Uncharted waters: what happens if rates go sub-zero?

Since the start of the financial year, the RBA has cut rates to an unprecedented 0.75%. What happens if rates crash through zero and into negative territory?

In August, Reserve Bank governor Philip Lowe told Federal Parliament’s Standing Committee on Economics that the RBA was prepared to do “unconventional things” to kick-start a flailing economy.

It may be that unconventional measures are needed for unconventional economic times. At the same time as early signs are showing that the housing market is starting to find its feet in a low-rate environment, the government slashed its expected revenue during December – erasing almost half the surpluses originally predicted through to 2023.

The Australian unemployment rate ended 2019 at 5.25%, wage growth has again been revised down and our GDP is tipped to fall. These types of indicators are not what the RBA wants to see after such dramatic cuts to the cash rate. It could mean rates will drop further during 2020.

“It’s possible that we end up at the zero lower bound. I think it’s unlikely, but it is possible,” Dr Lowe also told the parliamentary committee.

“Overseas, we see some central banks have very low interest rates and some countries have negative interest rates. So, some central banks have gone negative. That’s one possibility.”

What happens when rates go sub-zero?

Under a negative interest rate, the rules start to look a little topsy-turvy.

We’re used to higher rates meaning returns on cash investments are stronger and borrowers needing to pay back more on their home loans. As rates fall, cash sees weaker returns on savings, and those with mortgages can find themselves with extra money to spend.

Negative interest rates are intended to encourage spending even more than low interest rates. That’s because customers receive benefits for borrowing – those who borrow money would see their lender potentially paying them interest. Strange days, indeed.

The logic is that if you take what you have from the bank, spend or then borrow more, you’ll be helping to stimulate the economy.

So what does that look like?

A $100,000 loan at a fixed interest rate of minus one per cent – as an example – would earn a borrower almost $85 in interest each month. And it’s this freeing up of capital that makes negative rates a viable option.

“We’re used to higher rates meaning returns on cash investments are stronger and borrowers needing to pay back more on their home loans. As rates fall, cash sees weaker returns on savings, and those with mortgages can find themselves with extra money to spend.”

But for the banks, losing money when lending could mean a big dent in profit margins, and a less favourable landscape in which to lend. Likewise, zero-to-slim returns on savings accounts means banks risk having customers remove their money to invest elsewhere.

In countries where rates have gone into negative territory, banks have done everything possible to hold interest rates on savings accounts just above zero.

Where have negative rates become reality?

In 2016, Japan became the latest country to introduce negative interest rates. The move was designed to stop a rise in the value of the yen hurting the country’s export-reliant economy.

The European Central Bank – the central bank for the 19 member states of the European Union – has been “charging” commercial banks to hold deposits since mid-2014. And negative interest rates have also been introduced in Sweden, Switzerland and Denmark.

In August 2019, a Danish bank offered the world’s first negative interest rate mortgage. Taking one out means that you’re still required to make regular payments to repay the principal, but instead of interest being calculated and added to the value of the loan each month, it’s subtracted.

This sounds counter-intuitive, but the argument is that it’s more beneficial for a bank to take a small, guaranteed loss than seeing thousands of customers default on their loans. The downside for customers comes when banks are required to keep up the bottom line in other ways, such as increased fees and high interest credit cards.

And as well as encouraging spending, negative rates are also designed to keep a country’s central currency value low, with the aim of bringing in overseas spending and boosting exports.

In the US, where economic policy seems to have curbed unemployment and is holding off the risk of a recession – at least for now – President Donald Trump openly floated a desire for negative rates during a speech to the Economic Club of New York in November 2019.

“We are actively competing with nations who openly cut interest rates so that now many are actually getting paid when they pay off their loan, known as negative interest,” he said.

“Give me some of that. Give me some of that money.”

Have sub-zero rates worked in the countries that have adopted them?

The jury is out, with the decision clouded by the way banks look for other ways to generate income in negative rate climates.

Heading into negative territory is traditionally something done out of necessity, not choice. And the countries that have gone sub-zero all seem to be finding it difficult to drive rates back into the positive again.

Ultimately, the biggest unknown about negative rates is if the extra money it puts into Australian wallets would actually be spent in ways that drive the economy into a higher gear, rather than sitting in savings accounts.

And if our economic issues persist, negative rates could turn out to be a long-standing feature of the Australian financial landscape.