Negative interest rates are damaging the economy and hitting investment

Low rates delay essential restructuring to remove the detritus of previous crises. They restrict the supply of credit to the wider economy and deepen our malaise

Satyajit Das
Sunday 18 September 2016 14:19 BST
Mark Carney, Governor of the Bank of England
Mark Carney, Governor of the Bank of England (Getty)

A number of central banks now have negative official rates. Over $30 trillion (£10 trillion) of worldwide government bonds are now trading at yields of below 1 per cent with over $13 trillion currently yielding less than zero per cent. Government bonds in Germany out to a maturity of seven years are trading at negative yields. Swiss and Japanese government bonds out to 10 years trade at negative yields.

Negative yields mean that if an investor places a deposit with a bank at maturity the investor receives back an amount less than the original investment. In effect, the depositor pays to place money with the bank. In the case of bonds, negative yields mean that investors accept an economic loss, as the price paid by the investor is greater than the present value of the interest payments and principal repayment for a security.

Negative real rates entail return on the amount invested but loss of purchasing power because inflation rates are greater than the return. Negative nominal rates involve a guaranteed loss of capital invested.

To date, negative rates have not boosted growth or inflation, instead creating serious economic and financial distortions.

The lack of impact on the real economy reflects the failure of these policies to materially increase consumption and investment. Heavily indebted or increasingly cautious households are reluctant to borrow to fund spending. Low business investment reflects lack of demand, over-capacity and also a reluctance to increase debt in a potentially deflationary environment.

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Negative rates have not increased lending volumes significantly. In part, this reflects the fact that most banks have not passed on the negative interest rates to the majority of customers. One amusing reason is that banks which profess engagement with “block chains” and FinTech lack systems which can accommodate negative rates.

Banks dependent on deposits are reluctant to reduce rates, fearing the loss of their funding base. Lending rates have also provided sticky. Banks face profit pressures from the mismatch between hard to reduce deposit rates and loans which have interest payments contractually linked to the central bank’s policy rate. In practice, negative rates may impede lending because loan costs have not come down in line with official rate or profitability issues reduce willingness to lend.

Negative interest rates are also increasingly ineffective in managing exchange rates.

Initially, the Eurozone and Japan benefitted from a weaker euro and yen which boosted exports. Switzerland and Denmark limited the appreciation of Swiss franc and Danish krone against the euro. But in a world of limited growth and low demand, the increase is at the expense of competitors. US industry has been affected by a 20 per cent appreciation of the dollar, leading to criticism of currency manipulation. The likelihood of retaliation to restore individual nation’s competitive position is high.

The latest round of rate cuts have not affected currency values as expected. Both the yen and the euro appreciated against the US dollar after the announcement by the Bank of Japan and the European Central Bank of more negative rates. Persistence with this policy risks triggering a nugatory race to the bottom for both interest rates and currencies, as tit-for-tat cuts and devaluations vitiate each other.

Critics fear asset bubbles. The experience is mixed. Some European equity and real estate valuations have become stretched, as investors switch out of cash or safe assets.

A major concern is risky corporate bonds and bank securities, usually hybrid or quasi capital instruments. Investors, particularly individuals, lack the skills to analyse credit and complex structures. The suicide of an elderly Italian investor who lost a substantial proportion of his life savings when a subordinated note was written down to recapitalise the issuing banks highlights the risk.

Negative rates also distort financial markets and the economy.

There are mechanical complications. US money market funds operate under regulations which require them to maintain the capital value of the investment made by savers. Negative interest rates would require either changes in the rules or force these entities to close, effectively disrupting the flow of short term funding to industrial companies, banks and governments.

There are important fundamental alterations to rate relationships within financial markets and also funding arrangements, which have implications for central bank monetary operations.

Negative interest rates change the role of default or bankruptcy in debt markets. A borrower could only default on principal repayments as there is no interest payment. Covenants such as interest or debt cover designed to provide early warning of distress would have altered significance or none at all.

Depending on bankruptcy laws, borrowers may lose and lenders gain in cases of default.

Negative or ultra low interest rates also reduce the risk of default. As shown in Japan, it creates zombie companies and industries by distorting the cost of capital and finance encouraging mal-investment.

Businesses do not make necessary adjustments to strategy or business practices. Unproductive investments are not restructured or sold.

Banks do not write off bad loans, relying instead on low or negative rates to allow zombie companies to continue operations. Weakened profitability from negative interest rates discourages banks from aggressively realising bad debts.

In effect, low rates delay essential restructuring to remove the detritus of previous crises. It restricts the supply of credit to the wider economy affecting economic activity. Misallocation of capital deepens the malaise and makes ultimate resolution more costly and difficult.

A prolonged period of negative interest rates would damage the process of saving and investment central to the market system. One troubling historical precedent is the attempts by the German National Socialists to prohibit interest rate being charged on borrowings.

A policy of ever deeper negative interest rates is reminiscent of the strategy of an army officer during the Vietnam War destroying a village in order to save it.

Satyajit Das is a former banker. His latest book is 'A Banquet of Consequences' (published in North America as The Age of Stagnation to avoid confusion as a cookbook). He is also the author of Extreme Money and Traders, Guns & Money

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