Examining the Policy Effectiveness of Negative Interest Rates: A Case Study on Japan

As a global health crisis ravages across the world, central bankers have rushed to lower rates to historic levels in an attempt to soften the economic blow of the pandemic. Since the crisis hit in early 2020, interest rates have been slashed across the globe on 37 separate occasions. Almost all major economies have cut their policy rates and many are at near-zero levels. In light of this economic climate, the debate on whether negative interest rates could prove effective in adverse conditions has come to the forefront again.

As of today, 5 economies in the world follow a negative interest rate policy (NIRP).  In 2012, Denmark was the first country to announce negative rates, subsequently followed by the Eurozone, Switzerland, Sweden and Japan.

The decrease in interest rates is not a new phenomenon, rates have been sliding globally for the last 30 years [1]. This trend has been more pronounced since the financial crisis of 2008. While many economies have reached the theoretical zero lower-bound of rates, some have even dared to venture below the surface into negative territory. As of today, 5 economies in the world follow a negative interest rate policy (NIRP).  In 2012, Denmark was the first country to announce negative rates, subsequently followed by the Eurozone, Switzerland, Sweden and Japan. While the very concept of negative rates may seem baffling, it’s even more shocking to note that over $15 trillion’ worth of bonds is traded at negative yields globally [2]. This means that over 30% of the world’s investment-grade securities are traded in a manner such that lenders pay borrowers to use their funds.

Negative Interest Rates in Theory

Interest rates have widely been regarded as the most powerful weapon in a central banker’s arsenal. Until very recently, their only limitation seemed to be the zero-lower bound beyond which bankers have had their hands tied. However, with Denmark’s policy rates going negative in 2012, this limit seems to have been breached. In theory, the NIRP is put in effect by central banks making the policy rate or repo rate (rate at which banks park their funds with the central bank) negative. While the negative rates directly apply only to banks, its effects are transmitted to the entire system by effectively lowering overall real interest rates. Central banks envisage that negative policy rates would induce increased spending and stimulate the economy in two ways – firstly, by forcing banks to hold lesser deposits with the central bank and channelling these funds into increased lending to households and businesses. Secondly, a cut in the policy rate would also lead to lower rates in the overall lending market, thus encouraging borrowing and spending.

This policy, however, is riddled with several loopholes and works only under certain conditions. There has also been evidence of unwanted externalities associated with negative rates. The experience of the 5 economies which implemented the NIRP has been mixed and there is no consensus so far among economists and policymakers on the merits/demerits of the policy.

Japan’s Tryst with Negative Rates: A Case Study

In 2016 the Bank of Japan (BOJ), facing a relentless battle against deflation and a depreciating Yen, decided to venture into negative territory and has stayed there ever since.  The Japanese economy’s long downward spiral began with the real-estate asset bubble bursting in 1989-90. While Japan’s ‘lost decade’ is a widely known concept, many academics argue that Japan has lost more than a decade and has not fully recovered yet. The economy has been in first-gear ever since the crash – today, almost 30 years hence, the Nikkei 225 is still languishing at about 40% of its 1989 peak [3].

Over the years, the BOJ has tried almost every trick in the trade – low rates, printing more money, rounds of quantitative easing, you name it and it has been done already. But much like a car stuck in the mud, the Japanese economy just seems to be spinning its wheels in one place. It is in this backdrop that the BOJ pulled out one last trick up its sleeve, announcing a negative interest rate regime.

What Did Japan Hope to Achieve Through the NIRP?

To combat deflation, the BOJ has long been involved in multiple rounds of aggressive bond-buying, hoping to inject more cash in the economy. According to data from the BOJ statistics portal, the central bank has been purchasing bonds worth 8-12 trillion Yen per month consistently. This has led to a mammoth increase in the bond holdings of the BOJ and also the monetary base of the Japanese economy. This has had two direct implications –

• Japanese banks were now flush with money but this did not translate into increased lending activity. Rather banks were now parking this excess cashback with the central bank as reserves, thus defeating the purpose. It has been estimated that over 90% of the new money created by the BOJ since 2013 has ended up back with the central bank
• The downside of this aggressive bond-buying policy was that Japan had now accumulated a mountain of debt. As of 2020, Japan was the most indebted nation in the world, with its debt accounting for over 234% of its GDP [4]

The BOJ hoped that the NIRP would help address both these concerns. By announcing a 0.1% negative interest rate on excess reserves, it hoped to force banks to hold lesser reserves with the BOJ and use the money for lending purposes. On the other hand, negative rates would also help ease the burden of interest payments on the national debt.

Reasons for Failure of NIRP in Japan

While the NIRP did succeed in its immediate goal of reducing banks holdings with the BOJ, it has failed to stimulate bank lending. Instead, Japanese banks are now looking to park their funds elsewhere, to beat the low returns at home. With rates at historic lows in Japan and lacklustre borrowing sentiment from households and businesses, banks have turned to foreign investments to rake up profits. The NIRP, rather than stimulate the economy through increasing lending has instead spurred a massive outflow of funds in favour of overseas assets. As a result, Japanese banks hold nearly 20% of the world’s CLO’s (collateralized loan obligations) [5]. The foreign investments of the Japan Post Office Bank (owned by the government) alone stood at $630 billion as of 2020, showing glimpses into the outflow of reserves from the domestic economy.

The NIRP, rather than stimulate the economy through increasing lending has instead spurred a massive outflow of funds in favour of overseas assets. As a result, Japanese banks hold nearly 20% of the world’s CLO’s (collateralized loan obligations).

The failure of the NIRP to stimulate domestic spending and investments has shown that the Japanese economy faces several structural challenges that need to be addressed first. Given Japan’s ageing workforce, it will not be easy to discourage households from saving, especially in the current economic climate. Unless businesses and households are willing to spend or invest, the availability of cheap loans is redundant. No matter how low the BOJ pushes interest rates, the economy cannot be revived unless the structural bottlenecks subduing growth are addressed.

Policy Shortcomings of the NIRP

Japan’s case and the experiences of the other four economies have highlighted several loopholes in the NIRP. While it has been successful in reducing commercial bank holdings with central banks, it has not managed to translate this into lending activity. As in the case of Japan, banks can always find other ways to make use of excess funds. Even if banks manage to pass on the negative rates to the general public, households would continue to hoard cash in the form of mattress money, thus defeating the purpose of the policy. Take Sweden’s case for example – despite having negative rates, Sweden still has the 3^rd highest household savings rate in the world.

The NIRP has also been associated with several unwanted externalities –

• Decreasing Bank Profitability

Negative rates can destabilize the entire banking system by adversely affecting bank profits. In the Euro-zone alone, banks have transferred $24.2 billion to the European Central Bank (ECB) as negative fees in the five years since negative interest rates were introduced

• Create asset bubbles

A negative rate regime could also lead to the creation of property and other asset bubbles. Since rates are low (or negative) for cash holdings, people tend to invest in real estate or other tangible assets, thus driving up prices.

• Erode Pension Funds

Many academics believe that negative rates would hurt economies in the long run by eroding pension funds. This could potentially be a major cause for concern for countries like Japan which have an ageing population

Is the NIRP here to stay?

Despite its long list of flaws and potential side-effects, nations still seem to be sticking with the NIRP, with trends showing that even more may follow suit soon. Given the current economic climate, central bankers are left with no choice but to continue with low rates – that they do so despite its shortcomings speaks volumes of the precarious global economic conditions. The NIRP however, cannot be written off as a completely failed policy as it has shown that it can be successful under certain conditions. In Switzerland for example, the NIRP has been largely successful in helping depreciate the Franc (to keep exports competitive) and maintaining exchange rate parity in the face of large foreign inflows into the country. Switzerland’s experience is replicated in Sweden, with negative rates helping boost exports, although not substantially.

Different nations have had different motives for venturing into negative territory – while countries like Japan wanted to stimulate inflation, others like Switzerland and Sweden were more interested in maintaining their exchange rates. Success or failure of the NIRP depends on the prevailing conditions of the economy and the desired end-goals that countries are after. Since it has been a relatively new policy, countries are still in the phase of experimenting with negative rates and it is too early to draw conclusions on their successes and failures.  On whether the NIRP is an effective policy tool, the jury is still out.

References

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