Negative interest rates are a fast way for the banks to go broke


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Overseas experience shows what could be in store for Australia if it is forced down this drastic route

What is a negative interest rate?

In practice, it means the bank charges you to deposit your money and pays you to borrow. And if that sounds like a fast way for the banks to go broke, you're right. In most cases, negative rates have been applied by central banks on the cash deposited with them by banks.

The theory is that by penalising banks for holding excess cash, the central bank will force them to go out and lend more money, which should stimulate the economy.

Negative rates generally haven't flowed through to businesses and consumers, though Denmark's banks have ventured down that rabbit hole after living with negative rates for most of the time since 2012.

The country's Jyske Bank grabbed headlines in August when it announced a 10-year mortgage with a rate of -0.5%.

It said borrowers would still make their regular repayments, but the amount outstanding would be reduced by more than the monthly payment.

At the same time it announced a 0.6% charge on deposits over 7.5 million kroner (about $1.64 million). Swiss Banks UBS and Credit Suisse have also announced negative rates for high-value deposits.

Of course, it costs banks to lend you money and even a negative interest rate loan will come with fees and charges to cover the bank's costs.

Do they work?

The theory is that interest rate cuts reduce the cost of money, giving consumers and business an incentive to spend and invest, leading to economic growth. They also weaken the exchange rate, making the country's exports more competitive.

On that basis, countries with negative rates such as Denmark, Switzerland, Japan and the eurozone should be going gangbusters. But they're not.

Chris Bedingfield, portfolio manager at Quay Global Investors, says negative rates are proving ineffective in the current environment.

He says it's not the incentive to spend more that drives economic growth. It's borrowing to fund spending and investment that pumps new money into the economy.

He adds that low or negative interest rates work when people have the capacity to borrow more, but economies such as ours are already highly indebted. For many consumers lower rates present an opportunity to reduce debt rather than increase it.

Proponents of negative rates also underplay their negative effects on people who have excess savings, says Bedingfield.

"Yes, the cost of debt comes down, but it becomes a form of wealth tax on people who have savings, which is not stimulatory at all. Because the private sector is a net interest receiver, it acts as a tax across the economy."

Nicholas Stotz, investment research analyst at Stanford Brown, likens negative rates in Europe and Japan to trying to speed up a car where interest rates are the accelerator and fiscal stimulation (such as tax cuts and government spending) is the transmission.

No matter how hard you hit the rates accelerator, he says, you're not going to go fast if the car remains stuck in second gear, and you may end up doing more harm than good.

What are the solutions?

Central bankers such as our Reserve Bank chief, Philip Lowe, and the European Central Bank president, Mario Draghi, have called on governments to do more to stimulate their economies. That presents a problem for the Australian government, which made a virtue of budget surpluses during the last election.

Stotz says it is taking advantage of cheap debt to fund some infrastructure programs, but political considerations will likely keep a lid on major spending increases.

Bedingfield says the government needs a major spending program (think $60 billion-$100 billion deficits) to put a floor under interest rates and even push them up a little.

But if its measures are "half-hearted" we're likely to end up with zero interest rates and likely quantitative easing (where the Reserve creates new money) as well.

Savers and investors suffer

While negative rates might sound great to borrowers, they present a headache for savers. Retirees in particular may be forced into speculative investments to generate income to live on - a strategy that rarely ends well.

Bedingfield says sharemarkets overseas have performed poorly with negative rates and they are particularly bad for banks, which are hit with a triple whammy of being charged interest on their excess cash, poor credit growth, and pressure on their margins due to fixed costs and the pressure to keep deposit rates up as they provide a large part of their funding.

So it is no surprise that banks are reluctant to pass on the full rate rises.

Did you know?

Switzerland introduced negative interest rates in the 1970s to try to keep the Swiss franc competitive.

Foreign depositors were hit with a 41% annual penalty in 1975 after the floating of the US dollar and the oil shock. Did it work? No. Switzerland went into recession.

Best-case scenario

Inflation in Australia is still 1.6%, which reduces the likelihood of rates falling below zero (though it means many depositors are earning negative interest in real terms).

A fiscal kick-along from the government could help to offset wider risks to the economy.

Worst-case scenario

Investment research analyst Nicholas Stotz says there is an obvious risk in the Reserve Bank using emergency measures when the economy isn't in dire straits, leaving no room to move if there is a downturn.

The wild card

Our economy is still facing stiff headwinds from overseas. If these pushed us into recession, that could force further rate cuts whether they work or not.

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Annette Sampson has written extensively on personal finance. She was personal editor of The Sydney Morning Herald, a former editor of the Herald's Money section, and a columnist for The Age. She has written several books.