Why Aren’t Negative Interest Rates Feasible For Developing Economies?

Published on 31 Aug, 2016

Negative Interest Rates Research

Developed nations are fast adopting the Negative Interest Rates to boost economic growth and shake off money-hoarding. The trickle-down effect of the slowdown in the developed world is impacting the developing economies.

Naturally, we ask, “Is the unconventional policy really feasible for the developing economies?”

In the early 20th century, Silvio Gesell imagined living in a world of “free money”. 

Often referred to as a neglected prophet of economics, Gesell dreamt of a world where taxes prevented money-hoarding and discouraged money languishing in bank accounts. All, with the idea that spending cash will spur demand and avoid deflation in the market.

The world had conveniently forgotten about this Gesell tax, till the five major central banks in the developed economies adopted Negative Interest Rates to boost inflation and economic growth, and to keep the underlying currency devalued. Japan, the EU, Switzerland, Sweden and Denmark now have negative interest rates. This policy shift started with Denmark to protect currency appreciation from the inflow of money. In March 2016, the National Bank of Hungary became the latest country to cut its overnight deposit rate to negative (-0.05%) to boost growth and inflation. Central banks are cutting interest rates to enforce the growth engine and manage the disinflationary pressures observed in developed countries.

Developed Economies - Average CPI Inflation (%)

Post the Brexit referendum, the Bank of England is under pressure to cut interest rates, which are already zero-bound. Looming recession fears and a slump in corporate confidence are major concerns for the UK. The Brexit risk could promulgate to other parts of developed economies such as Canada. In addition, other countries such as Singapore, New Zealand and Australia are on the verge of an economic slowdown and are dwindling with low inflation, raising the prospects of an unconventional policy to expand in other parts of the developed world.

The trickle-down effect of the slowdown in the developed world impacted the developing economies. Naturally, the questions to ask are pretty straightforward: Will such an extreme monetary policy have any implication for developing economies? Will such a scenario pose a real threat?

That is a possibility when we look at global trends. Commodity prices declined drastically over 2015 and business confidence is very low coupled with anemic demand. Further, developing countries are facing slower growth post the financial crisis of 2008. The overall scenario is quite bleak for developing economies to keep the policy rates high. If this situation persists, the prospect of unconventional monetary policy measures could increase.

Disinflationary Pressure on Developing Economies

Price stability as the main target of the monetary policy of different central banks underpins the need to maintain stability in currency and inflation levels. Developing economies tend to have a spillover or spill-back effect from external events in developed countries. Inflation in emerging economies declined over the past four years due to the commodity price drop. The global deflationary pressure (world inflation declined to 1.4% in 2015 from 3.9% in 2012) weighs on domestic growth in developing economies, impacting the overall GDP growth.

Developing Economies - Average CPI Inflation (%)

In developing economies, inflation is relatively high compared to the developed world. However, developing economies with large exports are affected by foreign investment flows. Any potential shock in the developed world would have an impact on developing economies growth prospects.

For example, China is facing weakness due to a slowdown in global trade and is moving toward a consumption-driven economy. To address deflationary pressures and financial stability concerns, the People’s Bank of China cut interest rates five times during 2015. Moreover, China depreciated its currency (renminbi) to avoid the economic turmoil, which elicited challenges for its trade partners. China may even face the prospect of interest rates in sub-zero levels, if the economy continues to feel the strain from global headwinds.

Rising Debt Levels, Declined Investment Activity and Low Productivity Growth

Japan, with a huge debt, is trying to keep the debt load sustainable through zero-bound rates and by providing enough corpus for running the economy. The premises of negative interest rates in the developed world have been lackluster growth and falling inflation. Although developing economies have lower debt levels compared to some developed countries, the rapid expansion in debt is quite alarming.

Gross Debt as % of GDP

Developing economies, particularly in Asia and Latin America, witnessed growth in debt levels. India stands tall with a debt-to-GDP ratio of more than 65%. Moreover, China, Mexico and South Africa witnessed a rise in debt levels. Developing economies, struggling with slow growth prospects, increased the burden of high government debt, which will categorically diminish the economic growth achieved before the 2008 crisis.

Developing Economies - Gross Investment

The global economy is battling with declined productivity growth. Based on the neoclassical growth theory, long-term macroeconomic growth can be ascribed to productivity and population growth and investment. A decline in total factor productivity in developing economies (measures the level of technological progress of an economy) over the last few years is likely to influence real interest rates over the long term. Moreover, the decline in productivity overall has implications for long-term growth prospects.

Despite the large pool of young working people, the lack of productivity and employment opportunities will affect competitiveness and growth of developing economies. The declining investment trend in developing economies indicates that business expansion and infrastructure investments have been put on hold due to low business confidence. Under such scenario, developing economies might have to reduce rates further to facilitate investment activity.

The Impact of Exchange Rate Movement

Commodity export-driven developing economies often experience exchange rate depreciations and spikes in inflation, which result in the interest rate hike. Countries such as South Africa, Turkey, Russia and Brazil are vulnerable to a fall in currency prices and continue with a high interest rate policy, regardless of slower growth prospects.

In developing economies, inflation often runs high above the target rate and price stability is a major concern. Moreover, developing economies have low single-digit growth rates and an undervalued currency. Hence, the impact from lowering interest rates would have a counterintuitive effect on developing economies exchange rates. To combat exchange rate volatility, developing economies are less likely to go into the negative interest rate zone.

Under such circumstances, the negative interest rate policy will not be feasible in the near future. However, a prolonged slow growth rate, weak global trade and capital flows, and a potential recession could change the stance of the monetary policy in developing economies. Central banks in developing economies can employ unconventional monetary policy measures, which are currently implemented by the developed world.


Telltale Signs

To avoid treading along the NIRP path, the developing economies would need to closely watch four critical parameters: low inflation, weak economic growth, unwanted currency appreciation, and lack of market liquidity.

It is undoubtedly critical for the developing world to track persistent low inflation levels (global deflationary trends) including commodity price down cycle, and deflationary pressures due to the structure of the economy.

Similarly slowdown in economic growth can be tracked by watching subdued global demand, a drastic decline in exports, and a rapid increase in unemployment rates. Further, they need to observe if demand is unable to pick up, and there is an evident low business confidence, a decline in industrial or private sector investment activity, and lack of liquidity.


How Can Developing Economies Avoid Negative Interest Rates?

There are multitudes of lessons learnt from the developed economies that have adopted the Negative Interest Rates. Obviously as NIRP isn’t really a feasible option for developing economies, here are the critical lessons that can help the developing economies skip the rope.

  • To boost inflation, developing economies need to offer space for the goods and services industry, with few regulations, and tax incentives.
  • In case of lackluster demand in the market, developing economies should propel the domestic economy through infrastructure investments and promote foreign direct/indirect investments.
  • The developing economies should undertake structural reforms to boost the monetary policy transmission mechanism.
  • The developing economies should diversify revenue source to non-commodity sectors.
  • The developing economies have a large young population and the governments need to reinforce labor market participation for economic growth.
  • The developing economies need to manage vulnerabilities in the economy to tackle currency volatility and external headwinds..
  • During expansionary monetary policy, developing economies need to monitor investment flows in risky assets and potential asset price bubble.