Negative rates were hardly ever encountered in the economy before, there were only episodic cases, for example, in the 70s of the 20th century for foreign deposits in Switzerland. At present, negative rates are widespread in Europe and Japan.

The European Central Bank was the first of the major economies to lower its key rate below zero in mid-2014 and provoked similar actions from almost all national European banks ¹. The Bank of Japan followed the European example in the year 2016.

Negative rates were introduced for several reasons. Firstly, to maintain economic growth by cheapening loans. Secondly, to accelerate inflation, which in developed countries is at a very low level. And thirdly, this reduces the attractiveness for foreign capital, the influx of which strengthens the national currency, which creates problems for exporters.

Let view what this led to at the example of the Eurozone.

Credit Incentive

After the European Central Bank moved into the negative area, the corporate lending rates to the non-financial sector accelerated their decline, reaching 2% in the year 2019. But, despite the cheapening of the loan, European companies are in no hurry to use it. A sharp surge in lending volume was replaced by a long decline, and for the year 2019 the loans in the Eurozone are only 162% of GDP, at the level of a decade ago. Obviously, in this aspect, the easing of the monetary policy did not help.

Loan rates from one million euros to non-financial companies, Eurozone

Volumes of loans of non-financial companies, Eurozone

And if in the credit market the average rate still stays in the positive zone, the bond market is sinking deeper into the abyss of negative profitability. As of August 2019, almost 30% of all bonds ($ 17 trillion) guaranteed their holders a loss upon repayment ². In the Eurozone, the share of such bonds, both state and corporate, exceeded 42%.

Bonds with negative returns are bought mostly by European banks. The matter is that the European Central Bank's bond redemption program is constantly renewing, raising prices and creating strong demand. Since the year 2016, the European Central Bank has been redeeming not only government bonds, but also corporate bonds with an investment grade rating ³. In addition, government bonds of the countries of the European Union are one of the few instruments under which European banks do not need to create reserves. In the absence of other instruments, banks have no choice but to purchase bonds with negative returns.

But bonds with negative returns have a certain limit, after which the risk of holding them will not outweigh the possible benefits. For example, the cost of storing physical gold based on current prices costs banks about 0.4% per annum, and the yield on German government bonds is about -0.5%. If the yield falls even lower, then banks may decide that paying a previously known 0.4% for virtually risk-free gold storage may be more profitable than investing in bonds with a negative yield.

Of course, the super soft policy of the European Central Bank negatively affects the financial performance indicators of European banks. They are already so far behind the US banks, where the rate is positive. Since the year 2014, the situation has only worsened, the net interest margin of European banks is more than twice lower than the equivalent indicator of US banks.

For example, in the year 2018, the banks of Eurozone had to pay 7.5 billion euros just for holding deposits in the European Central Bank.

The super soft monetary policy of the European Central Bank also affects ordinary Europeans. Rates on deposits by individuals in the Eurozone have actually dropped to zero, and in some cases a negative interest is already charged on them. Theoretically, this should lead to an outflow of customers from banks, forcing them to spend more, but over the past two years, the growth in the volume of deposits has accelerated more than the turnover of retail trade. I.e., even in conditions of zero interest rates on deposits, Europeans prefer not to spend money, but to carry them to banks.

The volume of bank deposits of individuals and the weighted average rate on them, Eurozone (as of August of the corresponding year)

Dynamics of retail and bank deposits of individuals, the Eurozone

Eurozone rates give such a low return on investment that Europeans are simply forced to increase their savings rate - its sharp increase began in mid-2018, when negative rates spread throughout Europe. For example, if earlier, at a deposit rate of 2%, the average European planned to retire in twenty years with 300 thousand euros in a bank, it was enough for the average European to save about 1 thousand euros a month, i.e., to put in a bank only 240 thousand, the rest would have been done with compound interest. Now, with a conditional zero rate, the average European will have to save 1.25 thousand per month. Of course, at deposit rates of 2%, inflation will be higher than at zero, but an ordinary person rarely deals with the real value of money.

In addition, bubbles are inflating in other markets, for example, the residential real estate price index in the Eurozone has moved into the area of positive growth overtaking the United States in recent years.

Household savings rate, Eurozone

Real estate price index dynamics

Inflation

The introduction of a negative rate of the European Central Bank occurred at the time of falling consumer price index (CPI) into the area of deflation. Then the CPI began to grow, at some points even exceeding the European Central Bank target level of 2%. Nevertheless, in general, it remained below the target level, and recently it has fallen to 1%⁴. If there was an effect from the introduction of a negative rate, then it did not last long. And, worst of all, now the European regulator has no choice but to continue to further cut rates, for fear of a repeat of the deflationary scenario⁵.

National Currency Devaluation

Perhaps the only area where negative rates worked as they should is currency. The European Central Bank was interested in depreciating the euro to stimulate exports, and its efforts were successful. Euro has not cost so cheap to dollar since the year 2003.

What began as an experiment in intensive but short-term stimulation of the economy turned out to be the strongest narcotic for the financial system. Developed countries (and the People’s Republic of China) can no longer do without it⁹.

By joining the negative interest rate terra incognita, the European Central Bank was counting on extrapolating the trends observed under ordinary soft monetary policy. However, negative rates distort the logic of economic relations and cause unforeseen, at first glance, consequences. The objectives of credit incentive and acceleration of inflation were not fulfilled except devaluation. And among the negative consequences of a negative rate are the weakening of banks, supporting inefficient companies, depreciating household deposits and creating a favorable environment for market bubbles.