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Negative interest rates – A new abnormal?

By Ray Wallace, Manager of the Nedgroup Investments Money Market Fund

It seems a little odd contemplating the concept of negative interest rates, in a country where we are staring down the twin barrels of interest rate hikes and a possible ratings downgrade. Perhaps somewhat, like us worrying about Warren Buffett’s tax bill. Not our problem, or is it?

Negative real interest rates are nothing new to us. Post the 2008 Credit Crisis, relatively low nominal interest rates in South Africa meant that cash assets yielded returns below inflation for some time. However, to understand how negative nominal interest rates in other economies may impact us here in South Africa, we need to understand what has given rise to this phenomenon (that certainly wasn’t covered in my Economics 101 class, or did I just miss too many lectures)?

A number of countries have adopted Negative Interest Rate Policies or NIRPs over the last few years. These are mostly in Europe, Scandinavia and more recently, in Japan. NIRPs are really just another albeit unconventional monetary policy tool for Central Banks to use when other tools, such as Quantitative Easing (QE) or cutting interest rates to zero, have failed to stimulate economic growth.

One of the main features of a NIRP is the flexibility it gives central banks to “charge” retail banks a negative interest rate on the excess cash reserves they would normally hold at the central bank. The punitive cost of holding cash reserves should theoretically then encourage retail banks to lend more to their customers at lower rates; thereby stimulating consumer spending in the economy.

Another important perceived benefit of a NIRP is currency depreciation. As interest rates in a country decline, so too should the relative value of the country’s currency. In this way, goods and services in that country become more competitive globally which should stimulate further growth in the local economy.

The ease of implementation of NIRPs for central banks, as well as the absorption of the majority of the costs of negative interest rates by the private sector, is also an attractive feature of such a policy.

What drives a country to adopt negative interest rates? 

Right now, the biggest concern for central bankers in developed countries is deflation. This is a consequence of years of low global economic growth, with no end yet in sight. There are three major reasons why central bankers fear the prospect of deflation:

  • The expectations of falling prices results in consumers holding back on spending in the anticipation of cheaper goods and services in the future
  • Falling prices worsen the position of debtors (governments being the largest), by increasing the real burden of their debts in the future. This in turn results in stymieing credit growth during periods when it is needed most to stimulate spending and economic growth.
  • The effects of “sticky” nominal wages, which occur due to the difficulty of reducing wage costs in line with the reduction of other input costs, during periods of deflation. The quickest and easiest way of reducing wage costs is through job losses. However, as we saw in the case of Greece recently, this could result in social unrest or political turmoil.

The diagram below illustrates the basic theory behind the adoption of NIRPs by central bankers to stave off deflation.

What is astonishing though, is the extent of the impact that negative interest rates has had in the global bond market and how quickly this occurred. According to Reuters¹, the value of bonds which are trading at negative yields is now in excess of $8.3 trillion, which equates to 31 percent of the overall JP Morgan Government Bond Index². The countries that account for most of these negative yielding bonds include Japan at 64 percent, or $5.3 trillion and Europe and Scandinavia at 36 percent.

Do negative interest rate policies work? 

Given the purported benefits of NIRPs and the effect these have already had on the yields in some of the economies that have adopted them, do negative interest rates actually work?

Denmark, a country that adopted negative interest rates back in 2012 in reaction to a steadily declining inflation rate, continues to see deflation despite further sharp cuts in rates. On the positive side, however, banks in Denmark are now effectively paying increasing numbers of homeowners to buy and own their homes. Would that not solve a few social problems in South Africa?

Switzerland, which adopted a NIRP in 2015, has actually seen mortgage rates increase, because of retail banks’ unwillingness to pass negative rates on to their depositors. 

Instead, they have chosen the less contentious option of subsidising the cost of the NIRP on their reserves, by recovering it from their mortgage borrowers instead to ensure profitability. This is entirely the opposite of the original intention.

Meanwhile, banks in Europe increased, rather than decreased, their reserve cash balances with the ECB after rates went negative, contrary to common logic, which should have resulted in lower balances due to the holding costs involved.

However, by far the biggest gamble is in Japan and so far, the results also do not look that promising. The Bank of Japan began implementing a NIRP in early 2016 with one of its main desired outcomes a weakening of the Yen in order to bolster growth. The reality since then, however, is that the Yen has actually strengthened from around JPY/$ 120 in January 2016 to JPY/$ 105 in mid-2016, a rise of over 12%. Not what was expected, or helpful to an already weak economy.

Some countries, like Sweden, do appear to be bucking the trend and are showing positive responses to negative rates, but they remain in the minority of successful NIRPs. It is also too early to be able to anticipate the possible effects of Brexit on rates globally.


 

 

The unintended consequences of NIRPs 

First affected by NIRPs, are retail bank margins and ultimately market valuations of banking shares. By effectively charging banks to hold cash reserves with central banks, an additional layer of costs are generated for banks to absorb. Although banks have the ability to pass these negative interest rates on to their own customers via negative rates on savings deposits, they are understandably very reluctant to do this. Therefore, unless they can find other ways of subsidising these costs, bank profitability will consequently suffer.

Cheap money also has a dramatic effect on asset prices. Investors who can access zero or negative rate loans look to investing the proceeds in assets, which only need to provide small positive returns in order to be profitable. Examples of this phenomenon include the strong growth in real estate and equity markets over the last few years. The London House Price index, for instance, has grown by more than 70% over the last six years, as property income yields remain attractive compared to the declining cost of funding. Money market funds that provide a constant net asset value (CNAV) are not viable when a large part of their investment universe consists of negative yielding assets. Higher levels of credit and liquidity are required to maintain positive returns, negating the low risk benefits of such funds. Earlier this year, all eleven major money market funds in Japan stopped accepting new investments as a result. European funds too are beginning to get concerned.

Similarly, saving is discouraged when banks are compelled to pass negative rates on to their retail depositors, enticing them rather to hoard cash under the mattress or hold other assets such as gold. This has manifested itself in Japan, where sales of safes have more than doubled over the last year. The added threats of money laundering, tax evasion and theft become of even greater concern to governments as a result. The European Central Bank is already considering eliminating €500 notes in response.

Other, more practical consequences of negative interest rates may also become more apparent. Negative interest rates raise a host of operational and system related issues. These include the use of discounted cash flow (DCF) and dividend discount models (DDM) in valuations, which become problematic. Legal interpretation of loan and other financial agreements that never anticipated negative rates may lead to disputes. Similarly, concerns with respect to complex derivatives and hedging agreements threaten to become a nightmare for banks and regulators. Tax collection could also become contentious as taxpayers begin claiming refunds on investment income.

How do negative interest rates affect South Africa? 

In theory, the high interest rate differentials between South Africa and developed nations should encourage inflows into our bonds and equities. The Rand should hold up better against major currencies thereby reducing our imported inflation component. Foreign fundraising by SA Inc. should also therefore be much cheaper.

In contrast, we have seen major outflows and Rand weakening, due in large, to low commodity prices, ineffective labour, economic & education policies, real prospects of a ratings downgrade to junk status and above all, interesting politics.

As far as money markets in South Africa are concerned, it is business as usual. In fact, cash yields on the Taquanta managed Nedgroup Investments Corporate Money Market Fund, Money Market Fund and Core Income Fund, are currently providing relatively attractive real yields of anywhere between 2.00% and 2.50% per annum above CPI inflation, before fees.

 

1 http//www.reuters.com - Govt bonds with negative yield hit record high $8.3 trln - JP Morgan as at 10 June 2016 - 13 June 2016
2 JP Morgan Government Bond Index – 10 June 2016

3 http://www.bloomberg.com/news/articles/2016-03-21/ecb-doing-whatever-it-takes-can-t-push-euro-area-banks-to-lend

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