Negative interest came into play largely after the Global Financial Crisis. Many Central Banks have indulged in this policy, including Denmark, Sweden, Japan, Eurozone. Putting it simply, the excess reserves of the commercial banks held by the Central Banks are taxed instead of paying interest.
Rationale behind such policy measure is to encourage banks to utilise those funds for investing or lending. It is also intended to induce inflationary pressures and spur economic growth, but not limited to reasons like preventing further strength in currency, thus trade.
A weaker currency is favourable for exports as it makes it attractive for the importing nations or trade partners while raising inflation through increasing import prices of the goods and service for any nation.
Negative policy rates make loans and borrowing cheaper loans for the households and business. Likewise, it also hampers the strength of the financial institutions with lower margins.
Negative rates not only erode banks profitability but also instigate investors/banks to take higher risks, which may lead to higher asset prices. It may cause households to adopt cash instead of deposits, leaving additional funding blues for the banks.
While we have seen how insurance companies note the impact of lower interest rate on their businesses as it may cause inability to meet to the long term liabilities, and this is also true for the pension funds/superannuation funds – insurance companies as well as pension funds tend to invest largely in fixed income securities.
Australian Central Bank has no appetite for negative policy rates
Today (i.e. 1 April 2020), the Reserve Bank of Australia released the minutes of the latest policy meeting. It starts with COVID-19 led disruption that has disrupted the global economic order.
RBA has been mindful of the market behaviour, which has seen some of the wildest moves in the asset prices in a record time frame, and oil price shocks led by supply-side instabilities as well as weaker demand.
In August last year, the negatively yielding debt stood at around USD 17 trillion, as fears of recession knocked the doors – initiating flight to safe have assets – something similar has happened now, but the scale as well as intensity is paramount, causing major dislocations in the asset prices.
Which means sort of liquidity crunch in money markets, corporate bond market, sovereign debt market as credit spreads tighten across debt grades – leaving higher yields in the high-yield debt markets as well as short-term funding markets or money markets.
RBA noted Australian banks have strong funding positions. The Board was also mindful of the dislocations in the sovereign debt markets as sell-offs intensified in the government debt markets – leaving yields higher when policy rates are record low – making the funding expensive, despite being rated AAA.
The bank also intervened in the markets through pumping billions of dollars by open market operations and tweaking Exchange Settlement balances. It has been conducting daily operations in the short-term money markets, which has meaningfully pulled the yields lower on these market instruments.
Below shows how the Australian reference rate/floating rate (BBSW) has seen large falls across maturities as the RBA intervened in the short term money markets.
The bank was of a view that the Australian economy is likely to face a material contraction, and potential spillovers that could be caused by the COVID-19 led implications. It expects significant job losses to occur over the course of the future.
Members of the Board had agreed that the existing lower interest environment should persist until the satisfactory process is made to the mandate of the bank, which is full employment and price stability. More importantly, the Board has no appetite for the negative policy rates.
In the policy meeting, the bank had introduced several measures to combat the dislocation in the markets and the economy. It is now targeting a yield of 0.25% on the 3-year Australian Government Security.
RBA is also buying semi-government bonds or state government bonds while it is closely working with the financial manager of the Australian government – the Australian Office of Financial Management.
A large funding facility has opened by the bank for lenders to keep the small businesses as well as medium sized businesses of the country sufficiently funded amid these times. Meanwhile, the Australian Government and financial manager of the Government are providing support to the small businesses lenders and non-bank lenders, through investments in the Asset Backed Securities issued by these institutions.
Negative interest rates have even larger negatives for Australia
It is important to note that the CPI was at 1.8% in December last year and the RBA’s inflation target range is 2-3%, since December the bank has already undertaken emergency interest rate cuts.
Negative interest rates do not bode well for the Australian banking sector and non-bank financial sector, including insurance companies, superannuation funds, non-bank lenders, neo-lenders etc.
It raises questions on the profitability as well as the sustainability of these institutions. Meanwhile, it may not be viable for such companies to operate in such environment, specifically when banking companies of our country are coming out as a saviour amid this pandemic – despite knowing that the operational conditions would worsen as a result.
Given the blockbuster fiscal measurers inflicted by the Commonwealth Government, the need for negative policy measures to be applied in the Australian economy appears extremely bleak.
Australian insurance companies feel the brunt of ever-present natural calamities be it bushfire season, storms or drought, especially in the general insurance space – and with negative interest rates, the investment earning prowess of the insurance sector could face dire consequences as a result of yield starvation – inducing such large investors to increase risk appetite, which may cause asset prices trending higher.
Over to currency, the AUD is one of the risk-sensitive currencies, meaning when the economic risks appear larger – the AUD against wider G10 rates is likely to get weaker. In this episode, we had seen AUD touching lows of 2002. This also suppresses the need to lower AUD by having an unconventional monetary policy or negative interest rates.
Moreover, with robust fiscal policy measures as well as monetary policy measures by the Australian policymakers, the urge to introduce unconventional policy measures to stimulate the economic growth appears further unconvincing.
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