In the backdrop of our rapidly changing global financial environment, it is very frequently that we see advent of new phenomena and policies that have never been witnessed before. Negative interest rates is one of them.  The one natural question that comes to the mind of anyone who has even the slightest idea of finance and interest rates is: Why would anyone be interested to lend money which would not only result in nil earning for him but will even cost him? So this brief note will mainly focus on the theory and justification behind introduction of negative interest rates.

In the past few months, we have witnessed imposition of negative interest rates by central banks of many countries including Denmark, Sweden, Switzerland & Japan, and economists are expecting this trend to spread to many more countries in the near future. Every country may have its own objective to implement this policy. Generally speaking, the negative range remains between 0% and -1%. Very recently, this phenomenon has also hit the capital market for the first time when Sanofi, a French drugmaker, and Henkel, a German detergent manufacturer both issued bonds denominated in euros with a negative yield. The following points should clarify the negative interest rates concept:

  • We must keep in mind that existence of negative real interest rates have not been unheard of in the past in economies with positive inflation rates but our discussion here is concerned with the recently-witnessed negative nominal interest rates (including factor or inflation) that is a new phenomenon.
  • The major objectives for introduction of negative interest rates include:
    • To stimulate economic growth and to raise inflation in an economy
    • To prevent the currency of a country from rising too much since lower or negative interest rates will discourage investors from buying the local currency
    • Cross-currency buying of negative interest rate denominated instruments may even result in profits if the conversion rates of currencies move in favour. For instance, a US citizen buying a Euro-denominated negative interest bond will earn something if Euro rises enough against USD to compensate for the negative interest rate.
    • Lending to the government at negative interest rates would at times be less costly for banks than parking funds at the central bank that offer even lesser rates.
  • Although, negative interest rates are expected to reduce cost of borrowing for consumers and stimulate growth, there are fears that deposit holders who are forced to pay to hold funds in banks may be compelled to remove their cash from banks & banking channels altogether, causing a liquidity shortfall. On the contrary, if banks decide to take the cost on themselves, their spreads might squeeze discouraging them to lend at all.

The long term results of this policy are yet to come, which will eventuality decide its attractiveness for countries who are in search of new innovative ways to stimulate their economic growths.

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