Negative Deposit Rates in Europe: Unintended Consequences?

June 6 2014

Thursday was the most interesting day of the week as ECB president Draghi announced the central bank’s interest rate decision. Not only was the main refinancing rate cut with ten basis points to 0.15%, but, more interesting, the ECB decided that it will charge banks for depositing funds at the ECB. Deflation fears led to this historic policy change: the ECB is the first major central bank to

Negative Deposit Rates in Europe: Unintended Consequences?

Thursday was the most interesting day of the week as ECB president Draghi announced the central bank’s interest rate decision. Not only was the main refinancing rate cut with ten basis points to 0.15%, but, more interesting, the ECB decided that it will charge banks for depositing funds at the ECB. Deflation fears led to this historic policy change: the ECB is the first major central bank to implement a negative deposit rate. Let’s discuss some intended and unintended consequences of the ECB’s decision.

Destruction of Money Market Funds

Money market funds aim to maintain their net asset value (NAV) at a constant 1$ per share, while earning interest for shareholders. Its portfolio consists of short-term securities that are highly liquid and credit-worthy. It is for many funds and companies a relatively safe place to hold their cash-equivalent assets.

Yet as JP Morgan explains: “Last summer’s move by the ECB to cut the deposit rate to zero had led to the closure to new money of a number of European money market funds. This is because with rates at zero, these funds would have a negative yield after fees, which presents a significant obstacle to investors. Since August last year, the outstanding amount of the Euro area money fund industry had shrunk by €70bn or 7% to €900bn as of last February. That process will certainly accelerate if the ECB were to cut the deposit rate to negative.”

Money market funds will disappear and, as a result, velocity of money will fall (i.e., demand for cash holdings will go up), increasing deflationary pressures rather than decreasing.

Will Banks Decrease Deposit Rates or Increase Lending Rates?

Another unintended consequence of is an impairment of banks’ profitability at the worst possible moment. European banks are still massively deleveraging and recovering from earlier excesses. If banks are unable or unwilling to change their rates, as was the case in Denmark, they will have to incur considerable losses.

From this perspective it is interesting to see which European countries have banks that hold large positions at the ECB. The answer shouldn’t be surprising, but should worry the west. German banks have the largest position at the ECB, over €200 billion. Dutch banks have over €150 billion at the ECB; French banks follow with almost €100 billion. Dutch, German and French banks will see their margins shrink and might pass on some costs to depositors, borrowers and/or home buyers. I expect, at least in the Netherlands, for rates on savings accounts to come down further.

Will Small and Medium-sized Enterprises Be Able to Borrow and Spend More?

One of the ECB’s explicit goals of its negative rate policy is to stimulate banks to lend money to small and medium-sized businesses. However, a good argument can be made that the unwillingness of banks to lend money is actually a result of a lack of credit-worthy borrowers on a risk-adjusted basis. Will ECB policy make small and medium-sized businesses more credit-worthy? Not even slightly.

The power of central banks is highly overestimated. It can provide liquidity, but many European nations suffer from structural imbalances. And what are European nations doing to make small and medium-sized enterprises more credit-worthy? Not a thing. Some governments even punish such businesses by raising corporate and payroll taxes, impose additional regulations and legal requirements, and other taxes that indirectly put margins of companies in some industries under pressure (higher gasoline taxes, higher property taxes, higher insurance costs, etcetera).

At most, the ECB will force lenders into making risky investments in overvalued assets that might be worth pennies on the dollar in the future as markets readjust. More reasonable is that the ECB will fail to force lenders to provide credit to small and medium-sized enterprises to which they currently refuse to lend. In the best case scenario, the ECB will achieve very little with its policy shift. This is supported by the fact that Denmark didn’t experience any significant increase in lending and total credit. You can lead a horse to water, but you can't make it drink.

Will the ECB Do QE?

Draghi also hinted on the fact that preparations are being made for a possible asset-purchasing programme, similar to the QE programmes of the Federal Reserve. What will he actually follow through? Will ECB do its own QE?

In my opinion, a euro QE is highly unlikely. More likely, Draghi’s ‘we’re preparing’-hint was an attempt to lower the EURUSD exchange rate. He actually failed, because after a quick drop, the EUR surged back to 1.37 USD. In the weeks preceding the ECB announcement, the EURUSD rate already dropped from about 1.40 to 1.36, but is now actually higher than before the ECB policy announcement. Investors were clearly expecting more.

Any QE-like programme in the euro zone would stir up anti-euro sentiment, especially in countries such as Germany that form the backbone of European creditworthiness. I’m not convinced that Draghi actually dares to defy such sentiment. He will resort to other measures, as he just did with the negative deposit rate.

Falling Prices Not the Problem, Debt Is

The ECB should be careful what it is wishing for. Any monetary expansion might lead to other distortions or asset bubbles that nobody currently foresees. The problem right now is not falling prices, but the debt that permeates western economies. Deleveraging is necessary; corporate balance sheets have to be cleansed. The ECB would be far more effective if it would focus on debt, instead of falling prices. Anything it does to compensate for falling consumer prices caused by a necessary deleveraging, can only lead to new distortions. 

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