ECJ EUROPEAN Cleaning Journal

As the COVID vaccines rollout gathers pace, countries across the globe are reaching for the fiscal tools they may need to repair the catastrophic damage wreaked upon their economies. And one that has come to hand could prove highly controversial, writes Hartley Milner.

The commercial banking system looks set to be turned on its head with a growing number of economies seemingly poised to introduce negative interest rates in coming months.

Interest rates have tumbled over the past 12 months and are at, or very near to, an all-time low in almost every developed market. The question now for central banks that generally set the rates is how low dare they take them, as anything below zero means venturing into largely unchartered territory.

Negative interest rates are a measure used in especially stringent times to increase borrowing for investment by reducing the cost of loans and coercing consumers into spending their money on goods and services rather than hoarding it. The hope is that a more favourable borrowing environment will encourage businesses to put their growth plans into action, which will help them generate income and create jobs while delivering a boost to economies.

A side effect can be to weaken a country’s currency, but having a weak currency makes exports cheaper, driving up demand from overseas customers. The downside is imports become more expensive, so as with most monetary policies there are winners and losers.

How effective?

The move to negative rates may be good news for businesses seeking a loan, but is less likely to go down well with savers already receiving meagre or zero returns on their capital. In theory, they could find themselves having to pay a bank to look after their money instead of accruing interest on it, while borrowers are paid interest on their loans. The gut reaction of savers may then be to consider withdrawing their deposits to reinvest elsewhere or squirrel away around the house until when, or if, rates become more favourable.

A few countries have already ventured into negative territory, including Switzerland (-0.75 per cent), Denmark (-0.60 per cent) and Japan (-0.1 per cent). In December, the European Central Bank said it was maintaining the eurozone deposit rate at -0.50 per cent, the refinancing rate at zero per cent and the marginal lending facility rate at 0.25 per cent.

So how effective are negative interest rates? In the UK, Akeno Tanaka, associate lecturer in economics at the Open University, told ECJ that the policy is sound in theory, but the benefits in practice are hard to quantify. She said the European experiment has so far produced little evidence that they encourage greater lending, and could potentially have the opposite effect.

Eats into profits

“Making banks pay to park their excess cash at the central bank, instead of paying them to do so, eats into their profits at a time when many have not fully recovered from the 2008 financial crash,” Tanaka said. “The banks may feel inclined to recoup their losses by passing them on to savers via a negative interest rate. We have seen though, that where negative rates are applied, banks have been reluctant to do this, fearing a backlash from depositors. Instead, they increase banking fees or charges, or simply reduce lending, which is contrary to the aim of the exercise … to stimulate business activity.”

Last resort

Tanaka said businesses that secure loans should not get too excited about the prospect of being paid interest. That is most unlikely. Again, banks would not welcome the drain on their profits, and besides most business lending is done at a fixed rate of interest. This means that the interest the borrower pays is always a set percentage of the loan amount, and that percentage does not change. Even if the loan is based on a variable rate, there is usually a minimum rate that has to be charged that is always above zero per cent.

Apart from sparking a mass exodus of funds, there are other reasons why banks are unlikely to charge families and household savers for holding their money, or hand them extra cash when borrowing. Many loans, mortgages and savings products are fixed-term deals with rates that will not change until the term ends, no matter what the central bank does with its base rate. Even variable-rate mortgages frequently have clauses saying interest payments will never fall below zero. Any charges that are levied are more likely to impact on savings above a set threshold.

“Negative interest rates may provide a stimulus to some economies, but they are problematic, so should be seen as a backup of last resort when other measures, such as quantitative easing, are not enough,” Tanaka added.

However, increasing numbers of central banks are talking up what they see as a pivotal role they could play in lifting the global economy out of the COVID-19 slump.

Silvana Tenreyro, external member of the Bank of England’s Monetary Policy Committee (MPC), delivered a speech recently saying negative rates had worked effectively where introduced, with “some of the evidence pointing to more powerful effects”. She said their impacts should lead to higher consumption and investment, and boost net exports and inflation (inflation in the UK is currently at 0.3 per cent, well below the 2.0 per cent set by the government). And there was no reason to believe they “would impinge on the profits” of commercial banks.

Tenreyro said: “While we can never have complete certainty, negative interest rates should, with high likelihood, boost UK growth and inflation. Cutting the bank rate to its record low of 0.1 per cent has helped loosen lending conditions relative to the counterfactual (of no policy change), and I believe further cuts would continue to provide stimulus.

“It is possible that bank-lending channels would impart slightly less stimulus relative to experiences in other countries, at least initially, but I would consider it as very unlikely that we do not see any boost to lending. Looser monetary policy can help the economy recover faster, bringing inflation back to target, while also preventing some of the job losses and business failures that could otherwise reduce potential output in future.

“The MPC has given guidance that policy will not be tightened before there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the inflation target sustainably. It is possible that more stimulus will be needed to do so at an appropriate pace. If that is the case, having negative rates in our toolbox will, in my view, be important.” Tenreyro said UK rates could potentially fall below -0.75 per cent “without running into some of the constraints of a negative interest rate policy”.

Operationally ready

The Bank of England is looking at the technical feasibility of negative rates for Britain’s financial system and is expected to publish its views before the spring. As part of the study, it has written asking high street banks how prepared they would be if interest rates were cut to zero or turned negative.

Sam Woods, deputy governor and ceo of the Prudential Regulation Authority, said in the letter: “For a negative bank rate to be effective as a policy tool, the financial sector – as the key transmission mechanism of monetary policy – would need to be operationally ready to implement it in a way that does not adversely affect the safety and soundness of firms.”

Commercial banks are making preparations for rates going negative in the UK but not all are persuaded it would be the right thing to do.

Barclays Bank chief executive Jes Stanley acknowledged that negative interest rates could help in the long term but may hit its UK profits. “Zero, let alone negative interest rates, are very tough for banks and put pressure on bank profitability,” he said. “You don’t want to see consumers avoiding a negative interest rate by turning to cash, for example.” Stanley said that in countries that have already taken the plunge, Barclays’ large corporate customers have been charged for holding money in savings. “But we would rather not be doing that,” he added.

“Few positives”

Amanda Murphy, head of commercial banking at HSBC UK, told the House of Commons Treasury Select Committee that the Bank of England does have to “carefully consider” whether negative interest rates will have the desired outcomes. “Where they have already been introduced – Europe, Japan, Switzerland – we haven’t seen inflation rise and the growth hasn’t come back as strongly as one might have hoped,” she said.

A more damning verdict was delivered by Huw van Steenis, senior adviser to the chief executive of UBS. He told American news channel CNBC: “One of the most striking things from last year was that no central bank that already had negative rates cut them further. I think it was a failed experiment. It is an experiment that is corrosive to the banking system and more importantly it hasn’t been driving growth, nor has it been driving inflation expectations, so, in a way, it is a tool
that has got serious side effects with very few positives.”