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The Whats and Whys of Negative Interest Rates

May 2016

By WM in the Classroom

Dubai | May 12, 2016 | 14:30

Logic dictates money kept with a bank earns interest. Negative interest rates effectively translate into depositors actually getting charged to keep money with a bank. So, where then do negative interest rates fit in? And why are Central Banks world over resorting to this otherwise paradoxical way to banking. Denmark set negative interest rates in 2012; it has since been followed by the European Central Bank in 2014, joint by Switzerland and Sweden subsequently and most recently Japan in the early part of the current year.

The primary motivation behind this stems from policy makers globally attempting to innovate ways in stimulating their economy; setting a negative interest rate would dissuade banks to park funds with the central banks and thus induce them to be more active lenders. At a retail level, it would hold back an individual from maintaining deposits within the bank and instead look at more active ways to utilize it or alternately try other asset classes. Thus, it is meant to trigger a chain reaction which entails more spending rather than hoarding within an economy.

ECB, for one, has spelt out that the intent of having negative interest rates is to stimulate economic growth and raise inflation in the Eurozone – inflation in the region has dipped from 3% in 2012 to below 0% (-0.2%) this year. The ECB forecasts inflation at 0.1% in 2016, 1.3% in 2017 and 1.6% in 2018.

Some more economics:

  • A direct fall-out of this stance would see investors within the country moving offshore in search for better returns;
  • Thus, triggering a depreciation of the local currency
  • This would make imports expensive, aiding the goal of tackling deflation and;
  • Giving a boost to exports.

So what could be a bump in this journey? As the Bank for International Settlements summed up in a report earlier this year, ‘So far, zero has not proved to be a technically binding lower limit for central bank policy rates. Nonetheless, there is great uncertainty about the behavior of individuals and institutions if rates were to decline further into negative territory or remain negative for a prolonged period.’ It further goes on to highlight, given the relatively short history, the large question marks surrounding areas like – the impact on the financial system as a whole particularly the profitability of the banking sector.

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