Negative Interest Rates-What are They, Really?

The Story

Alright, for a while now people have been experiencing the weird phenomenon of negative interest rates. Granted, we have been seeing this only in certain developed economies in Europe and Asia, but it still merits attention.

So how did it get to this?

Well, here is a small brief from our first issue when we covered a Danish Bank offering home loans at – 0.5% interest rate.

Back in 2008, when the world was reeling from the after-effects of the great financial crisis, central banks the world over wanted to prevent a sustained global recession. Meaning nobody wanted to see the global economy fall apart on their watch. So they figured the best way to contain the mess was to flood the economy with cheap money, where everybody could borrow at ridiculously low-interest rates.

The thesis was simple. You put money in people’s hands and they’ll start spending it on needless stuff. It’s how you trigger a perpetual wave of economic growth.

Anyway, this idea seemed to work for a while, until about 5 years ago, when some European countries really turned it up a notch and introduced negative interest rates. Meaning central banks were now incentivizing businesses to borrow money by paying them more money on top of the borrowed money.

But this is only half the story. Granted that central banks want to keep pushing for negative interest rates, but why on earth would other investors approve of this scheme?

Well, one possibility is that these negative interest rates offer better investment prospects than other avenues out there. If the world is heading towards a recession tomorrow, it’s better to lock up all your assets in safe havens including banks and government bonds, even if they don’t offer you any money in return. It’s sad that the world has come to this but it is what it is.

Another explanation is that we could be heading towards a deflationary environment. If prices of goods and services fall steeply, the money that you hold in banks could get you more stuff in absolute quantity than before, even if it means not earning any interest on your deposit. While this might seem like a lovely world to live in, falling prices is a death sentence. Why would any business invest money in creating jobs and exploring new business opportunities when prices of goods and services are on the decline? Long story short, a deflationary environment does the exact opposite of promoting growth. So that’s not a good look either.

And that leaves us with India. Now interest rates in India (repo rate) are still high. But that doesn’t mean we are out of the woods yet. India is connected to the global economy in more ways than one. And when you see weird interest rate regimes elsewhere it isn’t far fetched to assume that someday we will see ripples reach Indian shores.

For instance, central banks might just choose to undo the damage. Maybe one of these days, good sense will prevail and they start pushing rates upwards. Can you imagine the kind of repercussions that would entail on the global economic fabric? The consensus today is that bankers will choose to keep rates low and thereby facilitate the promulgation of cheap money. If that expectation were overturned there’ll be pandemonium in the streets and it’s unlikely India will escape this scot-free.

Hopefully, it doesn’t come to that.

This article was originally published on Finshots