Co-authors: Ashok (Ash) Kamath & Nilkanth (Neel) Kulkarni
Already several central banks in the developed world have zero or negative interest rates. The list currently includes England, Germany, ECB, Sweden, Denmark, Switzerland, etc. Few weeks ago Japan surprised the world by introducing negative interest rates to stimulate their sluggish economy and prevent a slide into deflation. The intent of these monetary policies is to force people to spend rather than save thereby simulate consumerism, reduce the borrowing cost for corporations and in turn drive demand for easier and cheaper capital and financing. In general terms the negative interest rates strategies are seen as a sign of desperation. There is no precedence in recorded history of negative interest rates.
Let’s take a look at risks created by negative rates and impacts on three major stakeholders:
- Effect on the Local: economy, investors and the common man in that region (Series 1)
- Effect on the US: economy, investors and the common man (Series 2 to follow)
- Effect on Global economy, investors and population (Series 3 to follow)
1. Effect on the Local: economy, investors and the common man in that region
a) Effect on the local economy:
The Central Banks intention of taking such drastic measure is to simulate or jolt their economy, but with these extreme measures there are also negative consequences within their regions and beyond. There is no proven precedence that their economy will drastically improve. However there is antecedence that this strategy adopted may have an opposite effect. On the contrary it will create imbalance and higher risk in their economies in four key areas:
- Capital Flight: Savers in these economies shop for higher returns in risky investments or safety of US Bond
- Currency: The currency of the countries will depreciate as a result of capital flight Manipulation will rise
- Political Risk: Though inflation will rise, so will income inequality and restive populations.
- Market Risk: The stock markets will be in stagnation or drastically decline.
Geopolitical consequences: Capital controls, currency wars, trade wars and decimation of growth, drastic curtailment of investment for growth. Largely poverty will increase.
b) Effect on the local investors (in that region):
Based on history one of sectors that typically gain with these types of policies is capital protection and speculative sectors of the economy. Speculative investors will increase volatility in search for better yield and drive currency markets. Speculative investors will also drive volatility in their local markets resulting in wild swings unfettered by stabilizing conservative investors. Additionally Conservative investors will flee to safety and reduced risk. Asset Backed Securities and Treasuries of perceived safer regions are standard choices of conservative investors from these regions
But what about the investors who invested in Sovereign bonds of these countries, they will take a haircut as in the case of Cyprus, Spain, Greece and many others. These investors will turn out to be the biggest losers.
Political Consequence: The pensioners on fixed income will revolt against the establishment. EU and Japan specifically will see political turmoil due to population demographics. Carry trade will be the new norm for savvy investors.
c) Effect on the common man in that region:
The common man will have to actually pay banks to keep their money. Therefore people will tend to squirrel their cash in safe deposit boxes or under their mattress, there by destabilizing the local banking systems.
The banks will have more borrowers than depositors. The common man in these countries will quickly figure out that it makes better sense to borrow and spend today while squirreling cash away under the mattress.
The common man is not a savvy investor who can understand these complex monetary policies and its effect.
Certainly with this major overhauling monetary policy changes there are some winners and some losers, but in this case the balance is tilted more towards losers that is more of the middle class and the retirees in these countries. The question is will the common man be forced to keep his saving under the mattress?
A case in point, in Sweden the latest push towards cashless economy with even banks supposedly not handling cash specifically points to the consumer in that country validating our hypothesis that common people will borrow via available credit while squirreling away cash under the mattress. As trade settlements and tourists to that country will find it impossible to transact, while local population is restricted to local transactions.
Economic consequences: Local GDP will decline. Initially consumption will increase then drastically decline. Financial systems will be severely stressed to breaking point.
The Central banks globally may have inadvertently laid the foundation for their own demise and degrading confidence in the concept of “cash”. As in the case of Sweden the originator of physical paper in 1661 is now stepping back to a electronic barter system and marketing it as “cashless” by glossing over the risks created by negative interest rates.
Stay tuned….Series 2 and 3 to follow soon