Countries Face the Tricky Task of Undoing Negative Interest Rates

The longer countries wait to raise rates, the more damage it may do

By Brian Blackstone

Central banks in Europe and Japan are reluctant to reverse negative deposit rates for fear of derailing economic recoveries. Photo: Ralph Orlowski/Bloomberg News 

Europe has finally emerged from its debt crisis with healthy economic growth, but it can’t shake one relic of its troubled times: negative interest rates.

The policy was tried by Sweden briefly in 2009 and 2010 but eventually was implemented by Denmark, the eurozone, Switzerland and Sweden again over the subsequent five years before landing in Japan two years ago. Negative rates—where the central bank charges commercial banks for money held at the central bank—helped safeguard economic recoveries by lowering borrowing costs across fixed-income markets and, in some cases, boosting exports via weaker exchange rates.

None of these economies seems willing to be the first to lift rates above zero for fear of derailing their recoveries. The European Central Bank said on Thursday that it probably won’t touch its rates until at least summer 2019.

But the longer the banks wait, the greater the risk that damaging side effects—such as squeezing bank profits or fueling housing bubbles—may materialize.

‘An effective instrument’

When central banks want to stimulate growth and inflation, they typically set official interest rates below inflation, which in turn favors borrowing over saving. When inflation is superlow, as has been the case for the past decade, then policy rates might have to go below zero.

The U.S. never went down the negative-interest-rate path, in part because deflation—a dangerous decline in the overall price level—never emerged as the serious threat that it was in Europe. And Europe’s economies are heavily intertwined, so when the European Central Bank eases policy, its neighbors in Switzerland and Scandinavia often follow suit.

Another reason is that Europe relies more on banks for private-sector loans than the U.S., which depends more on capital markets, and negative rates work primarily through banks.

The policy has had mostly positive results in Europe, though they appear more mixed in Japan. Since 2014, countries deploying negative interest rates have avoided recession and, recently, have generally shown signs of healthy growth.

“I think they have been an effective instrument” by depressing long-term yields that spurred growth and inflation, says Stefan Gerlach, chief economist at EFG Bank and Ireland’s deputy central-bank governor when the ECB cut its deposit rate below zero in June 2014.

Meanwhile, the darker scenarios of negative rates—such as cash hoarding and evaporating bank profits—didn’t materialize. Banks haven’t passed negative rates on to retail depositors, instead eating the cost themselves or charging higher fees in other areas, such as mortgages.

“As much as we worried about Y2K, and that wasn’t a problem, it’s the same with negative interest rates,” says Karsten Junius, chief economist at Bank J. Safra Sarasin.

The eurozone’s deposit rate has been minus 0.4% since early 2016, but European countries outside the zone have made the most aggressive use of negative rates. Switzerland’s deposit rate has been minus 0.75% since early 2015, for instance, while Sweden’s is minus 1.25%, and its repo rate is negative too. Japan’s, meanwhile, is minus 0.1%. 
But each tool was designed to fit different economies. In export-sensitive Switzerland and Denmark, where exchange rates are paramount, banks were exempted from the negative rates up to a certain amount of deposits. That centered their effects on currencies and blunted the effect on the banking system somewhat.

In the eurozone and Japan, negative rates are used alongside large-scale bond purchases and commitments to keep rates low for a long time, giving the policies’ broader economic impact. “You have to think about the whole package,” says Mr. Gerlach.

No cure-all

Yet negative rates are far from a cure-all, and the longer they last, the greater damage they might do. European banks weren’t crippled by negative interest rates, but they have underperformed their U.S. peers since the policy became widespread. Swiss financial institutions have paid more than five billion francs ($5 billion) to the Swiss National Bank since 2015 because of negative rates. The total bill for Danish banks—which have faced a deposit rate as low as 0.75%—has been about 2.5 billion kroner ($400 million).

Swiss bankers, particularly at UBS Group , UBS +1.24%▲ were highly critical of negative rates two years ago, though they haven’t been as vocal about them more recently.

The impact of negative rates is especially big for regional banks in Japan because they depend largely on lending, unlike major banks that have sought revenue from commission income or overseas businesses.

“Downward pressures from the negative-rate policy on rates and profits are expected to continue for a while,” Koji Fujiwara, chairman of the Japanese Bankers Association, said at a regular press conference in Tokyo on May 17.

Bank of Japan Governor Haruhiko Kuroda acknowledges that the negative-rate policy has squeezed banks’ profits, but says it also benefits banks by helping to boost inflation and economic growth.

Other effects of negative rates may not be apparent for some time, such as their impact on pension funds, which depend on positive rates for returns on safe, short-term assets.

Then there is the effect of negative rates on increased borrowing to buy homes. Of the 15 cities world-wide identified by UBS as having housing markets that are overvalued or at risk of a bubble, eight were in countries with negative policy rates.

Still, central banks deploying negative rates seem in no hurry to raise them. Switzerland, Sweden and Denmark are widely expected to wait until the ECB starts raising rates before lifting their own. The ECB isn’t expected by analysts to do so until well into next year, meaning it could be years before rates are positive again across the Continent.

If there is a recession or shock to the economy, these central banks might have to tinker more by lowering rates even further or by eliminating exemptions, which would test the limits of how negative rates can go before inflicting bigger damage to banks.

“It would be nice if central banks have the possibility to reload before the next recession,” says Jean-Pierre Danthine, who was vice chairman of the Swiss National Bank when it adopted negative rates in late 2014.

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