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The way the current global economic scenario is poised, if you randomly buy any developed country’s bond, there is a 1 in 3 chance that you will lose your money, if you hold it to maturity. Warran Buffet

The words above portray the precarious situation prevalent in the global investment arena, where investing has become akin to losing. In this extremely volatile investment market, it is almost a bare necessity to gain a deep insight into this fast-spreading phenomenon called “Negative interest rates.” Negative Interest Rate Policy (NIRP) refers to a phenomenon wherein the central bank charges (instead of giving) interest on the funds parked by the commercial banks with it. Before delving deeper into the concept of NIRP, it is essential to understand the difference between real and nominal interest rates. Real interest rate refers to the actual interest rate after considering inflation. The following mathematical equation represents the relationship between real and nominal interest rates:

Real Interest Rate = Nominal Interest Rate – Inflation 

From the given equation, it is clear that real interest rate can be negative when inflation is greater than nominal interest rate. Negative real interest rates are quite common and have occurred innumerable times in the history of the world economy, the most notable instance being the fed rate in the U.S reaching the negative territory during 1974-77 in the aftermath of the stock market crash caused by the OPEC oil price shock. Therefore, it is a matter of extreme importance to understand that when we talk about this unusual phenomenon called NIRP, we are referring to negative nominal interest rates and not the real interest rate.

The advent of negative nominal interest rates can be dated back to the U.S. subprime mortgage crisis of 2008, which pushed the entire globe into a recessionary phase. To stimulate spending, central banks all over the world – especially in developed countries – reduced the deposit rate. This, in turn, led to a macroeconomic problem called Zero Lower Bound that occurs when short term nominal interest rate is at or near zero, causing liquidity trap and limiting the central bank’s ability to stimulate economic growth (Zero Lower Bound states that however steep the fall in interest rate may be, it can at minimum be 0%). However, this Zero Lower Bound barrier was transcended when the Swedish Central bank cut its overnight deposit rate to -0.25%.

Why Negative Interest Rates?

Denmark and Switzerland introduced NIRP to prevent high capital inflows and consequently stem the currency appreciation impact. On the other hand, the desire to combat slow growth and prolonged periods of inflation below 2% target level, were the key drivers behind Sweden and ECB’s introduction of NIRP.

The motive behind any Central bank’s decision to adopt NIRP can be broadly categorized into the following:

To stimulate the stock and bond market:

According to the Capital Asset Pricing Model,

CAPM(Re)= Rf +β (Mr) 

CAPM (Re): cost of equity

Rf: Risk-free rate (it is commonly considered to be the interest paid on a 3-month government Treasury Bill, generally the safest investment an investor can make)

β: Beta (Volatility of the given security relative to that of the market as a whole)

Mr: Market risk premium (additional return an investor will receive from holding a risky market portfolio instead of risk-free assets).

When the central bank introduces NIRP, the Risk-free rate falls. From the equation, it is evident that this will result in a reduction in the cost of equity. This reduces the cost of companies, results in higher profits and subsequently, higher stock prices. This, in turn, creates a stock market boom.

The same concept is applicable in case of bonds (however, instead of the market risk premium, bonds have something called a default spread).

To increase real investment:

  • Because of the decrease in cost of equity mentioned above, companies will have greater amount of funds to invest in new projects

  • This, in turn, will increase the real investment in the economy and pave the way for economic growth

To promote exports:

  • The onset of NIRP will result in a depreciation of the country’s currency

  • This will increase exports and increase inflow of foreign capital

The Paradox of Negative Interest Rate

However, reality and expectations are generally poles apart. The same applies in this scenario too. In introducing NIRP, the central bank is so hubristic and presumptuous to think that it is in the sole and pole position to influence the economy.

Although NIRP decreases the risk-free rate, it increases the risk of investing in the market. This consequently increases the market risk premium. This increase in the market risk premium armed with the multiplicative power of β (which is generally greater than 1 in such risky and unpredictable circumstances), offsets the decrease in risk-free rate and either increases or keeps the cost of equity constant. This may have the exact opposite effect of further making the stock market dormant.

Similarly, the introduction of NIRP sends a negative indication to the companies that the economy is in distress. As a result, companies may choose to play it safe and instead of increasing, may decrease their current investments.

Finally, the increase in exports may not even compensate for the imputed loss of foreign capital (foreign institutional investments will decrease as foreign investors are seldom so optimistic about investing in a market where negative interest rates prevail).

Transmission of the Effect of NIRP to the Economy

The effect of this Negative Interest Rate Policy can be passed on by the commercial banks to the economy through 2 channels:

Retail Deposit Channel:

  • This channel is used by those banks which have a large retail deposit base

  • Through this channel, banks either pass on the negative interest rates to the depositors or increase the service fees

  • This helps the banks in maintaining their spread

Portfolio Rebalancing Channel:

  • Negative interest rates penalize the holding of liquid, safer assets, incentivizing banks to rebalance their portfolios from low or negative yield liquid assets towards high yield, albeit riskier assets such as corporate loans

  • In the words of Brunnermeier and Koby:” As yields on safe assets decrease, banks decrease their lending rates for risky loans in order to substitute their safe assets positions into riskier high-yield ones”

  • However, this acts as a double-edged sword, as, though it may increase lending by banks, it may at the same time increase the incidence of Non-Performing Assets (NPAs)

When can an Economy Introduce NIRP?

It is a conventional view that if banks start charging negative nominal interest rates, then customers would not deposit the cash at all as they have the option to hold cash (rather than save it at negative interest rates)

However, this conventional view is based on the presumption that holding and using cash is costless and that may not hold for two reasons:

  1. Storing cash may require security (you cannot keep lakhs of rupees under your mattress without incurring any cost on its security)

  2. Using cash for some transactions may be expensive and perhaps infeasible (for example, Budget 2019 has proposed to levy tax deduction at source (TDS) of 2 per cent on the cash withdrawal of more than Rs 1 crore from a bank account in one financial year to discourage business payments in cash)

Thus, an economy is said to be ready to introduce negative nominal rates only when,

Negative nominal interest rates < security cost of storing cash + cost of using cash.

Such a situation is only possible in a highly digitalized economic system. This hypothesis is further validated by the fact that 3 out of the 5 countries which follow NIRP (namely Denmark, France and Japan) rank in the top 10 digitalized economies of the world.


“Reality is merely an illusion albeit a very persistent one.” This famous quote of Albert Einstein aptly portrays the reality of NIRP. This policy has yielded a mixed bag of outcomes, with a slightly greater inclination towards the negative side. This is vindicated by the fact that, while NIRP has provided Sweden and Japan with a much-needed bailout from the persistent deflation prevalent during the pre-NIRP period, Eurozone has witnessed a fall in its inflation rate. Moreover, NIRP has been largely ineffectual in aiding Denmark and Switzerland in stemming the trend of currency appreciation. To put it in a nutshell, it is too premature a time to comment on whether the NIRP is a rational and /or a successful policy or not. Only time will tell as to who will emerge as a winner in this “Race to the bottom,” if at all there will be one.

By Aravindaan


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