The European Central Bank (ECB) recently introduced a raft of unconventional measures to counter deflation that have come as a surprise to many in the field of finance. One is the ECB’s low-interest targeted longer-term refinancing operations (TLTRO), another is the bank’s negative interest on deposits.
In economics, a negative interest rate occurs when the real interest rate is negative, usually when the nominal interest rate is below inflation. Many countries, including Japan, the US, the UK, the EU and Taiwan, currently have a negative real interest rate. That is, a borrower still has to pay interest, but when the money is returned, it is less in nominal terms, because the cost of goods has gone up in the meantime.
In real terms, the bank is actually giving money to the lender. By using a negative interest rate of 0.1 percent on deposits banks hold in the central bank, the ECB is making the nominal interest rate negative, which means that banks are effectively being charged for holding deposits in the ECB.
The objective of this is to force banks to take out the deposits they have in the ECB to increase their credit. Another effect of this is that negative interest rates reduce short-term capital inflows through interest arbitrage — short-term investment in currencies due to favorable interest rate differentials — or capital outflows as a result of the carry trade. All this enables the asset valuation of the euro to fall and therefore reduces inflation.
With another type of TLTRO, the ECB is targeting households and non-financial enterprises, refinancing loans at a low interest rate to incentivize higher household consumption and corporate investment, thereby increasing effective demand among the general public. Banks more commonly use selective credit controls to restrict bank financing of specific sectors — such as real estate — to prevent the market overheating. However, in this case, the ECB has taken a less well-trodden route, using selective credit controls to make credit easier to obtain in certain sectors to stimulate the economy.
The main difference between the quantitative easing employed by the ECB and that of central banks in major countries is that most nations trade bonds in the finance markets to regulate capital, while the ECB is circulating capital through lending, most likely due to the EU’s lack of a single finance market, including bonds from all countries and of unified regulation of banks.
Deflation within the EU stems from the euro sovereignty crisis and the crises in which many southern European countries have found themselves. However, after a decision between member states on Nov. 2011 to keep the euro intact it is stable. This, along with the more recent banking and financial consolidation in the eurozone, means the economic crisis in the EU seems to be abating. Now, with the reduction of quantitative easing in the US, capital is coming from emerging economies, leaving the field open for interest arbitrage on euro debt, giving temporary relief for the debt crises in Greece, Italy and Spain.
International capital has flooded into euro bond markets, the price of bonds has soared and yield rates plummeted, allowing the euro to bounce back. However, economies throughout the zone are still struggling, with high unemployment rates and weak consumer demand, which is why the ECB was forced into making this response. With negative real interest rates in many other countries, it remains to be seen how attractive the EU’s negative nominal interest rate will prove to be.
If the EU is struggling, it is no surprise things are tough in Taiwan. The real question is what we are going to do about our own economic problems.
Norman Yin is a professor of financial studies at National Chengchi University.
Translated by Paul Cooper
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