Unreal

 Do low interest rates signal trouble?

Some shock waves from Europe’s economy reach as far as Kazakhstan.  Two weeks ago, the European Central Bank announced a negative interest rate for regional banks holding their deposits there.  These banks will have to pay for the privilege of lending their money to the ECB.

In a sense, negative interest rates have been common around the world since the financial crisis of 2008.  This refers to interest payments measured in terms of the goods and services that they can purchase – that is, to “real” interest rates.  In economics, “real” refers to quantities as opposed to money.  A real interest rate of 5% indicates that the lender can buy 5% more of autos and bottles than he could have done by spending the principal rather than lending it.   When the real interest rate is negative – say, -3% -- then the lender loses purchasing power despite the interest paid to him.  He can buy 3% less of goods than he could have done by foregoing the loan.

The ECB’s novelty was a negative money interest rate. I’ll explain.

Depositors to a bank are its creditors, since it can put their dollars to work by lending them out or by purchasing assets like government bonds.  (Indeed, a loan is an asset, since the lender can expect it to pay off.)  The ECB is no exception, although it does not make commercial loans as a rule.  A negative money interest rate of, say, 1% means that banks must pay the ECB 1% of their deposits there.  This is in addition to the loss of purchasing power that the depositors suffer by leaving their money at the ECB rather than spending it.

Why might this affect Kazakhstan?  Because the market for financial assets is global.  All assets enable their holders to consume more tomorrow by consuming less today.  If you buy a 5% bond for $10,000, then you give up $10,000 of spending today – on a long Caribbean cruise, perhaps – in order to earn $10,500 for spending next year (add a few lobster dinners to that cruise).  The rate of return on any financial asset – we might as well just call it the “interest rate” – tends to converge on a common global rate, because the assets market is fast-moving (“liquid,” if you will).  If the common rate is 5%, then a 6% asset will quickly attract buyers, pushing up its price and thus reducing its rate of return.  (Confused?  See the Notes.)

The Bankers’ Ball 

Today in the West, most interest rates are close to zero, largely because the central banks in the wake of the financial crisis printed money as if tomorrow would never come.  Increasing the supply of anything will lower its price; otherwise, the additional units can’t be sold.  The price of holding a tenge is the interest rate, since you must give up the interest payment if you choose not to lend out the money.

Adjusted for inflation, inflation rates tend to be higher in Kazakhstan than in the West, probably because people view investment here as risky and demand payment for the risk.  By adopting a negative interest rate, the European Central Bank is pressuring rates in the post-Soviet world to fall, since investors will bid up the price of post-Soviet assets.  For a while, the post-Soviet banks will smile, since Westerners are lending them more dollars than before.  (To the Westerner, these loans are assets.)  But the banks, giddy with new dollars, may make the same mistake that they did in 2007 – lending out the dollars recklessly.  If the financed projects fail, then the banks will be unable to repay Westerners.  Once again, the banks will flirt with insolvency.

Of course, the banks will assure us that they lend with the utmost prudence, that any shortfall of dollars is temporary.  That’s what they said in 2007, too.   –Leon Taylor, tayloralmaty@gmail.com           

Notes

1.  Consider a bond that costs $10,000 to buy and that pays off $500 in interest each year.  Its annual rate of return is $500 / $10,000, or 5%.  If its price rises to $20,000, then its rate of return will fall to $500 / $20,000, or 2.5%.  In general, the price of an asset relates inversely to its rate of return:  When one rises, the other falls.

              

Reference

Jack Ewing and Neil Irwin.  European Central Bank breaks new ground to press growth.  The New York Times.  June 5, 2014.