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Negative rate policy

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August 14, 2019

What is the issue?

  • Negative rate policy is becoming a more attractive option for some countries’ central banks.
  • This policy would counter unwelcome rises in the currencies of these countries.

Why have some central banks adopted negative rates?

  • To battle the global financial crisis triggered by the collapse of Lehman Brothers in 2008, many central banks cut interest rates near zero.
  • A decade later, interest rates remain low in most countries due to subdued economic growth.
  • With little room to cut rates further, some central banks have resorted to unconventional policy measures, including a negative rate policy.
  • The euro area, Switzerland, Denmark, Sweden and Japan have allowed rates to fall slightly below zero.

How does it work?

  • Under a negative rate policy, financial institutions are required to pay interest for parking excess reserves with the central bank.
  • That way, central banks penalise financial institutions for holding on to cash in hope of prompting them to boost lending.
  • The European Central Bank (ECB) introduced negative rates in June 2014, lowering its deposit rate to -0.1% to stimulate the economy.
  • Given rising economic risks, markets expect the ECB to cut the deposit rate, now at -0.4%, in September.
  • The Bank of Japan (BOJ) adopted negative rates in January 2016, mostly to fend off an unwelcome yen spike from hurting an export-reliant economy.
  • It charges 0.1% interest on a portion of excess reserves financial institutions park with the BOJ.

What are the pros, cons?

  • Aside from lowering borrowing costs, negative rates weaken a country’s currency rate by making it a less attractive investment than that of other currencies.
  • A weaker currency gives a country’s export a competitive advantage and boosts inflation by pushing up import costs.
  • But negative rates put downward pressure on the entire yield curve and narrow the margin financial institutions earn from lending.
  • If prolonged ultra-low rates hurt the financial institutions’ health too much, they could hold off on lending and damage the economy.
  • There are also limits to how deep central banks can push rates into negative territory – depositors can avoid being charged negative rates on their bank deposits by choosing to hold physical cash instead.

What are central banks doing to mitigate the side-effects?

  • The BOJ adopts a tiered system under which it charges 0.1% interest only to a small portion of excess reserves financial institutions deposit with the central bank.
  • It applies a zero or +0.1% interest rate to the rest of the reserves.
  • The ECB is expected to take “mitigating measures”, such as a partial exemption from the charge in the form of tiered deposits rates, if it were to deepen negative rates from the current -0.4%.
  • But designing such a scheme won’t be easy in a bloc where cash is distributed unevenly among countries.
  • It could even backfire by pushing rates up in certain countries, rather than down.

 

Source: The Indian Express

Quick Facts

Lehman Brothers crisis/Subprime Mortgage Crisis/Financial crisis 2008

  • On September 15, 2008, Lehman Brothers filed for bankruptcy.
  • With $639 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest in history.
  • Its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron.
  • Lehman was the fourth-largest U.S. investment bank at the time of its collapse, with 25,000 employees worldwide.
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