Thursday, February 11, 2016

Welcome to the World Of Negative Interest Rates!

The world is going to be a very different place. Since time immemorial, interest rate had been positive. This was very logical, at least to humanity. If we lend someone money, we are expected to be paid interest and at the end of the loan, we would get back the principal. No, that doesn't work anymore. The new rule is if we lend someone very, very credible some money, we would pay this person interest for the privilege of lending him money. Sounds great yah for people like us who are very, very credible! Welcome to the world of negative interest rates.

How did this absurd logic happen?

Well, we need to trace back its origin to the Global Financial Crisis a.k.a. the GFC. It was always said that there were three parts to this trilogy. It started in the US with the expansion of sub-prime credit which finally caused the Lehman bankruptcy. It then spread to Europe, as European banks held a lot of bad mortgages as well. This culminated to the Greek sovereign debt crisis. Now the issues are moving to Asia. This is the last instalment, when the excesses created by the Chinese government trying to avert the GFC caused bad debts and shadow loans across its whole financial system, which is now starting to implode. 

However, the world cannot afford to let China implode. In order to prop up global economic growth, central banks all over world needed more tools. Alas, the most powerful tool it had in its toolbox always had a limit - central banks could not reduce interest rates below zero. It contradicted human logic. So they used other half-fucked methods like QE, QQE, QE2, QE Infinity. It didn't work. Hence, we override the regulator and decided that we should go subzero into the quantum realm, In other words, we removed the arbitrary limit of zero and introduced negative interest rates. 

Ant-man going subatomic to fight his nemesis

Who said interest rates should always be positive? 

The Swiss and the Swedish were the first to experiment with the subzero realm, they have already dropped rates to minus 1%. This actually resulted in bizarre situations like some Swedish sex therapist actually receiving seven Kroner every month for her consumer loan. She's not complaining. The European Central Bank then went negative as well. And last week, we saw Kuroda Sensei bringing out his bazooka and brought the 10 year Japanese government bond interest rates to -10bps. This means that whoever lends money to the Japanese government is willing to pay the Japanese government 0.1%, every year, for ten years. The Japanese government is after all a very, very credible borrower. Investors are happy to pay to lend them money.

Okay, so much so for bizarre advanced countries. Now how might this impact the man on the street? 

So far, bank deposits had been shielded. While consumer banks pay central banks to put reserves with them, the negative spread that these consumer banks incurred were absorbed. However, if rates go further negative for much longer, it would come one day when we have to pay the bank to put money with them. After all, this is again a human-made logic that banks should provide banking deposit services for free. Why should it be free? 

Years ago, when the local banks imposed a fee for deposits less than $1,000 or some other amount, consumers cried foul. Today, it is the norm that is recognized widely: there is a cost to maintain a bank account and we need to put in at least a decent amount. So if we extrapolate the argument, we might some day need to pay the bank to put money, any amount. Theoretically, it could be up to 2-3%. Most credit cards companies charge 2-3% for using their network to settle financial transactions. It had been shown that this could work. So when push comes to shove, the banks might charge 0.5% to 1% initially and move it up to 2-3% for deposits over time. 

Those not willing to pay up can start buying high tech safes to store cash at home. At the same time please make sure no policeman sees your cash and be very careful if they were to conduct an exercise to determine that your safe is indeed safe by asking you to transfer the cash elsewhere. You don't want another Iskandar Rahmat to come after you! The moral of the story here is that there is a cost to deposit money, so consumers would come to the idea that they would have to pay for this service.

The other bigger implication would be inflation of goods and services and more importantly - asset inflation. Interest rates had always had a counterpart called inflation, the invisible enemy. Inflation is much tougher than Ultron or the other Avenger enemies that we have seen. Inflation cannot be too high, once it goes beyond 15-20%, it would morph quickly into hyperinflation becoming uncontrollable and would bring down the space-time continuum and the destruction of the universe. No lah, not so dramatic, but still, it could cause money to be worthless almost overnight, like the Deutsche Mark after WWI or our own banana money during WWII. During those days, whole existence of central banks centered on how they would fight inflation.

Inflation: the metaphorical Ultron

However inflation cannot be too low either. Inflation at 0-1% quickly meant that they would slip into the negative zone. This creates another set of problems like what we saw for Japan from the 1990s till today. Deflation meant prices kept falling, people procrastinated consumption, the economy stagnated, nothing grew, innovation stopped leading to more falling prices and less consumption. It became a vicious cycle. This was why Kuroda Sensei meant literally he would do whatever it takes to tame deflation. He had fired rounds of QE and now the negative interest rate bazooka.

Unfortunately, the world is slipping into this same problem Japan had faced for two and a half decades now.

Interest rates were setup by central banks to calibrate inflation into the sweet spot of 2%. But this is a profound art. It's so hard that no one has succeeded. Alan Greenspan was supposed to have succeed but it could now be argued that by eliminating the normal cycles over that many years (again around two and a half decades from c.1980 to 2005), the Fed created the GFC. We all need our ups and downs to recharge and grow. Earth has days and nights, summer and winter. Life has birth and death and offsprings. That's just universal.

So when inflation goes negative, in order to effectively combat that, interest rates had to go negative. This could be the future.

More on this topic in the next post!