The Global ANALYST: Negative Interest Rates

Global Banking: Negative Interest Rates*

M G Warrier

The task before GOI and RBI for the moment comprise (a) ensuring the savers continue to repose their trust in banking system and continue to save and keep their savings as deposits with banks (b) citizens including elders are assured of a positive and reasonable return on their investments made for social security and retirement concerns and (c) those, including corporates who borrow money from banks get funds at affordable costs.

So far, only central banks have toyed with the idea of negative interest rates. In India, over time, from the days of double-digit inflation, real effective interest rates have been negative, though. Here is how. If a bank paid 10 per cent per annum on deposit and the inflation rate was 11 per cent, in effect the depositor gets interest @(-) 1 per cent per annum!

The European Central Bank (ECB) ventured into sub-zero interest rates a year ago and in January, 2016 the Bank of Japan has recently caused tremors across financial markets by adopting a negative interest rate policy. A negative interest means that banks will have to pay the central bank for holding their funds. Banks in Japan will now have to shell out 0.1 per cent on the excess reserves they maintain with the central bank. The ECB already charges its banks 0.3 per cent and Sweden, Switzerland and Denmark similarly have negative interest rates. The US Fed Reserve chief Janet Yellen acknowledged in a congressional testimony recently that she was open to the possibility of introducing negative interest rates. According to one estimate, more than one-fifth of the world’s GDP is in countries that have imposed negative interest rates. That includes Japan, the EU, Denmark, Switzerland and Sweden.

The concept of lower central bank base rates(policy benchmark rate set by  a central bank to which borrowing costs are linked) triggering economic growth is based on the belief that lower interest rates will bring down the cost of borrowing, encourage spending and hence kick-start growth. Negative rates essentially penalise banks for holding idle funds and force them to lend it out to retail and industrial borrowers. The impact of reduced borrowing rate on production costs will depend on the interest cost content in the inputs for production.

What is negative interest rate for the consumer?

For starters, let me explain this concept with an example. Fish-vender Arundhati from a small town in Kerala has been selling fish by carrying headloads of fish from house to house for the last 25 years. Today, she buys fish costing about Rs3,500 from the wholesale market, transports it in an auto-rikshaw to her town and makes about Rs5,000 by evening by sale by carrying from door to door. Whole her life, she has been dependent on ‘Blade Bhasi’ a local money lender. Every Monday morning she borrows Rs5,000 and repays Rs5,500(including Rs500 towards interest) on Saturday evening. In this process, if the original Rs5000 belonged to Arundhati, the additional Rs500 paid is the negative interest she is paying to Blade Bhasi for safe custody of Rs 5,000 from Saturday to Monday. If the corpus of rs5,000 belonged to Blade Bhasi, the interest paid by Arundhati on the borrowed money @Rs500 per week on rs5,000 is at around 500 per cent per annum.

Why I should worry about negative interest rates?

My friend Ranade retired from service in 1992 after serving HAL (a prestigious PSU those days) for long 35 years. There was no pension scheme in HAL and he had a house to stay and a retirement corpus of about 8 lakhs with him after meeting all liabilities on the day of retirement. He had a son and a daughter who were well settled in life by the time Ranade retired. After keeping Rs 2 lakh for emergencies and some journeys he proposed to undertake post-retirement, he invested Rs 6 lakhs in National savings Schemes instruments and bank fixed deposits which together gave him a monthly average return of Rs 6,000 which was more than the net average monthly salary he brought home during the last year of his service. He has retained the original Rs 6 lakhs in tact till date, but the monthly return of Rs 4000 plus now he gets now on his investments is insufficient even for a week’s survival for the two-member family he heads. He had boasted about his lifestyle which would help him to live in dignity without depending on his children. Today, he is trying to opt to accept help from his children to meet his travel and medical expenses and household expenditure when guests including his own family members come and stay.

For Ranade, the monthly income has come down by one-third and the purchasing power of every rupee he gets today is a small percentage of what it used to be at the time of his retirement. The two-way impact

Dr Rajan explains impact of inflation on costs

Resreve Bank of India Governor Dr Raghuram Rajan in his C.D. Deshmukh Lecture  at NCAER, New Delhi on January 29, 2016 explained the effect of inflation using the example of price of Dosa asunder:

 “Before I turn to the main body of this talk, a word on interest rates. Industrialists grumble about high rates while retirees complain about the low rates they get today on deposits. Both overstate their case, though as I have said repeatedly, the way to resolve their differences is to bring CPI inflation steadily down.

Let me explain, starting with the retiree. The typical letter I get goes, “I used to get 10% earlier on a 1 year fixed deposit, now I barely get 8%”, please tell banks to pay me more else I won’t be able to make ends meet”. The truth is that the retiree is getting more today but he does not realize it, because he is focusing only on the nominal interest he gets and not on the underlying inflation which has come down even more sharply, from about 10% to 5.5%.

To see this, let us indulge in Dosa economics. Say the pensioner wants to buy dosas and at the beginning of the period, they cost `50 per dosa. Let us say he has savings of `1,00,000. He could buy 2,000 dosas with the money today, but he wants more by investing.

At 10% interest, he gets `10,000 after one year plus his principal. With dosas having gone up by 10% to `55, he can buy 182 dosas approximately with the `10,000 interest.

At 8% interest, he gets `8,000. With dosas having gone up by 5.5%, each dosa costs `52.75, so he can now buy only 152 dosas approximately. So the pensioner seems vindicated: with lower interest payments, he can now buy less.

But wait a minute. Remember, he gets his principal back also and that too has to be adjusted for inflation. In the high inflation period, it was worth 1,818 dosas, in the low inflation period, it is worth 1,896 dosas. So in the high inflation period, principal plus interest are worth 2,000 dosas together, while in the low inflation period it is worth 2,048 dosas. He is about 2.5% better off in the low inflation period in terms of dosas.

This is a long winded way of saying that inflation is the silent killer because it eats into pensioners’ principal, even while they are deluded by high nominal interest rates into thinking they are getting an adequate return. Indeed, with 10% return and 10% inflation, the deposit is not giving you any real return net of inflation, which is why you can buy only 2,000 dosas after a year of investing, the same as you could buy before you invested. In contrast, when inflation is 5.5% but the interest rate you are getting is 8%, you are earning a real rate of 2.5%, which means 2.5% more dosas. So while I sympathize with pensioners, they certainly are better off today than in the past.”

Now that we have a fair idea about the impact of inflation and interest rates on borrowings, savings and prices, let us look at the relevance of  negative interest rates in the Indian context.

Paragraph 14 of the April 2015 Monetary Policy Statement of Reserve bank of India read asunder:

“The Monetary Policy Framework Agreement signed by the Government of India and the Reserve Bank in February 2015 will shape the stance of monetary policy in 2015-16 and succeeding years. The Reserve Bank will stay focussed on ensuring that the economy disinflates gradually and durably, with CPI inflation targeted at 6 per cent by January 2016 and at 4 per cent by the end of 2017-18. Although the target for end-2017-18 and thereafter is defined in terms of a tolerance band of +/- 2 per cent around the mid-point, it will be the Reserve Bank’s endeavour to keep inflation at or close to this mid-point, with the extended period provided for achieving the mid-point mitigating potentially adverse effects on the economy. As outlined above, several favourable forces are at work, consistent with the change in the monetary policy stance towards accommodation effected from January. The Reserve Bank’s intent is to allow the disinflationary momentum to spread through the economy, but remain vigilant about any resurgence of inflationary pressures that may destabilise the progress towards the inflation objectives set in the Agreement.”

Quoted this to reassure that Reserve Bank of India is not expecting a negative interest rates scenario in India in the immediate future and the academic debates in the media and by economists need not make us sleepless beyond the point that policy makers’ capacity to apply their mind in the Indian context should be protected from a possible hijack and tampering by vested interests. But that is not easy. Here is why.

In our country, traditionally banks have been enjoying a high level of Net Interest Margins (NIM-Difference between return on resources and cost of funds). Though media, economists and analysts have been vociferous while demanding reduction in central bank’s bench mark rate, response to rate cuts by RBI was felt quickly by depositors/savers and very slowly and only on being pressurised by government and RBI the banks passed on a portion of the benefit they got by rate cuts to borrowers as reduction in lending rates. Perhaps, this behaviour may be resulting in increase in NIM.  In developed countries, where policy rates are negative, banks avoid passing on the impact of negative rates to depositors and savers and usually grit their teeth and bear the cost themselves, even if it means a squeeze on their margins. But in India, as banks’ depositors do not have many avenues to shift their savings, possibility of banks passing on all losses on account of reduction in bench mark rates is high.

Some policy precautions

In India, Arundhati, the fisherwoman, Blade Bhasi the moneylender, Mr Ranade the HAL retiree and Dr Rajan, the professor who is now a professional central banker have all different perceptions and concerns about the policy pursued by government on social and financial issues. The only way to move forward is to test every change for suitability in the Indian context. When the world moves, India cannot stand still. As Dr Raghuram Rajan mentioned in Washington on April 16, 2016, though India is now described as ‘the bright spot in the global economy’, ‘we have still to get to a place where we feel satisfied’. The journey forward is going to be uphill and slippery. Money, financial sector and interest rates are amenable to discipline and regulation, but…but, a lot depends on trust we are able to sustain in the system. Playing with interest rates is like playing with fire and RBI knew this better than many central banks. Any change will affect citizens in every walk of life. We should not just follow developed nations who can afford to make experiments and make mistakes, on such vital issues.

Economists from the Bank for International Settlements have taken cognizance of the adoption of negative interest rates by some central banks and have recently warned that ‘negative interest rates risk may backfire in the longer and more deeply central banks in Europe and Japan venture into this unconventional monetary policy, and it was difficult to predict how individuals or financial institutions would behave if rates were to fall further below zero or stay negative for a long period’. The BIS research pointed out that retail deposits have been insulated from the policy and that some mortgage rates in Switzerland have “perversely increased”.

The task before GOI and RBI for the moment comprise (a) ensuring the savers continue to repose their trust in banking system and continue to save and keep their savings as deposits with banks (b) citizens including elders are assured of a positive and reasonable return on their investments made for social security and retirement concerns and (c) those, including corporates who borrow money from banks get funds at affordable costs.

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*This is the submitted version of the article "Central Banks' Tool of Last Resort?" published under Global Banking: Negative Interest Rates in May 2016 issue of The Global ANALYST.