Negative Interest Rates

 

 Audio Version Given Below

 

A few days back there was a catchy headline in an article on the website of a leading Indian business newspaper that savings have been discouraged as the Real interest rate has become negative. At the first glimpse, it may seem to be a clickbait because banks are one of the safest avenues of investment in India.

Here’s the catch: the article talked about the ‘Real’ interest rate becoming negative.

In this article, I shall try to discuss the Negative Interest Rates.

Real Interest Rate

We know that interest is the cost of using money belonging to someone else. When we deposit money in the bank, we generally receive interest, because the bank is using our money. Similarly, when we borrow money, we are charged interest. This is the nominal rate of interest.

But over time the value of money reduces due to inflation. So the value of the interest is not the same as received. The impact of inflation should be considered. This leads us to Real interest rate or the Inflation-adjusted interest rate.
For example, the nominal interest rate is 7% and the inflation rate is 4% then the real interest rate will be 7 minus 4 i.e. 3%.
This is the rate a prudent investor considers while evaluating investments. ‘After-Tax Rate’ is also one criterion, but that’s the topic for another day.
Now, if the inflation is more than the nominal interest rate, the Real interest rate will become negative. It is this Negative ‘Real’ interest rate that the headline talked about. However, there is an actual concept of ‘Negative Interest Rates’ also.

Meaning of Negative Interest Rate

Negative interest rate effectively occurs when the nominal interest rate drops to a level below zero.
That means the depositors will have to pay interest for depositing their money, for keeping their money safe. It is a kind of cost of security.
On the other hand, the borrowers are charged minimal/ nil interest for the sum borrowed. Thus banking works in the reverse model.
We know that the nominal interest rates depend on the policy rates decided by the country’s central bank (RBI in case of India). If the central bank reduces the policy rates such as repo rate (the rate at which RBI lends to banks by purchasing securities), the banks will also reduce their deposit/ lending rates, as they now get funds at a cheaper rate.
By reducing the policy rates to negative, the central bank aims at making the parking of excess funds costly for the banks. This will encourage lending.
That’s why, in turn, banks also discourage savings by charging from depositors for depositing money with them.
It should be noted that adjusting the deposit/ lending rates by commercial banks in response to the changes in policy rates is not obligatory, but the banks follow it as a trend.

Need for Negative Interest Rate

In a country, the economy is regulated by the government and the monetary authority i.e. the central bank. The steps taken by the government, such as changing tax rates, increasing government expenditure etc are governed by fiscal policy. Similarly, changes in policy rates, ‘Quantitative Easing (QE)  done by the central bank are governed by the monetary policy. In QE, the central bank purchases long-term securities from the open market to increase the money supply in the economy.
Reducing policy rates to sub-zero level is an unconventional monetary policy. It is the last resort to promote economic growth when other policy changes show no positive results.

How Negative Interest Rates Lead to Economic Recovery

Generally, the interest rate is made negative to give a stimulus to the economy. The process is  broadly explained below:

      i.          There is a downturn in the economy due to any reason (for example, the ongoing pandemic)

    ii.          This fear of recession makes people save more and spend/ invest less

  iii.          This leads to a decrease in demand for goods and services as people are saving money

 iv.          Lesser demand will lead to lesser production and reduced prices to attract demand

   v.          Reduced prices and demand lead to deflation( opposite of inflation)

 vi.          To combat this, the government will make fiscal and monetary policy changes

vii.          If they don’t work, as a last resort central bank will reduce policy rates to negative thus leading to negative interest rate

viii.          As the borrowing becomes cheaper and deposits become chargeable, the people will spend/ invest more and save less

 ix.          This will lead to increased demand, employment generation and thus economic recovery

Challenges in Negative Interest Rate Policy

The main challenges in the policy are as follows. However, the effect of the same depends on the fundamentals of the economy.

     i.          Lack of credit supply: If people are discouraged to deposit in banks by making them pay for the same, this may affect the credit supply as banks may fall short of funds to lend to borrowers. Instead of depositing money in the bank, people may store it as cash or invest in other avenues.

   ii.          Fear of default: The biggest borrower in any country is the government itself. If the interest rates become negative, the government can borrow money from the public at a very low rate. This will lead to high public debt. Higher the public debt, more are the chances of default, because interest rates are bound to increase once the economy of a country recovers.

iii.          Zombie companies: With debt available at a lower rate, many zombie companies (highly indebted companies requiring regular bailouts) will remain alive. In a normal scenario, they will collapse due to lack of money.

Scenario in India

As I have mentioned in the beginning, banks are a safe avenue of investment in India. Every common man’s first choice is to park excess money as savings in the bank. With the advent of online banking, it is almost readily available for online purchases and transfer in a matter of few clicks. Even though the investor doesn’t earn much in terms of savings bank interest but the easy availability in time of need makes bank deposits (both savings and term) the first option of savings. A common man also finds it safer to keep excess money in a bank rather than in cash due to the risk of theft.
Now, if the interest rates become negative in India, i.e. the depositor will have to pay charges to park the funds in banks, this will nullify the purpose of savings.
India is still a developing country and our economic fundamentals are different than those of developed countries. As a young economy, we have the potential for growth and creating demand as compared to a few western countries where the GDP growth has been flat or very slow (even before the pandemic) that’s why they introduced negative interest rates.
In India, the policy rates are falling but are still positive. It means that the government and RBI believe that the economy is still strong enough to recover with other fiscal and monetary policy changes. RBI reduced the repo rate by 1.15% (from 5.15% to 4%) between March and May 2020 to promote economic growth amid the pandemic.

The real interest rate for savings account has been negative since a long time but now even the real interest rate for 1-year term deposits of a few banks has come to the sub-zero level because the current inflation rate in June 2020 is around 6%.
But this trend doesn’t indicate that policy rates will fall in negative territory in the near future.

Alternative saving avenues

As the bank interests rates are falling, one can deposit money elsewhere. The liquidity may be low or the risk may be high but the return from the investment will be better.

One can invest in high-grade corporate bonds and corporate fixed deposits. The risk is higher, but so is the return.

A safe fixed-income investment option is RBI Bond 2020. This pays a floating interest rate of 7.15% since 1^st July 2020.
Senior citizens can invest in Senior Citizen Saving Scheme of any bank. It pays 7.4% as on 1^st July 2020. Though funds are locked for 5 years. Similarly, PPF pays 6.8% but funds are locked for 15 years. Senior citizens can also invest in Pradhan Mantri Vay Vandan Yojna. It has a lockin period of 10 years with the rate being 7.4% as on 1^st July 2020.

Negative Interest Rates Around the World

Negative interests rate is not a new concept. It already exists in some of the developed economies.

Sweeden: Sweedish central bank reduced its repo rate to 0.25% on 2^nd July 2009. This led to its overnight deposit rate (the rate at which commercial banks get interest for parking their funds with the central bank overnight) to minus 0.25%. This was done to boost the economy after the 2008 financial crisis. It was the first country in the world to have a negative interest rate.
Inflation had been nearly zero per cent since 2012, so to stimulate inflation to around 2%, the bank again reduced the interest rate to negative level in early 2015. However, the interest rate was made zero in December 2015.

European Central Bank (ECB): The central bank for Eurozone countries cut the interest rates to negative in June 2014. It is reported by Financial Times that the banks have paid Twenty Five Billion Euros to ECB since then for negative interest rates and this has affected their profit badly. But household lending has increased by 12% since the cut and corporate lending has risen by 3%.

Japan: Japan cut interest rates to below zero in 2016, as the Japanese government was highly indebted. This had started in the 1990s after the recession due to the stock market and real estate bubble burst. Bank of Japan did QE between 2001-2004 and in 2013 to stimulate the economy but it didn’t work. So in 2016, Japan introduced negative interest rates. But still, Japan has not been able to have any measurable improvement in economic activity.

New Zealand: Reserve Bank of New Zealand’s interest rate is 0.25% w.e.f. 16^th March 2020. It has doubled QE since the ongoing pandemic outbreak. If this stimulus doesn’t work, the interest rate is expected to slip to sub-zero level by early next year.

Conclusion

Negative interest rate policy (NIRP) is an unconventional monetary tool aimed at economic recovery. But it has its challenges. It is felt that even though theoretically NIRP may work but so far the practical experience is otherwise. The recovery if any is minimal. But we need to understand that this concept has so far been only adopted by developed economies. The effect of NIRP on a developing economy can’t be forecasted.
 India has so far not felt the need of NIRP and may not require it in the near future. We can be hopeful if ever it is adopted, the Government of India will find solutions to the challenges with this policy.

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