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Negative Interest Rates

By Charles Smith

The point of an interest rate is to compensate the investor/saver for the uncertainty of the future.

In recent years, the base rate at the Bank of England has fluctuated below 1%. It now sits at 0.1%.

The reason for this is to stimulate lending by banks to businesses and consumers, as well as to increase the attractiveness of risker assets such as bonds and shares in relation to cash.

Recently, this has been done to stimulate the economy during the current economic crisis.

In recent days, there has been talk of taking the Base Rate at the Bank of England into negative territory. Simply, this means that any savings held at a bank will have an annual cost charged rather than interest paid. For borrowers, it means the amount they must pay back to the lender is less than the amount they have borrowed. In practice, there is some more detail and complexity.

Negative interest rates are not new around the world; however, they have never been used in the UK. In Europe, the European Central Bank (for Eurozone countries) has a negative interest rate set at its reserve facility. If a European bank wants to deposit money with the European Central Bank, they must pay for the privilege, whereas traditionally there would be a positive interest rate on this amount. This is to incentivise banks to lend excess reserves to businesses and consumers.

As we know, a retail bank has two main areas of operations: offering savings facilities and lending facilities. Traditionally, the savings facility is a “cost” to the bank (because they pay interest), and the lending facility is a “profit”. For this reason, banks will lend more than they have on deposit to create their profit margin. However, if the savings element becomes a “profit” (from negative interest rates) and the lending starts to be come a “cost” or at least not profitable, it can start to have serious implications for a bank. This has been one of the biggest problems for European banks over the last decade as their ability to generate earnings in a negative rate environment has diminished.

What does this mean for bank customers? Well, cash savings at a bank could potentially lose the last remaining interest available. Most mortgages are unlikely to be affected as the majority are fixed rate. Variable rate mortgages will usually have a minimum rate to which they can fall, such as 0%. In Denmark recently, a negative rate mortgage went on offer where the borrower would repay a lower amount each month.

Most other loans and credit are often fixed rate so may not see any change. However, the bond market is likely to see some larger moves. As interest rates decrease on bonds, their prices increase. If interest rates on tradeable debt securities go negative, this means the price has risen. This has led to inconsistencies in the bond markets in recent years, where for example, European High Yield debt (which has low credit quality compared to Governments and high quality businesses) had a lower interest rate than the US government debt. This means that on a like for like comparison, the market was suggesting that low quality companies in Europe had a higher creditworthiness than the US government. Of course, this is not actually true, but the drastic difference in interest rates and Central Bank policies in the US and Europe meant that prices were not consistent across the bond market.

If rates go negative in the UK, then theoretically at some point, the UK government will be paid to borrow money. This has been the case in Germany for several years, where the German government could spend money and pay back less than they had borrowed. However, current German leadership is averse to an unbalanced budget, so up until now they had not done so. However, during this COVID crisis, the German government has raised hundreds of billions of Euros at negative rates to keep its economy afloat.

Whilst this sounds like a great position for a government to be in, it brings with it serious problems (not least the banking sector losing its profit margins). First of all, traditional economic theory states that the reason an interest rate is paid is to compensate savers for the uncertainty of the future. However, if rates are now negative, this would imply that the future is more certain than the present. This creates a curious problem for the valuation of other assets.

For a bond, the price is dependent on future cash flows (i.e. the interest payments) being discounted by the prevailing interest rate. As the price of the bond will increase where there is a negative interest rate, does this mean that bond prices will become too high relative to their actual economic value? The same can be said for stocks. The most basic way of valuing a stock is the same as bonds, although with more uncertainty and an infinite time horizon. When interest rates are negative, how do financial markets effectively value stocks and bonds?

This creates a potential financial bubble. If holding risky assets is the only way of generating a return on capital, then investors will purchase more risky assets. This is why low credit-quality companies in Europe could borrow for a lower rate than the US government.

The next issue negative interest rates can cause is when the economy does start to grow. When an economy grows, it is likely that it will see a level of price inflation. As it is the central bank’s responsibility to control inflation, they will raise interest rates in a growing economy. However, if investors are largely invested in risky assets, then the price of these assets may well start to fall as interest rates start to go back to normal.

This then has impacts on the real economy. If the cost of capital to a business is very low, it means that it can borrow very cheaply. This may sound good and is certainly the intention of the central bank to increase investment in the economy. However, it can also have a negative impact. This is that many companies which are not necessarily very productive have access to capital which they might not have otherwise had. In the West, an interesting phenomenon of “Zombie Firms” has been observed whereby a company continues to operate through taking on cheap debt, rather than by sufficient profit margins. Negative interest rates would likely exacerbate this problem.

For now, the decision is currently under review at the Bank of England. The arguments for negative interest rates may be persuasive to borrowers and the Government, however it is likely that savers and investors may be a lot less enthralled.

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