that may accompany such an untested policy.[/ihc-hide-content]
Dato’ Seri Matthew Yeoh is managing partner of Yeoh Mazlina & Partners, member of ASEAN Legal Alliance.