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Usually, what happens is that people get interest from banks on their deposits, and have to pay interest on loans and borrowings. What comes to your mind when you read the term ‘negative interest rate’? An upside-down economy? Well, that’s not entirely true. Negative interest rates mean that the repo rate is set by the central bank at levels below zero; the commercial banks have to pay regularly to park their funds with the central bank. This does not directly imply that the commercial banks would follow the same pattern with the public (if they would have done that, all depositors would withdraw all their money from the banks and banks won’t be left with anything to lend). This essentially means that the commercial banks are willing to lend more since keeping money with the central bank becomes costlier. So they reduce their lending rates substantially (shrinking their profit margins), to incentivise public to borrow. The primary implication of this move is that people borrow more and spend more, and divert their savings to consumption. NIRP (Negative Interest Rate Policy) is a highly unconventional monetary tool. This phenomenon is not a matter of choice, but rather a necessity in countries where it exists.

There are often times when central banks run out of policy options to stimulate the economy and turn to the desperate measure of negative interest rates. During harsh economic times, people and businesses have a tendency to hold on to their cash while they wait for the economy to pick up. This, in turn, further weakens the economy as the lack of spending implies lack of demand which leads to less production, lower labour requirement, job losses and lower earnings, 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 as they wait for prices to fall further. This is known as the deflationary spiral. Negative interest rates are a drastic measure that the policymakers take to prevent an economy from falling into a deflationary spiral. By charging commercial banks to hold reserves at the central bank, policymakers hope to encourage banks to lend more which will bring more cash (liquidity) in the economy and revive the economy from deflation.

Historically, it had been believed that interest rates can’t fall below 0%. If the interest rates fall even fractionally lower, all the people would withdraw their savings from the bank. However, banks do not pass on the costs incurred to the general public. Different economists from different time periods have come up with different ideas to encourage consumption (which is the main purpose of negative interest rates). In the 19th century, Silvio Gesell proposed a tax on holding cash. In 2009, Greg Mankiw suggested a lottery scheme for randomly picking serial numbers on banknotes and declaring them void, making it risky to hold on to cash. In 2014, Kenneth Rogoff explained that if we could just phase out cash altogether, there would be no alternative to paying a negative rate on bank deposits and bonds.

However, this policy is not free from risks. It can create a bubble where the cheap loans push up the demand, just like what happened in the USA during the 2008 Financial Crisis. People may start withdrawing their money and start saving it in physical form in their homes. This may also lead to a huge increase in the demand for money if all the people start withdrawing their money. This leakage from the banking sector will lead to an increase in the interest rate. One way to prevent this can be setting limits for withdrawal. However, such a measure is difficult to implement and can lead to public dissatisfaction, similar to what happened during demonetization among the masses. There is a tendency amongst people to start looking for other instruments when the interest rates start falling. The demand for bonds, gold etc. will increase and consequently, so will their price. The central bank of Japan (Bank of Japan) adopted the NIRP on January 29, 2016, when the rate was set at -0.1% for the first time. The move was aimed at encouraging borrowing, spending and lending (based on the Paradox of thrift and circular flow of income model); to avoid Yen’s appreciation from its stable low level (to make exports competitive), and to make interest payments on national debt more affordable. But what has been observed is that the policy hasn’t helped. Negative interest rates, though incentivise banks to withdraw reserve deposits, but they do not necessarily create more creditworthy borrowers or attractive business investments. They don’t improve the capital stock or education and training for the workforce. NIRP could simply lead to even lower interest rates by putting pressure on banks (through reduced net interest margins) to contract their balance sheets still further. Despite lower borrowing cost, consumer demand remained weak. In the recent past, there has been some inflation, not owing to the negative rates, but because of tumbling of Yen by 10% post US Elections. This diminishes the effectiveness of Japan’s monetary policy. The folly of relying on monetary policy alone has been criticised by many economists, and some have even called it a ‘Negative rates, negative success’ phenomenon. Economic performance has not measurably improved. So the NIRP cannot be claimed to be an effective tool in the long run.

The European Central Bank (ECB) was among the world’s first major central banks to adopt negative interest rates policy (NIRP). It pushed its deposit rate to -0.4 per cent in April 2016 which means that all Euro banks have to pay 0.4% p.a. on their reserves held at ECB accounts. In other words, ECB was penalizing banks which parked their excess cash with the central bank with the motive of earning a decent interest. The idea was to discourage banks from stashing their excess cash in the central bank by charging them a modest rate for doing so. Since the banks would lose money rather than earn interest on their deposits, it was hoped they would be prompted to make more loans at lower rates to businesses and consumers. This would push banks’ excess cash into the economy. It’s an extreme execution of monetary policy, which includes changing interest rates, much like when central banks decrease the rates to stimulate economic activity. This move, in turn, has far-reaching consequences. Euro banks seek to evade this “penalty rate,” by buying government bonds which inevitably pushes bond prices up and lowers bond yields. Euro banks’ businesses suffer as they not only have to face difficulties to remain profitable in an environment of extremely suppressed interest rates but also have to bear higher costs due to a negative ECB deposit rate. In addition to this, consumers withdraw their cash deposits leaving banks with a cash drain. Economists realized that continuing to rely on negative interest rates could be dangerous as the policy had only a modest positive impact on growth but caused a higher risk to the global financial system as well. This policy would encourage individuals and businesses to take some of their money out of banks and stash it in safes, or under mattresses which would not be good for the stability of European banks. It would be far better if European governments used fiscal policy to increase demand by investing in roads, bridges, railroads, ports and other infrastructure which would create jobs and stimulate economic activity, and would not cost much.

As per our opinion, India is not ready to implement this policy. India wants to increase the consumption but this is not the right way to go about it. As per a report by the State Bank, advances to the public have declined by 1.9 % and the deposits have increased by 1.6 %. The banks are not willing to lend at high rates of interest, even if the borrowers are willing to pay the high interest. They would be willing to give even lesser credit in case of fall in interest rates. As on April 29, 2016, credit growth has declined to 9.2% as compared to 11.3% in mid-March and 10.3% during the same period in 2015. It needs to be highlighted here that the low credit growth rate has happened at a time when the central bank was continuously cutting interest rates. Moreover, if the lending increases, the chances of loan impairment also increase and banks are always wary about this. So, even if the Central bank is able to implement this policy, the commercial banks won’t respond positively to this policy.

By Sanat Goel, Ria Gulati and Palkin Garg


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