Low interest rates and relentless infusion of liquidity has been a path chosen by several countries to revive their economies. These measures, however, have had limited impact in terms of bringing about a major turnaround. Japan continues to be in a recession for over two decades, while the US may be just about struggling to stay above the line. The euro region is still down, with little signs of an imminent recovery, even as Mario Draghi has promised to do everything possible—meaning thereby provide more liquidity. This has also inspired several central banks to look at lowering interest rates to revive demand. Are there any warnings to take away from such measures?
Negative interest rates have pervaded countries which account for almost 25% of world GDP, and if close-to-zero rates are added, it would touch 56%. Hence any repercussion has the potential to impact the world economy quite decisively, given the quantum of output that potentially becomes vulnerable.
Low interest rates can definitely not be the precondition for growth, as no one borrows unless there is use for the same. But it can create a bubble, as was the case with the mortgage system in the US when cheap loans pushed up demand. In this economic euphoria, lending institutions were not thorough with due diligence as they repackaged and sold the same loans to unsuspecting investors. The consequences were severe when the system crashed. Not surprisingly, the Federal Reserve had played the role twice—the first time when it lowered rates to make borrowing reckless and subsequently increased rates thus unleashing a backlash. This is probably one of the first risks associated with cheap money, as it does create a wave, which, if unchecked, can potentially trigger other problems at a later date.
In fact, the surplus liquidity generated through quantitative easing has found less use in the countries of origin and has flowed to the emerging economies, thus boosting stock markets. A reversal of such policies starting with the tapering and conclusion of the QE programme followed by a rate hike has created turmoil in the recipient countries as well as currency markets.
The second issue is that low interest rates or negative rates lead to greater holding of cash. Households and corporates would prefer to hold cash once interest rates turn negative, thus increasing the demand for money. This creates challenges in countries which are vulnerable to the creation of a grey economy, as such usage cannot be tracked.
Third, low interest rates make it worthwhile to look at other investments. While financial savings definitely gets affected, there is a bigger risk of migration of investments to physical instruments such as gold. This can create an upsurge in the bullion market, and one reason for the recent revival in gold price has been higher demand on account of absence of other investible avenues.
Property could be an alternative, but the shadow of the financial crisis will lurk quite closely. Currently, we are giving a lot of incentives to housing, and this is probably the only segment which is doing well in terms of credit growth. While a crash is not expected as financial engineering has made limited inroads through securitisation, the fall in evaluation standards cannot be ruled out.
Fourth, low interest rates also affect bank profitability, as there could be a tendency for spreads to be pressurised when rates come to low levels. They would be less willing to lend under these circumstances, as lower lending rates may not be matched by lower deposit rates because the latter would dissuade households from providing the funds. This problem is already visible in case of American and European banks where lowering of rates has impacted their profit and loss accounts. In case of India too, we may have just about reached a situation where deposit rates cannot be lowered further, but the marginal costing method for reckoning base rate could pressurise banks, provided all lending rates come down commensurately.
Fifth, a major problem is for corporates once the cycle turns around. Normally, large sums are borrowed when interest rates are low and employed in riskier ventures. In India, for instance, we have seen companies go out and acquire other companies to expand their operations. However, once things turn around and interest rates move up—which has to happen once the cycle changes—the corporate debt levels would increase putting not just their own profitability under strain as their debt servicing ability comes down, but also the financial system becomes vulnerable to the buildup of NPAs. A large part of the problem in India concerning NPAs has been also due to this phenomenon. While business plans going awry is the major cause for such slippages, the turning point is almost always when interest rates are increased.
Sixth, low interest rates can affect businesses like pensions and insurance where these players do implicitly assure certain returns. As most of their investments are in fixed income instruments, any fall in rates affects their ability to service their customers. In addition, households become reluctant to invest in these instruments and could prefer to move to the riskier stock markets or property; this will choke the supply of funds which are used often for servicing the existing customers. Hence, the entire business chain gets affected when interest rates become negative or extremely low.
Seventh, chaotic situations arise when emerging economies borrow from developed countries in large quantities due to the interest rate differential. This has already been witnessed where developing countries’ indebtedness has increased. As rates are fixed with LIBOR, any increase in policy rates is first seen in repricing of all such loans, putting pressure on companies and hence the countries. The problem emerges once currencies depreciate, which has been witnessed in the recent past, thus creating debt challenges for countries and the world economy.
Given these possibilities, it is necessary to move cautiously with interest rates in the downward direction. Low rates in the West have raised some apprehension in the minds of analysts. This is more so because rates have been forced downwards to encourage borrowing in the face of limited demand. In such conditions, funds may flow to riskier ventures, which, in turn, can create future challenges when rates move up or currencies depreciate.
The author is chief economist, CARE Ratings. Views are personal