SLATE. All you wanted to know about negative interest rates

If you thought getting lower interest rates on your deposits was unfair, picture a scenario where you have to pay the bank to keep money in your account. As preposterous as this sounds, it’s not a myth. The European Central Bank (ECB) ventured into sub-zero interest rates a year ago and the Bank of Japan has now shocked financial markets by adopting a negative interest rate policy last week.

We know that all banks park their excess funds with the central bank from time to time. A negative interest means that banks will have to pay the central bank for holding these 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.

Negative interest rates are just an extreme form of the easy money policies used by central banks to try and stimulate the economy. Usually, central banks boost the economy by cutting interest rates, pumping more money into the system or both. When a central bank infuses liquidity into the market, it buys assets — usually government bonds — and pays institutions it bought the assets from. The institutions selling those bonds thus have new money in their hands, which they boosts money supply.

Lower interest rates work by bringing down the cost of borrowing, encourage spending and hence kickstart economic growth. The policy rate set by every central bank is a benchmark rate to which all borrowing costs are pegged. A sub-zero rate should reduce borrowing cost and spur demand for loans. Also negative rates essentially penalise banks for holding idle funds and force them to lend it out to retail and industrial borrowers.

An anaemic level of economic growth, as seen in Japan and Europe, brings bad tidings for everyone in the country. Low investment spending leads to less capacity creation, fewer jobs and lower economic growth. Hence a central bank resorting to a negative interest rate strategy is a sign of its desperation to stimulate demand, when all other conventional measures have failed. That is hardly comforting.

But even worse is the looming fear of banks passing on such negative interest rates to depositors and savers. Normally banks are reluctant to pass on negative rates to depositors for fear of losing them. So banks, even in the countries where policy rates are negative, usually grit their teeth and bear the cost themselves, even if it means a squeeze on their margins.

But banks may not be able to hold the fort for long. They may choose to implement negative interest rate on deposits — either due to their inability to maintain margins or on the pretext of encouraging people to spend more. A nightmarish scenario, wouldn’t you say? Even if your deposits don’t carry a negative interest, rates on other fixed income instruments are likely to track the benchmark rate. This could mean getting back a maturity value on your bonds that is lower than the principal.

All this may not matter so much if sub-zero rates were really effective in stimulating growth. But so far, the results have not been that encouraging in Europe.

The next time you complain about low interest rates on your bank deposits, think of the Japanese.

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