Heres Why Negative Interest Rates Are More Dangerous Than You Think

(May 9, 2016 - by Charles Kane, Fortune Insiders)

Europe and other parts of the world are in for big risks.

Desperate times call for desperate and somewhat speculative measures. The European Central Bank (ECB) cut its deposit rate last Thursday, pushing it deeper into negative territory. The move is not unprecedented. In 2009, Sweden’s Riksbank was the first central bank to utilize negative interest rates to bolster its economy, with the ECB, Danish National Bank, Swiss National Bank and, this past January, the Bank of Japan, all following suit.

The ECB’s latest move, however, was coupled with the announcement that it would also ramp its Quantitative Easing measures by increasing its monthly bond purchases to 80 billion Euros from 60 billion Euros — a highly aggressive policy shift. The fact that the ECB has adopted this approach raises two key questions: What are the risks? And, if the policy fails, what other options are left?

Negative rates are an attempt by the ECB to prod commercial banks to lend more money to businesses and consumers rather than maintain large balances with the Central Bank. In essence, it is forcing the banks to leverage its balance sheet to a higher level or the ECB will penalize the banks by charging interest on their deposits. Historically, such a practice would be highly inflationary, however, with oil prices falling to record lows combined with a slowdown in global growth, inflation is not feared. In fact, inflation is desired at a manageable level, as this would promote near-term growth in the economic markets.

This does not mean, however, that the ECB’s policy does not present risks. First, if the commercial banks decide to pass on the cost of the negative rates to their customers — in other words, they charge customers for keeping their savings in the bank in the same way central banks are now charging the commercial banks for keeping their money – the customers might simply withdraw their savings. In a worst-case scenario, this could create a run on the banks in Europe with customers hoarding their money rather than paying interest on deposits. This would inhibit the free flow of funds through the financial system — ironically, the very reason that negative interest rates were implemented in the first place.

Conversely, if the banks continue to absorb the costs, it could cut deeply into their profits. Even a tenth of a percent on billions of dollars adds up and can mean the difference in profit or loss in a major commercial bank. To date, the effect negative interest rates have had on bank profits have put downward pressure on the majority of bank stocks, which in turn, has depressed the European and global equity markets.

Negative interest rates also have a profound impact on the foreign exchange markets. Interest rate differentials from one currency to another drive the future value of currencies and as the ECB lowers rates into more negative levels, this puts downward pressure on the European Currency Unit (ECU). This may improve near-term EC trade

exports from the region. However, capital flight from the lower interest rate ECU markets to more favorable returns in positive interest rate currencies is inevitable over time. Additionally, the U.S. Fed has clearly stated its intent to raise rates over the next year to eighteen months, thereby making the interest differential gap even greater and thus downward pressure on the ECU even more pronounced.

Something has to give and the ECB is painting itself into a corner with very few options left.

The European banks (most vocally, the German banks) are already objecting to current negative interest rate levels; the Euro continues to be negatively pressured by lower rates relative to other currencies due to interest rate differentials; and Quantitive Easing measures, a practice that was shunned by the ECB when the U.S. did its first round of Quantitative Easing in the 2007-2008 timeframe, has been ramped up by the ECB with no apparent material impact on economic growth.

All in all, negative interest rates are not spurring economic growth and are likely to damage the banking sector in Europe if deployed for an extended period. Market stability, tantamount to improving long-term growth prospects, cannot be achieved by testing aggressive and relatively unknown monetary practices such as negative interest rates. Rather, further interest rate adjustments downward by the ECB will seriously hurt the European banking industry — in turn, increasing instability in the European markets. In short, pursuing a negative interest rate policy will most likely hurt economic growth in Europe, not help it.