Usually, when a person or an entity wants to borrow money, they usually need to pay interest on the amount borrowed until they pay off the amount in full. The lender’s margins are dependent on the difference between its lending rate and its own borrowing rate.
But, let’s take a scenario where –
Instead of charging interest for lending, the lender pays the borrower interest on the amount.
But, why would someone need to do that and when does it make sense to do that?
This is nothing new and was first known to take place post the 2008 subprime crisis or the great recession.
On 2 July 2009, Sweden’s Riksbank was the first central bank in the world to introduce a negative interest rate, when it brought its repo rate (the rate at which a central bank lends short-term money to commercial banks against securities) down to 0.25%. This caused the deposit rate (the interest commercial banks get for depositing money with the central bank overnight) to go down to −0.25%, while the overnight lending rate (the interest a central bank charges commercial banks for overnight lending) was pushed down to 0.75%
Source : “Repo rate cut to 0.25 per cent” (PDF) (Press release). Sveriges Riksbank. 2 July 2009. Retrieved 1 August 2018.
The European Central Bank (ECB) did something similar in June 2014 and brought its deposit rate to -0.1% to bring induced inflation in the economy.
The Bank of Japan (BOJ) did it in January 2016, to weaken the strengthening yen to boost exports.
How does it work?
The central banks want their economy to spend more or increase consumption to stop deflationary periods. This is usually done when there is a cash crunch in the economy or the economy is going through a recession. It is just a stimulus or an aggressive approach to maintaining inflation and steady growth in the economy.
But it is not the ultimate solution to all the problems of an economic crisis or slowdown. It can become a trap or become the new norm i.e. it has its own Pros and Cons.
Pros –
- It makes credit cheap in the country. It increases borrowing and lending as the commercial banks would otherwise lose money if they keep excess reserves with the bank.
- It could be a factor in increasing inflation in the economy.
Cons –
- It makes the margins of the lender i.e. the commercial banks too low. They may be discouraged to lend as then the lending rate becomes too low for them to make any good profits.
- The citizens of the economy may start to hoard cash and not deposit any money in the bank because they will actually be charged to keep their money safe in the bank.
- The government bonds yields turn red or go negative. This means the fixed investments of the people start becoming worthless investments as they start to lose their interest earnings. The person who has held on to the bonds all their lives and stays invested in them will actually not make anything out of their investments.
- The negative interest rates bring cash back into the system and thus reduces the value of the currency. Although this is great for boosting exports, it can hurt imports of necessary goods which might be vital for the survival of the economy or the daily livelihood of the citizens.
So what is the way out?
- The Bank of Japan follows a tiered system. This helps in mitigating the side effects of having negative interest rates by charging interests only on a percentage of reserves whereas on the remaining portion it applies a zero rate or non-negative interest rate.
- The ECB followed the Swiss National Bank’s suite. Their tiered system allows a portion of the bank deposits i.e. 6 times the mandatory reserves, to be charged no interest rates.
The Conclusion
The recent trade wars and a potential global economic recession made trump comment on the recent federal reserve rate cut. Trump opposed its decision of not going down to a negative interest rate and said that the country is not able to compete with the likes of Japan and ECB. This is because they have been able to depreciate their currency to boost exports and the US is struggling to do that.
Also, cutting interest rates down to a negative number creates a bearish sentiment in the financial markets. This unconventional policy may or may not work for an economy. It completely depends on whether the benefits of taking such steps for loosening the economy outweigh the risks or not.
