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In January the Bank of Japan (BoJ) became the fifth major central bank to embark on negative interest rate policy (NIRP) in the hope that progressively lower interest rates will encourage bank lending and consumer spending to drive growth and inflation dynamics higher.
While we acknowledge that there may be some near-term positives of NIRP, notably through expanded credit creation, our research suggests that there may be a number of potential unintended consequences which may weigh on the broader economy over the longer-term.
This month we discuss some of our concerns around NIRP.
As interest rates have fallen since the global financial crisis throughout the developed world, banks have largely been able to mitigate the pressures on their net interest margins by maintaining a relatively constant spread between their average cost of funding and the average price of lending.
However, as rates have been progressively moved into negative territory, in order to avoid a likely deposit flight from retail clients, banks have only been able to pass on the negative rates to their corporate depositors.
In addition to an unfavourable regulatory environment and reduced profitability brought by flatter interest rate curves, the additional complexity of a negative rate environment has caused renewed concern for their operating model going forward.
To mitigate some of these pressures, banks in some countries have actually increased household borrowing costs (rather than decrease them as a falling rate environment would have otherwise suggested).
For example, mortgage spreads in Switzerland have actually increased following the central bank’s intervention, which has potentially been a contributor to the house price growth moderation.
While we note that in other markets impacted by a negative rate environment, such as Sweden, the same phenomenon has not yet occurred, we consider the increase in the cost of money despite the lowering cost of capital as a clear indication of unintended consequences brought about by a negative rate environment.
In line with central banks’ intentions, there appears to have been some improvement in credit creation in certain countries which have introduced NIRP.
However, the picture is more complicated and must be considered alongside the recovering health of these economies as well as the other measures that have been put in place to expand lending (for example, quantitative easing).
In the eurozone, non-financial corporate lending growth has been gradually rising since the onset of the financial crisis, but enhanced regulation (notably through the asset quality review and the additional Tier 1 capital requirements), have led some analysts to forecast a progressive decrease in the financial institutions’ commitment to credit formation.
While this argument carries a lot of merit, we tend to see some of the European Central Bank’s policies (TLTRO in particular) as a valuable incentive to traditional banks and trust the ability of large cash buffers on corporate balance sheets to successfully offset some of the medium-term threats to credit origination in the region.
In terms of FX, the evidence so far suggests that NIRP has not materially helped to weaken individual countries’ currencies.
FX rates represent the equilibrium price for cross-country balance of trades and, as such, depend on the complex interactions between economic variables affecting two nations (one of which is the interest rate differentials).
While some of the countries that have initially adopted NIRP have seen their currency depreciating in the very short-term (e.g. Sweden), the majority of countries affected by NIRP have actually experienced the opposite.
The case of a strengthening yen, despite the onsite of a negative rate environment in Japan, is particularly telling as it illustrates the dominance of other fundamental factors (the strength in the current account and a decaying growth in the local economy in particular) versus the widening interest rate differential.
Evidence from countries which have already adopted NIRP suggests that NIRP has so far had limited success in boosting local economies.
Our research has shown that NIRP cannot as of yet be attributed to an expansion in credit conditions or local currency depression while banks’ business models are materially stressed.
Therefore, we believe the adoption of NIRP, or indeed lowering rates further into negative territory, has the potential to create greater challenges over the long-term.