Mattresses Over Demats?

While Raghuram Rajan stalwartly grappled with inflation during his tenure as the Reserve Bank of India (RBI) Governor, a few central bank governors across the world resorted to unconventional ‘economy stimulating’ policies to stave off deflation, inflation’s fraternal twin, generally regarded by many economists as more damaging to the economy. Deflation generally occurs during periods of recessions and depressions, the former characterised by a negative growth for 2 consecutive quarters and the latter by a negative growth for a prolonged period (usually more than 2 years). The combined attack by deflation and recession is the worst nightmare of central bankers around the world when circumstances sometimes lead them to experiment with the boundaries of macroeconomic theory. But lately those boundaries have been breached.

Negative Interest Rates (NIRs)

The theory of Economics has a Zero Lower Bound (ZLB) concept which states that nominal interest rates can’t drop below zero. The rationale behind the concept is easy. In normal circumstances, one opens up an account at a bank, deposits money in it and earns interest on it. However, if the bank institutes an NIR on all of its deposits, you would need to pay your bank an interest payment instead of receiving it.

Thus one would prefer stuffing up his/her house mattresses with cash rather than depositing it at banks, ultimately snatching the banks of their primary function and making their existence redundant. Also, borrowing money which has an associated cost would have a reward, gift-wrapped in the form of NIR. Hence zero is (was) a meaningful lower barrier below which interest rates cannot drop.

In July 2009, the Riksbank (Central Bank of Sweden), cut its deposit rate to -0.25%. In July 2014, the deposit rate was dropped to -0.5% which at the moment is -1.1%. Concurrently, the repo rate (rate at which commercial banks borrow from the central bank) entered the negative territory (-0.1%) in February 2015 and subsequently to -0.35%. In July 2012, The Danmarks Nationalbank (Danish National Bank, DNB), lowered the deposit rate to -0.2% which after a series of decrements and a January 2016 increment is presently -0.65%. Switzerland National Bank (SNB) and the European Central Bank (ECB) followed suit. Latest entry to this category has been Japan where its central bank (Bank of Japan, BOJ), on January 29 2016, announced a policy of charging a 0.1% interest rate on the excessive funds of commercial banks parked with the BOJ.

The reasons and the implementation of such extraordinary measures vary amongst these advanced economies. Riksbank, the ECB and BOJ, to abet their quantitative easing plan lowered key interest rates below zero while the central banks of Denmark and Switzerland used these drastic measures to control the upward pressure on the Krone and the Franc, their respective currencies, which had appreciated due to excessive capital inflows, as reasoned by Harriet Jackson in his paper “The International Experience with Negative Policy Rates” for the Bank of Canada.

One point which should not be overlooked is that these are Negative Nominal Interest Rates (NNIR) and not Negative Real Interest Rates (NRIR). The distinction between the two being the rate of inflation. Irving Fisher, a notable economist of the early 20th century, provided a relationship between the 3 rates, a linear approximation of which equates the nominal interest rate to the sum of the real interest rate and the rate of inflation. NRIRs are not very unusual and are theoretically, a stimulating agent for the economy as it lowers the cost of borrowing incentivising the consumers to borrow, spend and consume more. At the same time, it also hurts the savers of the economy but this impact is cushioned as commercial banks do not slash their deposit rates by much.

Switzerland and Denmark

These two economies entered the realm of NIRs to protect their respective currencies from massive appreciation as opposed to the Euro which plunged for the better part of the Eurozone crisis since its onset in 2008.

Switzerland’s economy is export dependent. According to World Bank data (2015), the Export/GDP level of Switzerland was 63.5% while its Current Account Balance (CAB)/GDP ratio was 11.4% (4th highest in the world). This reflects the extent to which the country is dependent on its exports.

Investors have always favoured the Swiss Franc over other currencies due to a stable financial environment pervading in the country.Their fondness grew deeper during the Eurozone crisis exhorting the SNB to introduce a cap on the appreciation of the Franc in 2011 limiting it to 1.2 Francs to the Euro to save the country’s exports (that had become more expensive owing to a stronger Franc) from expected blows (Fig. 1). The SNB went a step further in December 2014 and introduced NIR to promote capital outflows from the country which would in turn lead to the depreciation of the Franc bringing about an increase in its exports which are vital to its economy.

However, the SNB scrapped its 3.5 year policy in January 2015 by removing the cap on the franc. This led to a knee-jerk response by investors culminating in a sharp appreciation of the Franc. To avoid a further appreciation of their currency, the country’s key interest rate was pushed deeper into the negative territory reaching -0.75% in January itself.

Switzerland Exports/GDP (%)

The Danish Krone, on the other hand, has been pegged to the Euro since 1999. The reason behind the pegging of currencies to more stable ones varies across countries. It may be pegged to the currency that is the most traded in the world (The USD) or to the currency of the country which is its major importer (eg. Chinese Yuan to the USD). In the wake of a worsening Eurozone crisis, the value of the Euro started plunging in 2011 leading investors to other safe havens such as the Danish Krone which in 2012 started appreciating as opposed to a declining Euro (Fig. 2 & 3). To defend the peg and to keep it within its trading band, the DNB took the drastic measure of reducing their rates below zero to initiate capital outflows from their country.

Danish Krone



Milton Friedman, recipient of the Nobel Prize in Economics in 1976, was a big proponent of free markets. His work highlighted the importance of money and monetary policy tools over government spending, contrary to the seminal contribution by John Maynard Keynes. Suggesting that a control over money supply would provide a control over a country’s economy, Friedman’s theory has not seen much light in recent times where a lowering of interest rate (in an attempt to increase the money supply and ultimately consumption), even below zero, has not helped the Euro bloc and Japan to escape the clamps of sub-zero growth in recent times.

Euro Bloc and Japan

Although the unemployment rates in both the regions are at periodical lows, the opposite is true for inflation and GDP numbers with both the regions spiralling into a deflation-flanked recessionary phase. Living up to his claim of “doing whatever it takes to preserve the Euro and the Eurozone from collapsing”, Mario Draghi, President of ECB, lowered the ECB deposit rate to -0.1% in June 2014 after his attempts to raise prices and subsequently, the growth prospects of the region by following (un)conventional monetary policies failed.Currently the deposit rate is -0.4% (ECB, Key ECB interest rates).

Similarly, after a slew of quantitative easing measures could not reinvigorate the economy of Japan, the BOJ announced a -0.1% rate on excess reserves of commercial banks parked with the BOJ.

The idea behind NIRs on the deposits and excess reserves of commercial banks with central banks is to push the commercial banks to lend more since having their money parked with the lender of the last resort would now have a cost. To quicken the process of lending out from an expanded pool of funds, commercial banks would lower their lending rates.

Data rolled out by the BOJ shows that the long term prime rate (average rate of interest charged on loans by commercial banks to private individuals and companies) reached a record low of 0.9% towards the end of July (see fig. 4). Euro Area’s situation is strikingly similar where the ECB’s data reveals that the Euro Area bank lending rate reached at an all-time low of 2.36% in June 2016.

The deposits with banks carry a lower interest rate than what is charged on loans extended by them, the difference being known as the margin of the banks. With historically low lending rates, the situation is grim for savers as well as for banks who face the risk of losing out their retail customers to competition or mattresses.


Most banks, although offering extremely low interest rates (but positive), have not transferred the cost of NIRs to their retail customers, but that is slowly changing.

With the size of their profits shrinking, a few commercial banks have lowered the deposit interest rate below zero as reported by the Bank for International Settlements. Raiffeisenbank Gmund am Tegernsee, a community bank in southern Germany, announced on August 16 that they would be charging a fee of 0.4% on deposits of more than 100,000 euros held in current accounts. Royal Bank of Scotland and Natwest laid out the framework to impose NIR should the need arise.

Recently, Japan’s financial watchdog, Financial Services Agency (FSA), estimated that the country’s three biggest banks will have their earnings dented by 300 billion yen ($ 2.96 billion) for the current fiscal ending March 2017.

Another reason for NIR implementation is to encourage investors to shift from low yield government securities to riskier assets such as equities, real estate, debentures, etc.

This portfolio re-balancing would soon become a reality as $1.7 trillion (estimated by JPMorgan) of the Euro bloc’s debt is being traded with negative yields in a number of countries including Austria, Denmark, Germany, Netherlands and Switzerland. This malediction has plagued the business of money managers, especially pension and insurance funds on the lookout for positively yielding and at the same time safe assets.

The impact would be exacerbated by the demographics of the two regions where populations are skewing towards the senescent and more risk averse end of the spectrum, much more dependent on pensions and health benefits that those in the younger age brackets.

Some Hope for Europe and Japan

The major driving force behind these extraordinary measures is the deflation persisting in these economies. Even if nominal rates are negative, a lower level of inflation would mean a positive real interest rate which erodes the borrowing capacity of consumers.

If somehow prices were to rise, firms would produce more, generating more revenues and more employment along the way to maintain a steady increased level of outputs. The accumulated profits by these firms would be disbursed amongst its owners rebuilding the lost confidence that was once enjoyed by these firms. Higher profits in a stable macro environment would also enable these firms to borrow from financial institutions to invest in newer technologies and ventures with less apprehension of defaulting on the loans and running losses for prolonged periods leading to deleveraging. More investments through borrowing would also push the interest rates up reaching a higher neutral real interest rate (RIR that balances savings and investments at full employment).

However, what Europe and Japan are experiencing today is a phenomenon known as ‘secular stagnation’ which occurs when there is an increasing propensity to save and a decreasing propensity to invest. It was first mentioned by Alvin Hansen, a 20th century economist, in the aftermath years of The Great Depression (TGD) but his theory dwindled following the post war economic boom. The concept was later reintroduced by Lawrence Summers, former Secretary of the Treasury, in 2014 to describe the situations prevalent in most of the advanced economies.

According to the OECD, the percentage of GDP invested in a category that is mostly plant and equipment has fallen in Europe and the US in recent years from 7.5% (2004) to 5.7% (2014). Martin Wolf, chief economics commentator at Financial Times, points out the contribution of corporate firms to the ‘savings glut’, excessive savings over investments. He mentions that a dynamic economy is one where firms use the savings of others for their investments, thereby generating a buoyant demand and growing supply.

However, if the sentiment is negative and investments weaken, accumulated profits get stored as savings, thus increasing the overall level of savings in the economy. As a matter of fact, Japanese corporates, since 2009, have been running a net surplus of savings over investment (see Fig. 5). A much higher level of savings over investments depresses growth potential and the RIR.

Therefore, lowering of NIR wouldn’t have an ameliorative impact as it would only dampen the existing situation by impacting the economic-psyche of the population. Summers relies on Keynes’ rescue theory to pull the struggling economies out of the stagnation spiral they have entered. He believes fiscal policy would resolve all issues as it did during TGD. But would it really help?


Japan has the highest Debt/GDP (229.2%) ratio in the world followed by Greece (176.90%) at the second spot. The Euro area takes the seventeenth spot with a ratio of 90.70%, being dragged towards the top of the list by the metric-handicapped countries mentioned in the following table (Table 1). (TradingEconomics).


These values are catastrophically high, Japan being in a league of its own. The major sources of revenues for a government are taxes and borrowings, disinvestment of assets being a modest contributor. With such figures of debt, borrowings as an option is immediately scrapped. Also fiscal multipliers have a positive impact only when fiscal positions are strong1.

In addition to this, all sorts of taxation erodes the purchasing power of households and firms. However, there is one area, which if targeted might just take off well for these countries – low corporate tax rates. In Japan it is at an all-time low of 32.26% and close to its record low of 24.30% at 24.60% in the Euro area (TradingEconomics). Also, retained earnings in these economies have been soaring in the post-recession years (see Fig. 5). Although, taxation of retained earnings is a highly contentious issue, a few companies in Japan falling under the category of ‘Controlled Company’ are liable to a special tax (KPMG, Taxation in Japan 2015).

There are also other provisions following which retained earnings of corporate behemoths can be taxed, one of them being the infrequent disbursements of dividends. The taxes collected from these 2 sources would add to the revenues account of these governments allowing them to spend on their countries without having a severe economic and psychological impact on people and corporates, after all, everyone wants buoyant growth in their countries.

Well, even if the fiscal stimulus fails, there is always the burgeoning housing bubble to rely upon. A bubble is associated with inflated prices of corresponding goods and services due to an increased demand of those goods and services. A cheaper (negative) borrowing rate just acts as a catalyst.

Statistics Denmark released data which shows that apartment prices are now 5% higher than their peak in 2006 and more than 50% higher than their low point in 2009. IMF has warned the Danish authorities to act on NIR that have created a situation in the country where people are earning interest incomes on their mortgages. With expectations of NIR persisting in the country for at least the next 3 years, the size and the number of mortgages would increase. Let’s just hope that the Danish banks have a reliable credit scoring system.

Cover Image Source: Keystone and The Friedman Foundation, G marius, Educational                                                Choice’s images



  1. Huidrom R., Kose M.A., Ohnsorge F. (2016) “Under the cloud of cycles: Linkages between fiscal multipliers and positions”

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