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OPINION

Negative rate dangers

Negative rate dangers
February 2, 2016
Negative rate dangers

Last week, it announced that it would charge banks 0.1 per cent on big deposits with the Bank of Japan (BoJ), thereby joining Sweden, the eurozone, Denmark and Switzerland in taxing banks' deposits with the central bank. The BoJ hopes that this tax will encourage banks to lend to companies rather than to the BoJ, thus stimulating real economic growth.

Many economists, however, are sceptical of this. "No country that has gone into negative rates has experienced major shifts in its growth and inflation profile. Minor, yes; major, no," says Steven Englander at Citibank.

One reason for this is that even if banks want to lend, companies don't want to borrow. A combination of spare capacity (who wants to build a steel plant?), secular stagnation, risk aversion triggered by memories of the 2009 recession and a fear of future competition are all suppressing the desire to invest.

A second reason was pointed out years ago by Andrew Caplin and John Leahy. Monetary policy, they said, isn't simply a hydraulic process whereby central banks pull levers and the economy responds. It also has signalling effects. This poses the risk that companies might react to negative rates by becoming even more pessimistic, thinking "if the BoJ is that desperate, the economic outlook must be even worse than we thought". In this way, negative rates might, perversely, weaken spending.

The eurozone's experience seems to support these concerns. The ECB imposed negative rates on banks' deposits with it back in June 2014. Although bank lending to the private sector has risen slightly since then (albeit falling in December), the economy has grown only weakly since then.

This does not mean, however, that negative rates have no effect. They might encourage banks to buy financial assets or to invest overseas, or to lend to those who do so: this is why global share prices rose and the yen fell after the BoJ's announcement.

It's possible that the weaker yen will boost Japan's exports. But even here there is a risk. Keith Wade at Schroders says the move might trigger a "currency war" in which China retaliates by trying to weaken the renminbi.

While this might be good for global growth if it leads to looser monetary policy around the world, there could be an offsetting effect. The link between exchange rates and exports isn't mechanical. To increase exports, companies must invest in overseas sales networks. They'll only do this if they can be confident that the weaker exchange rate will persist. Talk of currency wars, however, undermine that confidence and so deter investment in export effort. It's no accident that world trade has been so sluggish in recent years amidst talk of currency wars.

Herein lies the danger for equity investors. If the market rally triggered by the BoJ's move is not matched eventually by stronger real economic activity and profits, we'll see prices fall as disappointment sets in - as we have so often in Japan since 1990.

None of this is to say that central banks have run out of ammunition. There's something they could do to boost growth. They could simply write everyone a cheque - the equivalent of dropping cash from a helicopter. Until they do this, however, doubts will remain about their ability or willingness to revive economies.