Let’s say you go to your bank after one year, with an expectation of an amount over and the above the INR 100,000 you deposited the previous year. It turns out that your balance with the bank has fallen even though you had not made any withdrawals during the year. You think it is a scam and complaint to the manager, who apologetically replies, ‘Sir, negative interests are prevalent in the country, so we have charged money for keeping your money in custody. You owe us some money not the other way around’.
Everything that transpired was a result of what is called, Negative Interest Rate.
We will break down this article into two parts. One part will explain what negative interest rates are and the other will talk about the various aspects of our macro environment this phenomenon will affect.
Negative Interest Rates
When NOMINAL target interest rates are set below the theoretical bound zero interest rates, the rates set are Negative Interest Rates. Real interest may or may not be positive but the real catch is that the nominal interest rates are negative for the deposits made in bonds or in the bank accounts.
During Deflationary period, people choose to hoard money instead of spending it. Thus, the aggregate demand falls, which leads to prices falling further. As a result, a vicious cycle starts, where the real production falls, and unemployment rises. The central banks and the government employ expansionary policies to push the demand up, by reducing the cost of raising money. Hence, negative interest rates may come into the picture. The banks are allowed to charge money from depositors to be incentivized to lend money more freely.
Negative Interest Rate Policy(NIRP) is not a preferred policy tool, but at times it becomes the necessary evil. Other than deflation, Swiss government ran a negative interest rate policy in the early 1970s to counter currency appreciation due to investors fleeing to other parts of the country.
The Swedish government and the Danish Government used negative interest rates to stem hot money flows into the country. (Hot money is the money invested in a country for short term to take advantage of the higher interest rates prevalent in the country. Such investors withdraw their money as soon as the rate falls.) Hot money, as against FDI are invested for short term thus the sudden inflow and outflow of money adversely affects the balance of payments and causes instability in the currency exchange rates.
The Impact of Negative interests
Negative interest rates can also be coupled with behavioral economics. They not only incentivize consumption but also promote risk taking.
• Impact on Banks
Lending is the core banking activity of the bank. Banks lend at a higher rate, using the deposits received at a lower rate. Negative deposit rates mean that the banks will charge for the deposits made. The implicit rate of holding money is zero. So, the bank charges money for the security it provides and other maintenance charges. Negative Interest Rate changes the role of the bankers from an investment destination or a lender to a custodian of money.
There has been a tendency of banks to absorb the low-interest rates, for fear of losing customers who may withdraw money citing the negative interest charged on their money. For banks mainly dealing with floating interest rates, it means a shrinkage in the spread and a falling bottom line, and in the short term, the one-off capital gains may arise on the outstanding fixed income portfolio. Since fixed-income funds take some time to reprice to a lower level.
There is a risk that low rates may cause short-term dislocation in financial markets already identified by Bernanke and Reinhart in their 2004 newspaper on the implications of very low-interest rates.
• Taxation Aspect
Income tax acts or the direct tax acts across the world have provisions regarding charging interest on savings deposit. In India too, there is a tax on interest on savings deposits beyond INR 10000. On the other hand, there is no provision to claim a deduction on account of saving deposits. The reason is that the expense will account for the application of Income for personal expenses which falls outside the ambit of Income Tax acts across the globe. Exceptions may be needed to be created in the law.
• Loans and NPAs
In the absence of any monetary policy action, servicing floating rate loans and mortgage loans become affordable as interest rate falls. Borrowers who are struggling are less likely to default. Secondly, more accommodative policies are likely to create a favorable macro environment. Empirical pieces of evidence suggest, negative correlation between economic growth rates and non-performing loans. However, the long-term impacts of sustained negative rates are still not very clear.
• Legal Challenges
Recently there has been a spurt in litigations against the banks, with some major banks have decided against the banks’ ability to charge negative interest on the savings accounts. Legal counsel needs to take into account the changing scenarios and appropriate the sections accordingly.
• Change in the lending structure
Negative interest rates can lead to excess risk taking by the banks, as fall in interest rate corresponds with increasing lending to SMEs. in order to maintain the profitability, the banks may start lending to smaller firms to sustain the profits.
• Stock Buybacks
When interest rates are low, companies can borrow cheaply by issuing corporate bonds very cheaply and use the proceeds for share buyback. For example, Home Depot Inc. issued $2 Bn in bonds partly to finance a share buyback. The same trends can be seen with record amounts being raised for the said purpose leading up to 2008 crisis and then again when the rates fell. further.
Lower rates increase the companies’ ability to take risks, by leveraging more.
• Asset Bubbles
One of the reasons given for housing bubble of 2008 was easy access to cheap money for mortgages. A buyer of an asset of less income can purchase an asset of higher value with lower interest rates.
Written By : Raunak Bhiwal
Raunak Bhiwal is a PGP First year student at IIM Ahmedabad