Thursday, August 18, 2011

Negative interest rates in Switzerland

Amidst all the turmoil in Europe and the global financial markets, a less reported but remarkable event happened when the Swiss interest rates, including medium-term rates, in the LIBOR market plunged into negative territory. In other words, instead of being paid by their borrowers, lenders would now have to pay for the privilege of getting borrowers to accept their money!

As the Eurozone economies plunged into crisis, Swiss Franc emerged as a possible safe haven. The resultant capital inflows boosted the Franc by over 20% against the Euro, hurting Swiss exports and economic growth. In fact, as Gillian Tett writes, the Goldman Sachs has described it as "the most overvalued currency" in recent history, 71% stronger than fundamentals justified.

In response, early this month, the Swiss National Bank (SNB) acted aggressively to lower interest rates to virtually zero (from 0.25%), inject unsterilized cash, build up sight deposits (cash withdrawable on demand from the central bank) with the SNB, and repurchase outstanding SNB bills and use the proceeds to buy Euros in the forex market. The SNB press release said,

"Effective immediately, the SNB is aiming for a three-month Libor as close to zero as possible, narrowing the target range for the three-month Libor from 0.00-0.75% to 0.00- 0.25%. At the same time, it will very significantly increase the supply of liquidity to the Swiss franc money market over the next few days. It intends to expand banks' sight deposits at the SNB from currently around CHF 30 billion to CHF 80 billion. Consequently, with immediate effect, the SNB will no longer renew repos and SNB Bills that fall due and will repurchase outstanding SNB Bills, until the desired level of sight deposits has been reached."

The results of this aggressive response has been spectacularly successful, with interest rates on Swiss two and three-year government bonds falling into negative territory and spreads with German bund widening on the negative side. The Swiss ten year bonds have fallen off precipitiously in the last two months. The futures markets are currently predicting negative rates until 2013 and minus 8 basis points next summer.

This effectively means that "if you want to lend Swiss francs or make a deposit in the next year, you must pay for that privilege", an anomaly that has led to Gillian Tett of FT to describe it as "Alice in Wonderland" economics! Alternatively, anyone holding two-year or three-year Swiss bonds is now demanding that the price exceeds the coupon-included return in order to be tempted to sell.

Apparently, this is not the first instance of negative interest rates. In the 1970s the SNB imposed negative interest rates on foreign accounts to deter inflows; and in 2008 some short-term Swiss market rates briefly turned negative. That also happened in Japan in the late 1990s and recently some dollar short-term rates have touched negative territory. However, in all these cases, the negative rates covered only ultra-short rates, whereas the present Swiss situation is for medium-term rates covering the next two years. In simple terms, borrowers could take out a two-year loan with the assurance that they would need to be paid by the lenders for the next two years.

However, given the depth of the financial crisis, as FT Aplphaville says, even this situation is fraught with dangers. Technically, the build up of sight deposits (which would be used as reserves by banks) should "cause Swiss rates to fall sharply since the more reserves banks hold, the less they require to borrow from each other and the lower the rate falls". FT Alphaville writes about the distortionary possibilities,
"Since the SNB pays zero on its sight deposits, there is a very real risk banks might be encouraged to hoard cash on deposit rather than to lend it out for a negative rate. This would be the exact opposite of expanding the money supply. It might even be contractionary.

Now, the SNB is probably hoping that the extreme unattractiveness of having to pay an additional rate to hold Swiss francs will be enough to encourage holders of the currency (especially those abroad) to sell the franc and move elsewhere. This, theoretically, should flood the market with Swiss francs, lowering exchange rates and easing liquidity. But there is still the danger that the move could drive Swiss francs straight into the coffers of Swiss-based banks, who would then be unwilling to lend them out at a negative rate.

In that circumstance, a deflationary spiral motivated by 'capital preservation' could begin. Once that starts, no matter how much 'QE' money is printed, it becomes completely ineffective at boosting the money supply. In fact, if anything, it arguably becomes a deflationary force because the money is being pumped directly into a liquidity trap, in which capital preservation (rather than yield) is the chief priority of banks and depositors. Which, by the way, happens to be exactly what happened during the Great Depression."
This has echoes of the Great Depression (see this Ben Bernanke paper), when "the market for unsecured lending died a death because counterparties no longer trusted each other",
"Everyone turned towards a collaterised lending regime, one in which only the very best collateral (Treasuries and gold) would do. This had the effect of causing a run towards Treasury securities. No matter how much money was printed by the Fed to ease liquidity concerns it only intensified the obsession with capital preservation. Largely by eliminating the number of Treasury securities in the market. Since, there was no one the banks could lend money to in the wider market due to credit concerns, Treasuries became a bit of a Giffen good. The money had to be parked somewhere... With capital preservation becoming the top priority for banks, institutions were willing to pay more than the face value of Treasury securities, because investing elsewhere would come with too great a risk of default."
In the uncertain environment, as the prices of Treasuries went up (and the yields fell down), banks purchased more of the same. The same story is being repeated today with Swiss Government Bonds, pushing yields into negative territory.

As an update, it does now appear that the SNB's aggressive actions have not been as successful as initially thought in curbing the Franc's rise.

Update 1 (19/12/2014)
Switzerland announced that from January 22, 2015, it intends to charge negative interest rate of 0.25% on bank deposits held with the central bank which are beyond 10 million francs. However, this will be applicable only on financial institutions. Its objective is to make short-term Swiss assets like franc-dominated money market funds and debt securities unattractive to foreign investors, thereby stemming capital inflows (as capital flees in search of safe Swiss assets) and limiting the appreciation of the franc.

This follows the ECB's decision in June to impose a negative 0.1% rate on excess reserves of banks with it, which was raised to minus 0.2% in September. The ECB's decision though was taken to encourage banks to lend. 

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