What if you went to a bank, parked your money in a deposit account, and the bank told you would have to pay parking charges for it? Meaning you give your money and also pay interest for it. Funny, right? Not so. It happened before, it's happening now, and it will happen in the future.
Enter the world of negative interest rates. First up, this idea turns conventional wisdom on its head. Yet, in one way, this is not new.
For instance, if you make an investment at say 5 per cent, and inflation is running at 7 per cent, both of which are normal, you earn a real rate of minus 2 per cent. However, there is some difference with what we are talking at present. Now, the nominal interest rate, that is, the investment rate itself, is negative. Say it's negative 2 per cent. If the inflation rate is 1 per cent, it means the real rate of return is negative 3 per cent
Encouraging borrowings
Why would a country want you to pay interest when you deposit money in a bank? And, why would it want a banker, who is lending money, to pay interest to the borrower? Well, the fundamental idea is to encourage borrowing and discourage saving money.
This happens when the growth rates are abysmally low. It can also happen to stabilise the currency because growth improves the exchange rate. In the 1970s, the Swiss government did exactly this — imposed negative interest due to save a floundering Swiss Franc. It was done to encourage people to borrow money from banks and to discourage both banks and the general public from depositing their money with the central bank and banks, respectively.
In the late 2000s, as the global financial crisis set in, Denmark, Sweden, and Japan did it. Today, to fight post-pandemic blues, apart from those three, Switzerland and Spain are following zero interest rates.
So, how does it happen? The central bank decides it is time to revive the economy and that every other measure has failed. It announces that commercial banks would lend and accept deposits at a negative rate. This forces the public to get into a spending mode that will propel economic growth. Also, it improves their standard of living.
Further, the currency becomes less attractive for investment, thus indirectly boosting exports by increasing the demand for domestic goods in foreign markets. The stock market also will go up as investors will now move to the equity market and not bank fixed deposits for return.
Double-edged sword
However, the strategy is a double-edged sword. One fear is that banks will not be able to make significant profits. Many banks are reluctant to slash deposit rates, and so the spread takes a hit, leading to losses. Another worry is that money may go out of the banking system wholesale.
Economists point out that it can have effects that overshadow textbook benefits. For instance: The public can see it as toxic, and their view of the central bank can dim. Then there is the contagion effect. Because several borrowing costs are linked to the central bank's benchmark, negative rates spread to fixed income securities, with government bonds beginning to yield negative yield to maturity.
History indicates that this idea has not worked well at the ground. That's because small cuts below zero level are inadequate. You need them to be significantly negative.
In essence, a negative interest rate is an emergency weapon to be used only in exceptional situations of drastic deflation and no growth.
(The writer is a CA, an author, teacher, and public speaker.)