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.
**** **** ****
*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.
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