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SCB EIC ARTICLE
17 สิงหาคม 2016

Strong Side Effects of Ultra-low Interest Rate

Worldwide growth numbers in the past few years have been disappointing. As more uncertainties arise in the global economy, central bankers are taking ever more drastic measures in desperation to save growth. In July, one month after the Brexit result, the Bank of England cut its interest rates to the historic low to stave off potential impacts from the fallout. Central banks around the world too have taken their policy rates to unprecedented low levels.

Author: Sutapa Amornvivat, Ph.D.

Published in Bangkok Post newspaper / In Ponderland column 17 August 2016

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Worldwide growth numbers in the past few years have been disappointing. As more uncertainties arise in the global economy, central bankers are taking ever more drastic measures in desperation to save growth. In July, one month after the Brexit result, the Bank of England cut its interest rates to the historic low to stave off potential impacts from the fallout. Central banks around the world too have taken their policy rates to unprecedented low levels.

In Thailand, interest rates have been lower for even longer. Despite no apparent crisis, Thailand’s policy rate has been held at 1.5% for over 16 months now (only 2 months short of the low-rate period following the global financial crisis in 2008).

 

Desperate times call for desperate measures, so the old saying goes. But the side effects of this strong pill are becoming harder to swallow.

 

One hardest-hit area from this policy is the banking industry. Low interest rates are intended to get banks to lend out more, greasing the wheels of the economy. With deposit rates already tracking zero, lowering policy rates further squeezes banks of their profit margins on loans. This, in turn, makes it difficult for banks to build up capital, which acts as a cushion to absorb potential losses, as they manage risks in day-to-day operations. In the post-crisis world, impaired capital and high credit risks hinder banks’ ability to expand lending volume to help with economic recovery.

 

The combination of falling bank interest margins and sluggish growth could lead to a vicious cycle of weak banks and fragile economy.

 

Latest developments in Europe are a good demonstration of this policy’s side-effects. Unexpected events like Brexit expose Europe’s weak spot: the banking sector, which is suppressed by a long period of low interest rates and tighter regulations. European banking stocks slid 22% in the two days following the vote. This prompted investors’ concerns on banks’ ability to raise capital putting them at risk of failure.

Among others, troubled Italian banks were dominating the headlines as a potential spark of the next financial crisis. Italy’s non-performing loans amount to 18% its total grossed loans. How it gets here in the first place is a long history of inefficient legal systems and delayed reforms, aggravated by low interest rates and a triple-dip recession. The issue has now fallen off the front pages as immediate disaster was averted. Monte dei Paschi, the third largest and the worst performing of all Italian banks, received a private bail-out from large international investment banks led by JP Morgan Chase and Goldman Sachs right before its devastating stress test results came out. Yet, problems persist. Such bailout and Atlante, another private backstop fund, will only serve to stop the short-term panic. In the long run, they increase systemic risks because now more players become intertwined.

 

Poorly capitalized banks become a constraint to the economy itself as they cannot act as proper financial intermediaries. Banks’ inability to lend leads to another unconventional monetary policy, in which central banks lend directly through purchases of corporate bonds. Artificial growth of corporate bond further weakens banks because corporate bonds are substitutes of bank loans. It will be difficult for the economy to resume a respectable growth rate again, unless Europe deals with its troubled banking sector.

 

Another example of this disastrous loop is the case of Japan’s lost decades. In the decades following the asset price bubble’s burst in 1990, Japan suffered from a balance sheet recession; during which, firms were trying to pay down debt instead of spending on investment. The BOJ has kept interest rates close to zero. Yet, the positive impact on the economy was not seen until in mid-2000s, after its banking industry regained some strength through major reforms.

 

Latest BOJ’s actions induce results that are opposite of what intended partly because of its negative impact on the banking industry. The experimental negative interest rates have failed to generate substantial loan growth. In fact, outstanding loans of major banks grew only by 0.8% in the first quarter compared to the same period last year. Yet, the low rates have been brutal to Japanese banks whose interest margins are close to zero, the second lowest in the world. Mitsubishi UFG Financial Group, the largest bank in Japan, reports a 32% drop in its second quarter net profit with a similar trend found in Japan’s second and third largest banks, Mizuho and Sumimoto-Mitsui.

These large banks are forced to seek growth overseas, undercutting their incentives to lend in the domestic market. This is therefore less likely to support Japan’s economic recovery as intended.

 

On the other hand, healthy banks are one of the pillars required for economic recovery. Better-capitalized banks in the U.S. are a contrast example to Europe’s and Japan’s experience. American banks regained their pre-crisis health quickly, bolstering their CET1 capital, the highest quality buffer, by 46% from 2009 to 2013. During the same period, European banks were slow to recapitalize and remained stuck in a painful transition, adapting to tighter regulations and shedding bad loans on their balance sheets. Healthier banks in the U.S. help support the economy by supplying adequate credit which contributes to a faster economic recovery in the U.S. Moreover, a strong banks’ balance sheet can act as a cushion for the next economic downturn.

 

Looking back at Thailand, banks are relatively stronger as they have learned lessons the hard way through the 1997 Asian Financial crisis. Many reforms had since upgraded the Thai banking industry with risk management systems and prudential regulations in place. As a blessing in disguise, the post-1997-crisis mentality gives Thai banks extra caution to stay well-capitalized beyond what is required by the regulator.

 

Yet, with interest rates in Thailand staying low for an unusually long time, things could take a turn for the worse. The presumably risk-off events like the Brexit vote still triggered capital inflow to Thailand because global investors are in desperate search for yield. We are indeed in an unusual time. We’ve seen from the case of Japan and Europe that dysfunctional banks can hinder the economy. Keeping interest rates low is necessary but not without side effects. The continuation of this unfamiliar environment will eventually erode the functionality of the banking pillar, which would be crucial for a healthy economy.  Now it’s the time for businesses to invest in building up defenses such as improving productivity as it will get increasingly more difficult to maintain a delicate balance between these trade-offs.

 

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