“There is no precedent in economic history for negative nominal interest rates, even during the Great Depression in the United States.”
Hervé Hannoun’s recent observation didn’t stop there. The Deputy General Manager Bank for International Settlements remarked that even Keynes didn’t contemplate negative nominal interest rates: “An experiment is under way in continental Europe to test the boundaries of the unthinkable in monetary policy."
Once considered an academic exercise by economists, negative interest rates have now become a legitimate policy tool for central banks around the world. The GFC and the subsequent deflationary pressure placed on the global economy has meant that a number of central banks have resorted to negative interest rates to revive economic growth. Deploying the unconventional economic tool, central banks offer negative cash or deposit rates, charging commercial banks to hold their funds overnight. This penalty on deposits is supposed to act as an incentive for banks to lend to consumers and businesses, facilitating access to capital which in turn will stimulate economic activity and inflation.
Due to the lack of global aggregate demand and seemingly no change in expectations on the horizon, central banks have flocked to lower interest rates. Five central banks, the Bank of Japan (-0.1%), Denmark’s Nationalbank (-0.65%), the European Central Bank (-0.40%), the Swedish Riksbank (-0.50%) and the Swiss National Bank (-0.75%), are all offering negative cash or deposit rates. An additional cluster of central banks are narrowing in on a 0% deposit rate. As a consequence of falling interest rates, the value of negative-yielding bonds worldwide has swelled to US$12 trillion as at September 2016.
Efficacy of negative interest rates
Despite offering an economic solution to low growth and inflation on a theoretical level, there has been much commentary debating the virtues of negative rates in the current global context. Negative interest rates provide incentives to move capital and investments to jurisdictions with higher yields, putting downward pressure on the exchange rate of an economy, making exports more attractive in the global market and creating inflationary pressure in the economy. However, economists warn that currency devaluation as an economic strategy is a ‘zero-sum game’: if enough of one nation’s trade partners implement the same policy, it will be of limited effect.
Low or negative interest rates should – again, in theory – induce corporations to undertake expansion and investment. However, some commentators doubt that corporations would drastically increase investments on the basis of a small reduction in an already low cash rate. By the end of 2015, Apple, Microsoft, Alphabet, Cisco and Oracle were collectively holding US$504 billion in cash, an indication that monetary policy might not be having the impact intended. Concerns have also been raised about the behaviour of investors in a low or negative interest rate environment. Investors, driven by the search for greater returns, have shifted their portfolios towards riskier assets, which may be exposing the global economy to greater financial instability and worsening its prospects of recovery.
Impact on the financial services sector
The greatest threat posed by negative interest rates is to the financial sector, particularly to commercial banks who play a key role in regulating and facilitating economic activity. Commercial banks, in the generation of profit, induce savers to deposit funds at their institution with the promise of ‘high’ interest rates and then lend out that money at an even higher rate to those who require the funds. As interest rates decline, commercial banks are pressured to lower their lending rate but most continue to offer a positive savings rate to attract deposits, narrowing their profit margins. In an attempt to remain profitable, banks may be forced to reduce costs, make riskier loans and introduce - or increase - fees on current accounts.
The European experience
Despite the doom and gloom emanating from newspapers and online commentary, early studies on those European economies which have implemented negative deposit rates offer positive signs. The Swiss National Bank has used negative interest rates combined with intervention in the foreign exchange market to lower the value of the Swiss franc. In 2015, exports contributed over 50% to Switzerland’s GDP, whilst imports accounted for approximately 40%. This underlines the impact movements in the Swiss franc have on the prosperity of Switzerland’s domestic economy. The Swiss National Bank achieved its goal: the value of the Swiss franc has been gradually declining since 2015 making Switzerland’s exports more competitive in international markets.
In Denmark, negative rates were introduced in response to large inflows of capital into the country in 2012. These inflows had been sparked by distress in the Eurozone and required the Nationalbank to purchase large amounts of foreign exchanges in order to maintain the value of the krone. In contrast with Denmark, inflation in Sweden had been low for a number of years and, in late 2014, inflation expectations fell further. In February 2015, the Swedish Riksbank adopted negative rates and started a quantitative easing programme.
Despite their differences, both Denmark and Sweden present a positive case study for those concerned about the impact of negative interest rates on bank profitability. While some interest margin compression has been observed, the profitability of banks in the two countries has remained stable and even increased for mortgage banks in Sweden. Commercial banks in these jurisdictions were able to retain profitability due to a high reliance on non-deposit funding and rising non-interest revenues from areas such as mortgage refinancing and corporate advisory services.
The Australian context
While Australia remains somewhat of an outlier with a cash rate of 1.5%, the risk of negative interest rates is not entirely removed from the Australian economy. The economy is facing the end of a mining and resources super-cycle, the end of on-shore automotive manufacturing and (potentially) the end of a housing bubble, leaving a sizeable dent in the country’s prospects for economic growth.
The IMF recently released a number of preliminary findings about the state of the Australian economy. Of particular concern are external risks, particularly the risk of a sharp growth slowdown in China, and the profound impact those risks could have on our local economy. Also of concern is the Federal government’s priority to return a balanced budget. The IMF believes the Federal government should increase spending on growth-friendly infrastructure projects, spending which the Federal government appears unwilling to undertake at this stage.
The Reserve Bank of Australia (RBA) has been steadily lowering the official cash rate since December 2010 to support domestic demand and facilitate a lower exchange rate. During this time, pressure has been placed on the Australia’s four big commercial banks to pass on the full impact of those cuts to retail customers. Simultaneously, competition among the banks has increased for household deposits, squeezing the banks’ margins. Desperate to preserve their margins, the ‘Big Four’ banks only lowered their mortgage rates between 10 and 14 basis points in August of this year after the RBA lowered the cash rate by 25 basis points. Analysts estimated that, by only passing on roughly half the RBA interest rate cut, the Big Four banks preserved A$917 million in combined profit.
However, Australia’s major financial institutions may not be afforded this luxury forever. If the RBA continues to lower the cash rate in an attempt to support economy activity, pressure will remain on the Big Four banks to lower their mortgage rates. In a negative interest rate environment, Australian financial institutions will need to rely upon other sources of income to retain their current levels of profit. If negative factors prevail and the Federal government and the RBA are unable to create inflationary pressure, this scenario may become a reality in our backyard.
The one certainty is that negative interest rates are not good. The fact that central banks have moved below zero sends a signal to markets that we are in a highly stressed period of great economic uncertainty, and that the central banks are nearing the end of what they can achieve with monetary policy.