Banking

What’s Going On? Behind the Downward Spiral of Global Interest Rates

Interest, or the money paid to someone for the privilege of using their capital, has historically always been positive.  When you put money into a certificate of deposit, savings, or other deposit account, the bank uses the cash you’ve entrusted to them to loan out to other borrowers or make other investments.  You earn interest for giving them the opportunity, and you get a safe place to keep your money. However, around the world, interest rates have steadily been falling, from zero interest rate policies (known as ZIRP) to negative interest rate policies (NIRP).  So what happens when interest rates become negative?  

In short, when interest rates fall below zero, everything reverses – savers pay the bank to store their cash and borrowers can get paid to take out loans.  This isn’t exactly black and white, as country regulations and bank policy dictate specifically how it plays out. For example, while some banks are legally disallowed from passing on negative rates directly to their customers, they can implement fees to help offset the cost.  Meanwhile, according to regulation, some corporate customers can see negative rates passed on to them. For borrowers in countries like Denmark and Germany, taking out certain loans actually pays a profit, while others have simply seen borrowing costs significantly reduced. Regardless of the variations, negative interest rates discourage saving and promote borrowing.

Why would a central bank make interest rates negative?  A hotly debated topic, the reality could include a myriad of influencing factors.  However, when you examine the justifications according to market participants, such as central bankers, economists and investors, two major theories arise.  

The Central Bank Premise: Economic Stimulus

The official government statements regarding their decisions to take interest rates negative all cite stimulating the economy as the driving factor.  The theory, that disincentivizing saving will encourage spending and encouraging borrowing will boost economic growth, applies to banks as much as individual consumers.  When interest rates are positive, banks can leave their excess reserves in interest-bearing accounts at their central bank, earning a return on their capital without taking any risk.  By implementing negative rates, banks have an incentive to lend their money out rather than lose money storing it. Additionally, the lower a country’s interest rates, the lower interest that is paid on their bonds, making demand for them lessen – weakening the country’s currency and making exports more attractive.  The assumptions, however, that banks will decide to lend money just because it now bears a real cost versus simply opportunity cost, or that a weaker currency will stimulate the economy though it simultaneously reduces consumers’ buying power, have not proved fruitful. So far, countries that have implemented negative interest rate policies, such as Japan, Germany and other countries across the Eurozone, have seen stagnant or even reduced growth.

An Alternative Rationale: Debt Mitigation

A second explanation has also been offered by some economists and other market participants.  Beyond the roughly 19 trillion in risky corporate debt that has accrued since interest rates first dropped near zero almost a decade ago, government debt is at an all time high.  Currently standing at over 65 trillion, a massive amount of government bonds have been issued around the world to pay for monetary stimulus programs in the wake of the financial crisis and fund increasing government spending.  Bearing interest that must be paid to the bondholder, these IOUs carry an increasing financial burden. Lowering interest rates, particularly into negative territory, not only removes this interest burden, but creates positive cash flow that can then be applied to reduce the deficit or even fund new spending.  As global debt grows, negative interest rates essentially act as a government refinancing, freeing countries from the exponentially expanding problem of needing to continuously borrow increasing amounts to meet their rising interest obligations.

The effect of monetary tools such as negative interest rates have yet to be fully observed.  Originally intended as a temporary measure to combat short term economic woes, negative interest rates are becoming increasingly standard.  While some tout the benefits, others warn it is an ominous sign of larger economic concerns. The world is closely watching the effects of negative interest rate policy already implemented in countries across the globe and hotly debating its merits versus risks.  Regardless of perspective, the worldwide trend towards negative interest rates is an unprecedented shift in monetary policy.

 

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