Will Negative Interest Rates Work: Fire or Backfire?

18 Dec 2019 Read 379 Views

Albert Einstein once said, "Compound Interest is the eighth wonder of the world." Had he been alive, he would have declared 'negative interest rates' as the ninth wonder of the world.

Years before, this was unimaginable. Is this an out-of-the-box thought, or a desperate call for desperate times, you will be able to figure this out by the end of this piece.

The Monetary Policy

A country is governed by two kinds of policies, fiscal policy and monetary policy. Fiscal Policy is the government's affair. It deals with taxations, budget, revenue and expenditure. On the other hand, monetary policy is forte of Reserve Bank of India (central bank of a country). Monetary policy deals with the amount of money in the economy, banking systems and foreign exchange reserves.

RBI balances the growth and inflation rate by changing interest rates. You must have heard every two months that RBI has announced 'repo rates.' Repo rate is the rate at which banks borrow money from RBI. They use this money to lend further to consumers.

The Cycle of Money

When there is less consumption in the economy, there is less economic activity and the growth is slow. This also means that the demand for products is less. It means inflation is also less. In this stage, RBI would reduce the 'repo rate.' It means banks have to pay less cost to borrow from RBI. This ultimately means a low rate of interest for consumers. This would mean that more people would take more loans. This means more economic activity, more demand and, ultimately, higher growth.

If low-interest rate stimulates growth, why doesn’t RBI keep loans so cheap? Here is the answer.

If the repo rate were low, then banks would lend a lot of money at a cheap price. When people have so much money, there is a lot of demand for goods. People would want to buy so many things. Since demand is high, the prices of goods increase. This means that inflation starts growing.

RBI's job is to keep this growth balanced. While the country grows well, inflation should not rise much. Otherwise, the ill effects of inflation will outplay the sound effects of growth.

The Depositors Side

There is also the other side of the story. When the repo rate is high, banks have low capital to lend to consumers. To get more capital, they would offer higher interest on deposits to attract more money from depositors.

When the repo rate is low, banks have already borrowed enough money from RBI. They do not need your money. Hence, they reduce the interest rate offered.

The bottom line is interest rates are in absolute sync. When interest rates increase, it means depositors will get more interest. Also, loans will be charged higher.

In the other case, loans would be cheap but depositors would not get enough interest on deposited money.

Summary

 

Monetary Policy (Repo Rate)

 

Increase

Decrease

Interest Rate of Banks

Increase

Decrease

Growth Rate

Decrease

Increase

Inflation Rate

Decrease

Increase

Interest Charged on Loans

Increase

Decrease

Interest Earned by Depositors

Increase

Decrease

The Global Interest Rates

Now you understand that Central Banks control the interest rates. These, in turn, are passed to consumers by banks. In developing countries like India, banks are the primary source of loans for normal consumers. This means the demand for loans from the bank is high. The underdeveloped bond market, higher inflation and higher growth rates mean that we have higher interest rates as compared to developed countries.

This means that RBI has a vast scope of increasing and decreasing the interest rates whenever deemed fit.

US, Japan, and West European countries are developed and have a stable inflation rate. Their growth rates are as low as 2%. Under such conditions, the interest rate there is already low. The scope of cutting down interest is even less.

The Negative Interest Rate Saga

As seen above, when a country wants to stimulate growth, they reduce their interest rates so that people may borrow more and spend more.

Now, what would happen if people still do not borrow? Until what point would you reduce interest rates? How less would you charge on loans? A zero interest rate means that you will be charged nothing on loans. What does a negative interest mean?

It actually means that you will be paid to take a loan! How astonishing or amusing it may sound, but in one or another, this is true. This policy has been adopted by banks in Japan on and off, since 2016 and recently taken up by European banks starting from Deutsche Bank AG.

The model just differs slightly. Say you borrow Rs 100 from Deutsche Bank AG. They will charge you 2% as interest and deduct 2.5% from it (making it effective -0.5%). This means that when you pay them the interest of Rs 2, they will account Rs 2.5 repaid. In accounting terms, for Rs 100, your loan account would ask you to repay Rs 102, but the account will be closed when you pay them Rs 99.5.

Therefore as said, you got Rs 0.50 for taking this loan of Rs. 100.

How Do Banks earn from Negative Interest Rates?

The world is suffering the problem of T-lows or triple lows. These three lows are low growth, low inflation and low-interest rates. Trade wars have aggravated problems.

To stimulate growth, banks have resorted to negative interest rates. They plan to earn money through growth in investments.

In addition, with negative rates, the depositors are charged for storing their money in the bank. Assume you keep Rs.100 in the bank, and the bank has an interest rate of -2% on deposits. This means by the end of one year, and your account has Rs 98 only. This means that banks are charging storage costs on deposits. Only this can incentivize them to use their funds and lend it somehow.

Is it all good?

Not at all.

A negative interest rate is a double-edged sword. On the one hand, it may appear to stimulate growth, but on the other hand, depositors have no advantage. Why would one keep money in the bank if it would only reduce in value, except for storing in security?

If banks don’t get deposits from depositors, from where will they get funds to lend? Depositors would look elsewhere to park their savings. This would mean banks might even fail if not curated properly.

The senior citizens are most affected. They want to park their lifelong savings in less risk funds. In developed countries, they spend on government bonds. With European Central Bank going sub-zero, senior citizens and pension funds would be the biggest losers. This might lead to a loss of faith in the banking system. Nothing would be as detrimental as this.

Now once we understand that this is hazardous, something more is coming. When borrowing rates go as low, the government too will borrow. It would come up with impractical promises because it can get money so easily. While banks are still looking for growth through a rise in the value of their assets through investments, the government has no such plan. How would it repay its borrowing if it just spends without any responsibility? This will be disastrous!

The Closing Word

Not every out-of-the-box idea is good. This is a risky path that needs meticulous monitoring, quick and decisive decision-making. Though sub-zero lending may reduce the cost of loans, it reduces liquidity due to a lack of funds by depositors. Working with this plan is much required for retaining the balance in the global financial system.

About the Author: Vivek Tiwari | 46 Posts

Vivek Tiwari is a Software Engineer and a Data Scientist who hopelessly fell for Economics. His plans to move to Finance might now save mankind from his IITJEE selection story.

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