The Weird World of Negative Interest Rates

Negative interest rates are exactly what they sound like- interest rates on loans and deposits, among others, below zero. A situation wherein a borrower will end up paying back less than what he borrowed, a depositor ends up losing money on his principal amount. A situation wherein the borrowers are rewarded and the savers are penalised. However, it’s generally only the banks that would be looking at these sub-zero interest levels even if it ends up getting implemented. Not the consumers directly (again, generally).

The concept was first explored after the global financial crisis of 2008, when economies around the world were struggling. The central banks around the world backed that flooding the economy with cheap money was the way to battle recession. Central Banks in Europe and Japan were the first ones to implement negative interest rates, because their economies were still struggling years after the financial crisis of 2008 and some form of emergency measure was expected of them.

The Europe Central Bank (ECB) first introduced the negative rates in 2014 and the Bank of Japan (BoJ) in 2016. Neither of them have managed to bring it back to positive levels since.

Interest rates are one of the main levers at the disposal of the Central Banks, which they use to adjust monetary policy and maintain balance in the economy.

These key interest rates include the rate at which the central bank lends to other banks (repo rate) and the rate it pays for the excess cash that the banks store with the central bank (reverse repo rate). When these rates dip below zero, it means that the banks are encouraged to borrow, and charged for parking excess cash. This means that they are encouraged to ramp up spending and lending of the excess cash that they have, rather than holding it.

Negative interest rates may occur during deflationary periods when people and businesses hold too much money instead of spending and investing. This can result in a sharp decline in demand, and send prices even lower. It is generally implemented during times when the economy requires a boost in spending and demand. Such low rates in loans is expected to provide the required stimulus.

 The coronavirus pandemic has now put pressure on central banks to pump even more stimulus into their economies.

However, it’s highly unlikely that the negative rates will be passed on to the retail consumers by the banks. If a bank starts charging the people for deposits, they would rather just withdraw their money and slip it under the mattress, where it wouldn't at least depreciate. This could create a severe shortage of funds for the banks commonly known as “run on the banks”. Banks would be equally reluctant to incur a loss in lending consumers money.

The impact doesn't stop with the banks either. Even if not into negative zones, the loans lent to the public are expected to be provided at record low rates. Also, the key interest rates of the central bank influence general yield rates throughout the country. Bond yields might take a hit and plunge into the negative levels. So technically, when the bonds mature, you'll end up getting less money than you invested.

Though the Banks are incentivised to lend more, there may not be good lending opportunities. Banks would be reluctant to tie up their money with risky borrowers, and increase their own risk profile. The profitability of the banks take a hit too, because of very low rates that they earn from lending and having to pay a charge for holding excess cash. This might deter them from lending even more.

Though the idea has been explored and implemented for a while, its effectiveness is yet to be proved. There isn’t sufficient research and proof to back the idea and evaluate potential risks. Central banks around the globe are still toying with the idea, or experimenting with it.