Negative interest rates. The new normal? – AFCA Think Tank Working Paper by Hubertus Väth


The concept of negative interest rates appears anathema to conventional economic thinking, and it is rarely discussed in economic literature. However, this changed when central banks began cutting their leading interest rates below zero. First in Sweden in 2009 and then in Switzerland, Denmark, the eurozone and Japan. Negative rates became a part of the monetary tool kit. Sub-zero rates soon spooked bond markets as well. For a brief moment in 2019, as US rates rose and even more euro-denominated bonds began to see some positive yields, markets expected a return to normalcy, that is, to positive rates. However, the sudden COVID-19 pandemic ended this trend and even the US, the UK and Singapore are on the brink of joining the negative yield club.
This article analyses negative rates from a European and mainly German perspective and focusses on three central aspects:

1) stiff headwinds for the international profile of the euro,
2) the impact on banks, particularly those with a strong deposit base, and
3) the interaction of rates and government debt.

This article also contrasts the views of central banks and their critics, which range from monetary economists warning of low-interest rate’s potential contractionary effects to followers of Modern Monetary Theory arguing that public debt volume and interest rates are mostly irrelevant.
Meanwhile, negative interest rates have become more common as the traditional arsenals of monetary policy have become depleted. However, the side-effects are considerable and deserve consideration.

Negative interest rates. The new normal?

To lend money and from the outset expect less in return is counterintuitive to the notion of money as a store of value. It also conflicts with the economic theory that foregoing consumption now to save for a later date deserves a reward, especially if you lend this savings instead, taking a risk. This thinking is not easy to align with negative rates. Hence negative rates send market participants a clear signal of an extreme economic scenario, a stressor on the system. Not surprisingly, except for some time from 1972 to 1979, when Switzerland tried to discourage foreigners from holding CHF deposits and lifting the Swiss Franc, interest rates were positive in all markets.

Times changed for good in July 2009, when the Swedish Central Bank, the Sveriges Riksbank, cut its main repurchase rate to 0.25 per cent, depressing the actual overnight deposit rate for the banks to minus 0.25 per cent.  For the first time in July 2012, Denmark’s Central Bank directly fixed its key interest rate below zero.  The European Central Bank (ECB) followed suit in June 2014, the Swiss National Bank in January 2015 and Nippon Ginkō – the Bank of Japan – in January 2016. The ECB cut rates four more times over the following years, reaching minus 0.50 per cent in September 2019.  Sveriges Riksbank cut the repurchase rate itself below zero to minus 0.10 per cent in February 2015 and to minus 0.50 per cent a year later  but reversed it to zero in December 2019.

Negative rates have spread to the bond market as well. By August 2019, USD 16.8 trillion of outstanding bonds carried a negative yield, according to Bloomberg. In December 2019, the volume decreased to USD 11.2 trillion. Governments and international organizations, as well as highly-rated banks and corporates from more than 30 countries across the globe from Japan to Germany, from the US to Singapore could raise money and essentially be paid for the issuance. The biggest countries to do so being Japan with USD 4.8 trillion, France and Germany with USD 1.6 trillion, Spain with USD 467.5 billion and international organizations with 428.9 billion.

Based on Sweden’s example and the reduction in outstanding sub-zero bonds from August to December 2019, one could have concluded that negative interest rates were gradually retreating. However, the COVID-19 pandemic stopped this trend in its tracks. It is safe to say that negative rates have become a fixture in the monetary toolbox and may even become the new normal provided inflation remains subdued – a provision that deserves debate. As the pandemic is both a demand and supply shock, we will see deflationary and inflationary forces at work at unprecedented levels. What we know for sure is that the vast recovery programs rely on these low or sub-zero rates. According to the International Monetary Fund (IMF), as of May 2020, these already amount to USD 9.0 trillion.   The OECD estimates that developed countries will raise at least USD 17 trillion of new public debt.

Considering this fiscal expansion, the US, the UK and Singapore are on the brink of joining the negative yield club. Interest rate futures markets in the US sent a remarkable signal during the first week of May 2020, as they appeared to price in expectations that the Fed’s benchmark federal-funds rate would fall below zero by year-end.  Donald Trump applauded via Twitter, “As long as other countries are receiving the benefits of Negative Rates, the USA should also accept the ‘gift’. Big numbers!”  On 20 May 2020, the UK government sold three-year gilts at a negative rate of minus 0.003 per cent for the first time.  A day later, the one-month swap offer rate in Singapore fell below zero.

A multi-pronged approach for economic growth and combatting deflation

In the wake of the financial crisis in 2008 and 2009, negative interest rates made their first prominent appearance in policy circles, when the traditional toolbox seemed depleted. The suggestion has been discussed by, amongst others, Mervyn King, governor of the Bank of England, George Mankiw from Harvard, a former Chairman of Economic Advisers, and Kenneth Rogoff, also Harvard, who even suggested abolishing paper currency to make it work . 
According to Philip R. Lane, the chief economist of the European Central Bank, the downward pressure on real rates has been “a significant environmental constraint on the options available to central banks.”  Since the 1980s, real interest rates have declined due to rising life expectancy, an ageing population, slower productivity growth and digitalization. 

Furthermore, the euro zone’s inflationary targets remain elusive, coming close but always below the ECB’s 2.0 per cent target. While this could be considered a success to the primary mandate of price stability, deflation is a major concern.

Therefore, the ECB pursued an “innovative, multi-pronged approach in the design of its policy stance.” The current policy mix includes four elements:

1) negative interest rate policy by fixing the deposit facility rate below zero,

2) an asset purchase program, specifically concerning eurozone government bonds,

3) support of bank lending through targeted longer-term refinancing operations (TLTROs), and

4) forward guidance on the path of policy instruments.

As a result, the European Central Bank received broad praise for its contribution to eurozone stability following the financial crisis.  Over the past six years, unemployment decreased as well as the risk of a deflationary spiral.

Nevertheless, critics focus on the harmful side-effects of negative interest rates. Just as any medicine carries certain risks and side-effects, it is a matter of careful consideration whether the positive impact outweighs potential negatives, especially long-term. Current research demonstrates that quite a few areas are affected by negative rates.

Side-effects on the domestic economy and international trade

Traditionally, central banks in industrialized countries cut rates by around 4% in response to recessions.  With rates already low or negative, possible changes will almost certainly be too small to substantially alter the profit rationale for households or corporates creating extra demand via credit. What low or even negative rates certainly do is relieve pressure to adjust and adapt, as the cost of debt remains manageable for most companies. Therefore, critics blame a “zombification” of the economy, citing the lack of dynamic in the Japanese economy as proof, by keeping weak companies afloat.

Sweden, an early advocate, became more sceptical on the balance of its impacts. At the December 2019 monetary policy meeting, Deputy Governor Henry Ohlsson remarked: “the minus world has not had a full impact on households […] The impact of monetary policy has been less than in the plus world.”

The so-called “theory of reversal interest rates” goes even further. According to Princeton University’s Markus Brunnermeier and Yann Koby, a specific interest rate level – which could even be above zero – exists at which the effects of accommodative monetary policy reverse and become contractionary for lending. The key determinants are the banks’ long-term fixed-income holdings, their capitalization, the tightness of capital constraints and the deposit supply. “A monetary policy rate decrease below the reversal interest rate depresses rather than stimulates the economy.”

Strong headwind for the international profile of the euro

Negative interest rates also affect exchange rates. Cuts can contribute to downward pressure, reducing a currency’s appeal to store value, hampering its role as an international reserve and investment currency. 
Despite the ECB’s strategic objective to strengthen the euro internationally, its share in global reserves peaked at the end of 2009, at almost 28 per cent at current exchange rates, but fell from 24.2 per cent at the end of 2013 to 21.2 per cent at the end of 2014 after the introduction of sub-zero rates. Since then it drifted in a narrow range of between 19 and 21 per cent.   The same is true for the international bond and loan markets. Initially, the share of the euro in the outstanding international debt securities climbed from just above 20 per cent in 2000 (at current exchange rates), to about 32 per cent in 2008 and 2009, but has since almost returned to its initial level.  
The US Federal Reserve has demonstrated the global lead of the US dollar during the Corona pandemic, offering swap lines to 14 foreign central banks. The move successfully calmed offshore US dollar markets, especially for euro- and yen-based borrowers who had to pay extra margins in US dollars. 
As exchange rates became politicized, the impact of interest rates on exchange rates has been significant as well. Interest rates impact monetary flows; thus, currencies can be strengthened or weakened through higher and lower rates, respectively, all else equal. Much like an afternoon espresso, the short-term effects of a weaker currency are positive.  Lower exchange rates stimulate growth, improving international competitiveness both for exports and import substitution. Thereafter, much like the coffee-induced stimulus subsiding, lower rates lead to worse terms of trade and in the long run, can impoverish a nation, relatively. Worse risks are written on the wall as well. There is a fine line between what other countries may consider currency manipulation rather than coping with a recession.  The former ultimately risks a trade war which would damage the global economy. In this regard, interest rates are obviously seen as a tool in trade wars as well.

Downsides push banks with more substantial deposit bases to invest in riskier assets

Banks are the point of entry for negative rates spreading into the economy. First, depositing excess liquidity with the central bank is costly. Deutsche Bank recently stated that as a result of negative rates, it paid EUR 327 million to the ECB in the first quarter of 2020, for the privilege of keeping its money. As long as cash storage is an option, banks find it difficult to pass on negative rates to households. Circulation of banknotes and coins increased by 27 per cent from EUR 1.041 billion at the end of 2014, to EUR 1.323 billion at the end of 2019. Corporates have also changed their behaviour in big and small ways. For example, financing has become increasingly geared, and equity light financing has made corporates so much more vulnerable during the pandemic. Even invoicing (later) and payment (earlier) behaviour adds risks to the system without anything in return other than saving negative rates.  
In April 2020, the European Central Bank published research on systemic banks showing those with a more substantial deposit base, primarily the German financial industry, are more affected by negative rates and therefore pressured to compensate by increasing risk. They prefer to invest additional in-flows in more liquid securities than illiquid loans. The ECB research shows that investments were directed towards riskier debt with longer maturities issued by private financial and non-financial companies, as well as higher-yielding securities denominated in US dollars, increasing risks to creditworthiness, maturity and exchange rates.  
Another more recent ECB study finds that net interest income has so far remained rather resilient. The adverse effects of interest rates have been offset by positive borrower creditworthiness reducing loan loss provision costs and decreases in financial asset yields, increasing the value of securities held by banks.  These arguments are likely to be severely tested in the coming months following COVID-19.
Where investments were once assessed in relation to a risk-free return, banks must now cope with return free risk in the system. This shift clearly has a negative impact on banks, particularly those with higher deposits, which would typically enjoy a better reputation. Pressures on profitability have made the banking system as a whole more fragile. 
German banks hesitated to pass on negative rates for a long time. Only some smaller actors raised negative rates for their wealthy clients in October 2014. However, banks have recently overcome their hesitation and typically charge negative rates for amounts exceeding EUR 500,000 to 1 million. 
The European Central Bank is aware of the dilemma between transmission and profitability. In late 2019, it introduced a two-tier system exempting part of a bank’s liquidity holdings in excess of the minimum reserve requirements from the negative remuneration. In December 2019, the ECB fixed the multiplier on the minimum reserve holding at six.  The estimated net charge for German banks was about EUR 2.4 to 2.5 billion in 2018 and 2019, respectively, and as a result, would fall to about EUR 1.6 billion in 2020. 
Furthermore, the ECB supports banks that expand their net lending activities. According to the terms and conditions of its targeted longer-term refinancing operations (TLTRO III), the banks can refinance at an interest rate even below the negative deposit rate. Facing the current economic disruption and heightened uncertainty, the ECB fixed the applicable rate 50 basis points below the average interest rate for a period until June 2021, meaning banks can refinance at minus 1.00 per cent p.a. when expanding their lending activities.
These policies demonstrate that negative rates lead to subsequent actions by central banks to avoid a banking crisis.

Are public debt and interest rates negligible?

A review of the ECB’s negative deposit rate would be incomplete without a look at the central bank’s various Asset Purchase Programmes (APP). While negative rates focus on the short term, the purchase of securities focuses on the long term. According to the ECB, after the recalibration in 2018, the ten-year bond yield would have been around 95 basis points higher in the absence of the APP. 
There have been various APPs which have applied to covered bonds, asset-backed securities and corporate bonds. In March 2020, the ECB announced a EUR 750 billion Pandemic Emergency Purchase Programme (PEPP) of private and public sector securities to counter the serious risks posed by the outbreak and spread of the Corona pandemic.  However, the most important APP, the so-called Public Sector Purchase Programme (PSPP) applies to government bonds. By the end of April 2020, the Eurosystem held EUR 2.7 trillion in assets, of which almost EUR 2.2 trillion was public sector debt.  
The PSPP raised the question, whether the purchase of public sector bonds qualifies as monetary financing of member state budgets. A lawsuit was filed with the German Federal Constitutional Court. In May, the Court did not find a violation of monetary financing but requested an analysis on the side-effects of the program. Initially, this appeared to be simply a request for paperwork. Still, due to the legal independence between European and national courts as well as between central banks and courts within the EU, the German government must untangle the legal knot in order to find a solution for that judgement.
Modern Monetary Theory (MMT), the school behind negative rates, considers levels of public debt and interest rates for this debt irrelevant and would not be concerned with a debt overhang in a post-pandemic world. According to Stephanie Kelton of Stony Brook University, public debt poses no inherent danger to currency-issuing governments for three reasons. “First, a currency-issuing government never needs to borrow its own currency. Second, it can always determine the interest rate on bonds it chooses to sell. Third, government bonds help to shore up the private sector’s finances.”  She argues that governments only issue bonds to protect the “well-guarded secret about the true nature of their fiscal capacities” instead of directly enlarging the monetary base. 
The power of a currency-issuing government or at least a common fiscal policy is crucial in a system of free-flowing capital across borders. Until now, the eurozone lacks such competence, which escalated in Germany, the Netherlands and Austria’s refusal to accept the common liability for so-called Corona-bonds issued by eurozone countries, especially Italy. However, the EUR 500 billion recovery fund recently proposed by German and French leaders Angela Merkel and Emmanuel Macron has been compared by many, including the German Finance Minister Olaf Scholz, to Alexander Hamilton and could mark a turning point in the history of the European Union.
Yet, critics interject that governments can only print money as long as the public remains confident in its currency.  Willem Buiter, a former Global Chief Economist at Citigroup, is convinced “that governments […] able to monetize massive budget deficits without ever boosting inflationary pressure gets us to the wonderland.”

A return to the old normal?

The pandemic is undoubtedly a turning point which challenges all conventional doctrines. At this juncture, negative interest rates appear to be the new normal. Although negative rates may weaken the financial system, their effects on banks’ profitability seem manageable in the near-term; but only if inflation remains subdued by competing deflationary- and inflationary-impacts. At this stage, how negative rates will affect risk management in the entire financial system remains theoretical. Lacking alternatives, it becomes ever more like an all-in bet. Finding out where the risk created by negative rates is hiding in the system could prove a painful experience. 
Central banks newly confronted with negative rates, in countries like the US, UK or Singapore, at least enjoy the advantage of being able to reference others’ experiences. After almost a decade of negative rates, prophets of doom have reverted to the scientific and political fringes. But doubts do remain. Even the best medicine is poisonous in a high enough dose. So far, the world has proven receptive and resilient. And yes, policymakers are navigating unchartered monetary waters. Hopefully, the monetary world is round, rather than flat. But, they better hold their breath as there is plenty of concern of no option B on the horizon. Returning to the old monetary regime, in such an indebted world, would pose a substantial political risk, so it can safely be ruled out, at least for now. That is the new normal.

Source: Asian Financial Cooperation Association – Think Tank: Negative interest rates. The new normal? (Hubertus Väth)