Gloria F.T, Associate Consultant, TCS BaNCS
Most discussions on interest rates, and specifically on the Negative Interest Rate Policy (NIRP), start with reference to the theoretical and practical implications of monetary policies. While this serves in cases where historic data is abundantly available, NIRP plays a fairly nascent role of a firm foundation in forward-looking discussions.
In current times, governments, regulators, financial market agents and organizations across the globe are earnestly seeking measures to route fund flows towards productive sectors and simultaneously increasing consumption levels. They are engaging with different tools in varying degrees including:
- Lowering interest rates
- Debt purchase programs
- Large scale government spending
- Quantitative easing
- Direct transfers
- Tweaking taxation
Figure 1 - Circular Flow of Money
Amongst the available tools, one of the most widely and often used tool is the Management of Interest Rates. However, in the recent past, many countries have reached, or are nearing to what is called, the Zero Lower Bound – the point at which the economy stops effectively responding to interest rate manipulations. The liquidity trap ends up limiting the central bank's capacity to stimulate economic growth and this, when coupled with consumption slump from households and excess unutilized capacities in production, can amount to an environment calling for unusual intermediation.
In economic climates where markets fail to discover solutions to meet critical demand shortages, classical economics concurs that below zero interest rates (read negative interest rate) may be an answer to nudge up aggregate demand.
Negative Interest Rates – Recent but Untapped:
In practice, negative interest rates have been around in varying forms for some time now.
The current global negative yield bonds are at around USD 18 trillion dollars.
Varying timelines ranging from 1970s in Switzerland, 2009 – Sweden, 2012 – Denmark, 2014 – Japan and ECB in 2014 have all tried periods of Negative Interest Rates for diverse reasons.
Considering these experiences, the effectiveness of NIRP as a monetary tool should have been tested and referred. An OECD research1 has indicated that while NIRP can provide additional monetary accommodation in the situation where the neutral rate of interest is most likely negative, there are also unintended consequences for banks’ profitability and potential financial stability risks associated with the policy. Despite such apprehensions, regulators in many countries are still exploring, calling for discussion papers, consulting financial market players, testing technological readiness etc.
There are some reasons why the historic data and current environment of exploring NIRP is different:
|Historical Scenario||Current Environment|
|Why||In the past, most instances indicate that the NIRP was employed to curb unchecked capital inflows and unsettled currency valuations in the country.||The extant need in many countries is to boost consumption and kick-start production momentum.|
|Where||Sub-zero rates were fairly localized to the country / zone. This resulted in flight of currency to relatively safer countries.|| |
In the current scenario, the possibility of currency flight gets limited because:
1. Stráský, J. and H. Hwang (2019), "Negative interest rates in the euro area: does it hurt banks?", OECD Economics Department Working Papers, No. 1574, OECD Publishing, Paris, https://doi.org/10.1787/d3227540-en.
|Historical Scenario||Current Environment|
|Period||Some countries have tried to sustain NIR for a period of time, which could have been the cause of some collateral counterproductive outcomes.||The current thought process is to employ NIRP as a short to medium term measure to garner sufficient thrust and thereafter resort to conventional monetary policy measures.|
|Players||Regulatory-driven - these trickle down to treasury and bank borrowing. In some countries, these were not passed down to the end consumer. This caused severe NII margin squeeze on banks, consequently affecting their profitability.||Presently, thebanking sector is exploring the idea of passing on the NIRP to the end consumer (households and firms) and broad base it to deposits and lending.|
|Economic Metrics||Majority of situations in the past indicate that the economy had supply side pressures with high inflation.||Current economic metrices indicate both demand side and supply side pressures exist in the system. Additionally, revival and positive sentiment are on the uptick, making it a good time to provide support through targeted and momentary thrust.2|
|Ecosystem Play||Theoretically, if deposits attract negative interest rates, depositors could display an indifference to the system and hoard cash, especially if the economy is experiencing deflationary pressures. There has, however, been no evidence so far to indicate this possibility.||With digital currency becoming more wide spread, the theory of cash hoarding does not hold. In fact, decreasing purchasing power makes holding any cash disincentivized.|
|Bank Capitalization||Since sub-zero rates were not passed onto the end consumer, banks that were not sufficiently capitalized, i.e., those which relied on deposits for their capital, faced profitability concerns – thus putting the entire sector in an adverse position.||Well-capitalized banks can take the lead in implementing the NIRP policy and pass it down to the end consumer, thereby building on consumer acceptance. This can be followed by onboarding the broader banking segment towards implementing the NIRP.|
2. Economic Indicators
Implementing the NIRP – The Possibilities
While this may not be the standard text-book measure nor the traditionally proven tool, NIRP could be an instrument of choice for a short to medium term revival in many economies. While implementing it, few factors that may be worth considering include:
- While consumption debt may not go the negative interest way, investment debt could look at embracing sub-zero.
- In the case of deposits, accounts above a certain threshold or of a certain currency may be subject to the NIR.
- In case of loans, part tenor of the loan may be considered for NIR. Also, certain targeted production segments may be incentivized through sub-zero rates.
- Race to recovery – Some countries which have a higher revival sentiment, higher than estimated GDP growth in the post– recession period or have effective alternative monetary tools may continue to refrain from going below zero.
- Countries with higher level of public debt may also refrain from resorting to extreme measures since the immediate trickle-down effect in such economies could be uncertain.
- Countries with higher level of exports to GDP or those working towards increasing exports may be inclined to introduce sub-zero rates due to the impact of NIR on currency rates.
- Derivatives markets, especially hedges and cash flow-based instruments, may witness a negative impact due to the sub-zero interest rates (as for example - Interest Rate Swaps).
- While most monetary policies have an immediate impact on the fund flow into the economy, banks, while keeping in mind the counter-intuitive and untested measure of sub-zero rates, may hold on to the rate before passing it to the end consumer. This lag could lead to the measure losing relevance in the economic environment when it is eventually implemented.
Other Impacted Areas
- Legal implications and Contracts - The impact on new loans, existing floating rate loans and benchmark-linked loans need to be looked at to ensure legal loopholes with respect to fund flows are accounted for. Breaching / capping of floor rates would need additional consideration by the respective parties to the contract.
- Accounting Changes - Net interest outflows and interest inflows would have to be accounted under finance costs or indicated as a separate line item in the income statement.
- Technological Readiness - Software readiness to commence implementation of the NIRP may be critical, especially where real-time accounting and downstream processing needs to be in place. This readiness has to be ensured for all the financial intermediaries and market players to confirm there is no divergence in the accounting and / or reporting.
- Impact on the Exchange Rate - Sub-zero rates in a country have a direct and immediate impact on the currency exchange rates since it would be less attractive, thus posing a concern for maintaining the balance of payments for the country.
- Tax Issues - Where the tax receipt / inflows are subject to taxation or tax outflows receive incentives with subsequent carry-forwards spread out across many years, the corresponding netting of negative interest flows has to be accounted for.
Counter-intuitive as it may seem, the current trends indicate that NIRP is a possibility as a monetary measure in the short to medium term. The success of the implementation would depend on the ecosystem readiness in the geography of implementation and the interplay of dependent economies reacting in varying measures to the policy.
Disclaimer: Views or opinions represented in this blog are based on the author’s own research and do not represent TCS BaNCS.