askST: Why do banks impose negative interest rates and does this policy make economic sense?

A reader who wished to remain anonymous wrote to askST after the Bank of Japan imposed negative interest rates on Jan 29. He asked why banks impose negative interest rates and added: "Does this policy make economic sense? Is this policy sustainable in the long run? How would negative interest rates affect the decision making of different people in the economy?"

Economics reporter Chia Yan Min answers the questions.

Negative interest rates are seen as a radical policy move and a sign that traditional policies to boost economic growth have proven ineffective.

The Bank of Japan surprised markets to become the latest central bank to push policy rates into negative territory on Jan 29. The move came about two years after the European Central Bank became the first major central bank to venture below zero.

When an economy is struggling, central banks typically move to cut interest rates. This makes saving less attractive and borrowing more so, boosting the amount of money being spent and contributing towards an economic recovery.

Many central banks around the world have taken this approach in the wake of the global financial crisis, mostly to battle a disinflationary environment brought on by the collapse in oil prices and poor global growth.

Despite their efforts, the outlook for economies such as the European Union and Japan remains lacklustre. They are also facing the threat of deflation, the phenomenon of persistent falling prices across an economy.

The Bank of Japan's struggle to achieve its goal of bringing inflation back up to 2 per cent - considered a healthy level for most economies - was the most pressing reason behind its move to negative interest rates.

People usually expect to get back interest on bank deposits, but when rates are negative, this relationship is reversed, and lenders have to pay to lend money or to invest.

Negative interest rates dissuade lenders from parking cash with the central bank. The hope is that banks will lend out more money to individuals and businesses, who will then spend and boost the economy.

Interest rates below zero should reduce borrowing costs for companies and households, pushing up demand for loans.

Negative interest rates also affect the foreign exchange market. They might send investors in search of better returns abroad, leading to depreciation of the currency.

That would make imports into the country relatively more expensive, helping to combat deflation, while also making exports relatively cheaper on the world market and giving a boost to the economy.

In practice, however, there is a risk that the policy might do more harm than good.

Consumers might well respond to negative rates by withdrawing money from banks and stuffing it in their mattresses, since cash carries an implicit interest rate of zero per cent. This would result in a shortage of funds available for banks to lend out.

Negative rates may also create financial instability in other ways.

Banks may be reluctant to pass negative rates on to depositors for fear of losing customers.

But those same banks may earn returns on their assets - mortgages, for instance - which vary with interest rates.

Negative interest rates would lead to lower profits for these financial institutions, and weak banks will not be able to do much to drive a strong recovery.

It is still to early to assess whether the negative interest rate policy will work out well for economies like Japan and the European Union, but given the lacklustre global outlook, even more central banks might soon be jumping on the bandwagon.

More askST stories here.