The Investor 89 Asia

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THE INVESTOR | 07
ANALYSIS
ECONOMY
On 10 March 2016,Mario
Draghi, President of the
European Central Bank
(ECB), announced the
latest set of measures
designed to stimulate the eurozone and
steer it away fromwhat central bankers
regard as the dangerous waters of deflation.
As a central banker who is closely
associated with‘big bazooka’monetary
measures, Draghi used plenty of
ammunition.The ECB increased its
monthly asset purchases – also known as
quantitative easing – from €60 billion to
€80 billion, and announced a scheme
to give Europe’s banks new incentives to
lend. It also took its deposit rate further
into negative territory, reducing it from
-0.3% to -0.4%1.
Historically, the setting of a negative
interest rate by one of the world’s major
central banks would have seemed so
odd that it would have sent shockwaves
through the financial markets and the
wider economy. For the ECB, however,
it is almost old hat. It first reduced its
deposit rate below zero in June 2014
and the latest move is just another in
the sequence.
And the ECB is not alone. In January,
the Bank of Japan also adopted negative
interest rates, just months after its
Governor, Haruhiko Kuroda, had
suggested there was no need for it to do
so.The Swiss National Bank also has
negative interest rates, as do the central
banks of Sweden and Denmark.
Why is this happening? For central
banks, the interest rates they set are
typically on the reserves that commercial
banks hold with them, so in that sense the
banks are a captive Paul
Sheard, Chief Global Economist at ratings
agency Standard & Poor’s, puts it:‘Central
banks can do this because they get to
determine the total amount of liabilities
they issue, giving them the unique ability
to set both the quantity and the price.’
That explains how central banks can
break the normal rules and set negative
interest rates. But why do they do it?The
fall in inflation, which has been brought
about by weak oil and commodity prices,
has worried central bankers, who do not
want deflation to become embedded. It has
also meant that, while a zero interest rate
looked very lowwhen inflation was, say,
2%, it no longer looks so lowwhen
inflation itself is also zero, or when prices
are falling. In other words, to provide the
same stimulus, official interest rates have to
go negative.
Central banks are also keen to ensure
that commercial banks have an incentive
to lend to businesses and households. Some
of the reserves held at central banks are
there for regulatory reasons, but some
are there because the banks are choosing
that course of action, rather than using
themmore productively; they are‘excess’
reserves.A negative interest rate on these
reserves – in effect charging commercial
banks for keeping their money at the
central bank – should either encourage
them to move it into other assets or
increase their lending into the real
economy. In theory, it should no longer
be sitting idle at the central bank.
The other powerful consideration for
central banks has been the exchange rate.
Readers with long memories may recall
that Switzerland adopted negative interest
rates on foreign deposits in the 1970s.The
aim then was clear:‘hot’money flows –
partly as a result of the sudden riches
enjoyed by oil-producing countries – had
a destabilising influence.Their effect on
safe-haven currencies such as the Swiss
franc was to push them sharply higher.
Switzerland’s course of action was
intended to stop that happening, or at least
limit it. Preventing currencies from
Getty Images
A zero interest rate
no longer looks low
when inflation itself
is also at zero
Corbis, Getty Images