Image courtesy of Flickr, Keith Williamson
Central banks around the world are using negative interest rates as a tool to boost their economies. They are facing challenges with unintended consequences.
The monetary policies of governments around the world have the potential to make or break not just their country's economy but also have global repercussions. Like a row of dominoes, the problems in one country can be transferred to other countries, unless they have made solid plans to counter any possible fallout.
The BIS (Bank of International Settlements), which operates as a central bank to the central banks of different countries, is predicting an economic challenge likely to occur in late 2016. In their BIS 86th Annual Report, they state that "a shift to more robust, balanced and sustainable expansion is threatened by a 'risky trinity': debt levels that are too high, productivity growth that is too low, and room for policy maneuver that is too narrow." They go on to state that "the global economy cannot afford to rely any longer on the debt-fueled growth model that has brought it to the current juncture."
According to BIS claims, governments around the world are running out of positive monetary policy options, which could potentially lead to economic vulnerability at a global level. There are concerns about negative interest rates being implemented in many more countries in a bid to increase growth and deal with falling oil prices. The CIS chief, Claudio Boro, says that this gathering economic storm is the result of the tug-of-war between market stagnancy and economic vulnerability. The problem has been in the making for a long time and could soon come to fruition.
The beginning of 2016 saw stocks in China fall by significant margins, one of the worst stock market falls since the Wall Street credit crunch in 2008. The price of oil also fell at the same time. All these factors led to investors seeking safety in core bond markets. Instability in emerging economies also affected advanced economies, leading investors to worry about another possible global recession. Lower productivity and growth in credit has only increased these concerns.
The profitability of banks is also a growing concern as without it, the global economy risks stagnating. The response of central banks to these problems has also led to a market expectation of lowering interest rates. As bank equity prices fell below the market rate, credit spreads also widened.
All of this uneasiness and instability are mostly caused by the lack of policy support to governments. With a tight financial situation and no attention paid to any kind of restructuring of current policies, central banks are running out of options.
One of the few options that are left to governments is to implement negative interest rates. Major banks in Europe have moved towards this policy, including the European Central Bank itself. Even an economically stable country like Japan introduced negative interest rates as recent as January 2016. Designed to promote borrowing, increase trade and stifle inflation, negative interest rates are being explored as a means to revitalize economic growth. This policy also tries to ensure that the money stored in banks is invested wisely. But does it really work?
A glimmer of hope comes from Sweden where negative interest rates have led to a severe drop in inflation, making it one of the few successful initiatives of its kind. However, in other areas around the world, this policy has had little to no success. Concerns have been raised that lowering the interest rates is good for increasing exports as it makes the currency weaker, which could be temporarily profitable for a country. However, from a global perspective, it achieves nothing and does not help in promoting global economic activity.
Only time will tell, but with the current situation in Europe regarding Britain's exit from the European Union, investors have been left holding their breath and some scrambling to hedge their risks. Billions of pounds have already leaked from the markets in this time which is only adding more fuel to fire.
In a strange turn of events, some borrowers in Europe holding mortgage notes have started to receive interest payments by their lenders, instead of the other way around. How is this possible? Let's consider a simple example below.
The majority of existing mortgages in Europe have variable interest rates, similar to how ARM loans work in the United States. These variable mortgage rates in Europe follow the fluctuations of EURIBOR, Europe's version of LIBOR. There is a fixed spread between the central bank rate and the retail bank rate. For example, if the central bank interest rate is 1.5%, banks may charge a rate of 3%. A lowered central bank interest rate of negative 2.5% means the bank may charge negative 1%. This means that the bank now owes an interest rate of 1%.
Certain banks in Denmark have already started sending borrowers checks, however several other nations like Spain, Italy and Portugal, are challenging this as they face having to potentially pay out billions of dollars in interest. Some lenders have already started to include language in their mortgage contracts warning borrowers that they will not be able to profit from negative interest rates.
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