Negative interest rates to make RBI's work harder

There will be more currency volatility and it could spark competitive depreciation

The most counter-intuitive of all monetary tools, the negative interest rate, is now being implemented in various major economies on an unprecedented scale. Previously, only Japan had experimented with negative rates in the 1990s; but, right now, countries that account for close to 30 per cent of global gross domestic product or GDP have negative policy rates. The European Central Bank imposed negative rates in 2015, charging commercial banks to hold money overnight. Switzerland, Sweden and Denmark and other European nations outside the euro zone perforce introduced negative rates to stay in step. The Bank of Japan announced a negative rate in January, charging banks money if they maintained reserves in excess of statutory requirements. In addition, Canada's central bank governor has indicated that the bank would not be averse to a negative rate. Even the US Federal Reserve, which raised rates in December, is conducting stress tests to assess the possible impact of negative rates on short-term US treasuries. The Reserve Bank of India (RBI) - which just held rates - is, along with the Fed, playing counterpoint to the ECB and Japan. The Fed seems prepared to raise interest rates again if US growth stays strong. This dissonance in central bank policies will accentuate existing interest rate differentials.

Negative interest rates are akin to an act of desperation. In theory, negative rates offer an incentive to lend and spend. Hence, these should stimulate demand, and combat deflationary tendencies. A negative rate should also weaken the currency (assuming it is easily convertible) by offering an incentive to exit. It should lead to short-term bond yields going negative. In theory, governments could refinance public debt at negative yields. On the downside, negative rates reduce bank profitability since banks absorb the impact of the negative rate, while paying positive rates to depositors. Negative rates should theoretically also induce misallocation of capital and excessive risk-taking by encouraging switches out of debt as investors seek higher returns.

The results so far don't seem to conform to theory, such as it is. It is harder to stimulate demand than to combat overheating. It is too early to tell about Japan - but the euro zone looks to be stuck in a trap with ample liquidity but little credit demand. Inflation has not risen. It is at near-zero in most of Europe. Bank lending has grown very little, and consumption remains weak. Among other unusual effects, Denmark has seen early payment of corporate taxes. High-rated German, Austrian and Dutch treasuries have attracted much buying and yields on these are negative all the way out to 10 years. Japan's government bonds have also seen negative long-term yields. The Swiss franc has strengthened, while the euro and the yen have weakened.

The global impact of negative rates is not yet fully understood, but these will complicate the already complex task of currency management for the RBI. There will be extra currency volatility and Japan's move could spark yet another round of competitive depreciation. But there is also an opportunity. Capital is cheap though investors are showing risk aversion in the preference for hard currency debt. Carry trades, borrowing in yen and euros to buy rupee-denominated assets, would become very attractive if that risk aversion could be conquered. But the domestic policy environment must be improved for that to happen. Hopefully, the Budget will perform that task.