Negative Interest Rates

Updated on 2023-08-29T11:59:58.336581Z

What are Negative Interest Rates?

Negative interest rate policy is an unconventional move which is usually adopted by governments to stimulate demand in an economy. Interest rates that are usually maintained in a market are positive interest rates for lending and borrowing between financial institutions and consumers. When positive interest rates are offered, an investor will receive interest on his investment while a borrower would have to repay the loaned amount along with interest.

However, under the scenario of negative interest rates, the situation is the opposite. On technical grounds, a lender should pay the interest, and the borrower should receive this interest in such a scenario. High interest rates are a way of combating inflation, while low interest rates are used to combat contracted demand. As interest rates are lowered to near zero levels, the government and the central banks expect that consumption would increase with this move.

However, even when near zero levels of interest fail to increase borrowings, then the central bank may decide to lower interest rates further down to negative levels. Essentially, this means that consumers would have to pay the banks to keep their deposits in the bank, and lenders would have to pay interest to borrowers and so forth.

These consequences are supposed to encourage borrowings in the economy. However, there are other sets of challenges that may arise.

How do negative interest rates stimulate the economy?

Negative interest rates make it costlier to hold money, as depositing in banks means paying interest to them. Therefore, consumers are compelled to spend, thus, expanding the economy. Also, when negative interest rates are implemented, it means that taking a loan becomes cheaper now than in the future. Which would lead to increased borrowings, with the help of these people would make investments.

For instance, a family might want to buy a home and take a loan when interest rates fall to negative or near zero levels. Such a loan would not have been possible for them under normal circumstances as the interest rates charged by banks over home loans are exorbitantly high in many countries. Therefore, negative interest rates would urge the family to take a loan and invest in a house.

Increased investments would kick-start the economy as investments are a part of the national income. As consumers take loans for houses, cars, education, the demand in the economy increases. To meet this demand production is also increased by firms. In return, jobs are created as firms need to produce more. Therefore, the interest rates provide a “nudge” to the economy and eventually can expand it under favourable conditions.

On the international front, foreign investment would decline because of negative interest rates. This means that the demand for domestic currency would decline due to decreased foreign investments. Therefore, the domestic currency would depreciate because of negative interest rates in the economy.

As a domestic currency loses its value compared to foreign currency, domestic goods become cheaper. Thus, exports rise, and imports fall. Thus, negative interest rates can boost production in an economy and can improve the GDP as well.

What are the adverse effects of a negative interest rate policy?

Negative interest rates bring with them the possibility of increased savings too. As people fear a decline in their savings deposits, they would start to save more and consume less. This could contract the demand in the economy, which would clash with the initial goal of expansion.

However, this vortex may or may not occur depending on the expectations of the people. Adding to that, the people might develop a loss of confidence in the banks who would face direct costs as a result.

The financial sector would face the direct impact of negative interest rates. As more and more people would want to withdraw money from their deposits, banks might face a lack of credit. Even in the cases when people do not remove their money, banks would not earn any interest from these deposits.

What are some countries that have experienced negative interest rates?

Negative interest rates have been seen in countries like Japan, Switzerland, and Denmark. These countries have maintained negative or near zero levels of interest rates for almost half a decade and continue to do so. Sweden and Spain both have been maintaining a 0% interest rate. These examples might paint a positive picture of the negative interest rate scenario.

On closer inspection, one can see that for these countries, the implementation of negative interest rates was an act of desperation. For example, in Switzerland, the lifting of a minimum Swiss Franc Exchange Rate led to the need for a negative interest rate. However, the cost of such a move was paid for by the financial sector. Banks faced the impact of this move by the SNB and had to bear the costs. The entire burden fell on a few banks as certain other banks had been exempted from the policy. This heightened the adversity in the banking sector.

Therefore, the short-term goals of depreciating the currency and increased demand can be achieved with interest rates that are close to 0%, or in some cases, even 0%. Over a long period of time, the costs attached to negative interest rates may outweigh the benefits brought along by them.

Similarly, the Jyske Bank in Denmark launched the world’s first mortgage with negative interest rates. For a 10-year period, it offers -0.5% interest, and for deposits, it offers 0% interest. The bank was able to function by transferring the negative interest down to its customers.

Thus, it can be argued that it is better to steer clear of the policy unless it is the only way out. The expectations of increased demand may not always collide with the reality brought along by negative interest rates. As a result of which, the economy might face a rough patch.