Negative Interest Rates: Could This Spark a Global Economic Collapse?

Economic CollapseThe Bank of Japan (BoJ) is trying to jolt its economy with negative interest rates, but the central bank’s actions could be pushing the world towards economic collapse.

Noting “depressing” at best inflation, Bank of Japan Governor Kuroda surprised the markets. He announced the BoJ would adopt negative interest rates to stimulate investment and consumption. The markets reacted as intended: the Nikkei index jumped by more than four percent to 17,638 points following the announcement.

The euphoric reaction betrays the markets’ rather mixed feelings over the BoJ’s decision. There are opportunities for USD/JPY currency traders and there are risks for the global economy.

The BoJ will charge 0.1% for new commercial bank reserves to stimulate economic growth and get closer to the central bank’s inflation target of two percent. (Source: “Bank of Japan adopts negative interest rate policy,” CNBC, January 29, 2016.) All previous BoJ efforts to raise inflation have failed. Even in the second half of 2015, inflation was a sumo-sized zero. Despite its best efforts, the BoJ was unable to lower the USD/JPY.

The idea of negative interest rates is for banks to pay to keep deposits at the central bank. If the zero interest rate fails to boost Japan’s inflation—growth—the BoJ has no other tools left to stimulate its economy. This has consequences for the global markets as well.

The Japanese government, led by Prime Minister Shinzo Abe, has applauded the BoJ’s decision. Abe, father of “Abenomics,” sees the negative interest rate move as the path that could finally allow the Japanese economy to take off.

Abe won an election based on the promise of more public spending and an expansionary monetary policy (Abenomics). Abenomics’ goal is to devalue the yen compared to the U.S. dollar (the current USD/JPY rate is one U.S. dollar to approximately 100 yen) to stimulate exports and domestic industrial growth. This should have led to more domestic spending as well. Yet weak emerging markets and the slowdown in China have weakened prospects of an export-driven recovery. Zero rates seemed like the only solution left.

Japan feels its inflation rate is too low in comparison to its two-percent target. Meanwhile, Japan depends on China, which accounts for a significant amount of its gross domestic product (GDP). (Source: “Japan third-quarter growth seen slowing sharply as Asian demand slumps,” Reuters, October 19, 2015.) Should the yuan drop further against the U.S. dollar, Japanese exporters would suffer.

At this point, any further increase in interest rates by the Fed becomes unlikely, at least for the next few months. A hike would make Japanese goods too competitive. It would scratch growth away from other key economies, including China, Europe, and, of course, the United States.

The BoJ believes that the negative interest rate will prompt banks to approve more commercial loans, revitalizing the economy. Moreover, as in Europe, Japan hopes the negative interest rate will cut government debt. Thus, governments will widen public spending, adding its own economic stimulus.

The BoJ had little choice but to cut rates. Had it applied a mere quantitative easing (QE) increase, the effects would have been marginal. Therefore, the bank had to act boldly. Since last year, the USD/JPY has taken investors on a wild rollercoaster ride. The yen jumped from 116 to peaks of 125 and then back down to 116, moving to 121 after Kuroda’s announcement.

In the end, the Japanese yen has given up 1.5% against the greenback, 1.7% against the British pound sterling, and 1.1% against the euro. The expectation is for the USD/JPY to continue falling. Negative interest rates will encourage investors to sell their yen positions.

Still, the BoJ’s negative interest rates stunned the markets, sending a jolt that sent equity and bond markets surging. Yet, there is little surprising about the move. It imitates the efforts of several European central banks moving their rates into negative territory, including the ECB.

While the negative rates promote growth, they might encourage banks to take risky investments, searching big profits. The other risk to the world economy is that the cheaper yen makes Japanese goods more competitive. While the impact in Europe or the United States would be marginal, in China, consumers would be encouraged to buy Japanese.

This would put more pressure on Chinese domestic production at a time when its GDP is already low enough to worry investors worldwide. Even so, the BoJ had little choice. Despite the U.S. Federal Reserve’s interest rate hike last December and Japan’s longstanding QE policy (Abenomics), the yen had a tendency to appreciate. This is the opposite of what the Abenomics, stimulus-based policy intended.

So, the BoJ’s Kuroda had no option but to adopt negative interest rates. It has followed the examples of its counterparts at the European Central Bank (ECB), the Swedes, and the Swiss. The ultimate goal is to achieve a two-percent inflation rate. As it happens, the ECB shares that same goal.

Yet the BoJ’s negative interest rate carries special risks. Japan’s consumers behave differently than Europeans or Americans. Even as the low or negative interest rate has produced good results in Europe, Japan has a high savings rate. It is part of its tradition; it is the reason why Japanese seniors are such ubiquitous tourists in the world’s major and most expensive cities.

The BoJ will continue to buy domestic bonds as it has done for the past few years. But the negative interest rates may not succeed in jolting Japanese consumers to spend more. Japan has become the new frontier of monetary expansionism.

Last fall, Standard & Poor’s (S&P) became the latest rating agency, after Moody’s and Fitch, to downgrade Japan’s economy from “AA-” to “A+.” The downgrades suggest that Abenomics has not worked in pulling Japan out of recession. The downgrade was not significant at first glance. Yet it was S&P’s first cut since January 2011, before Abe’s election and in the midst of an economic slump.

S&P said it downgraded Japan because “Despite showing initial promise, we believe that the government’s economic revival strategy—dubbed ‘Abenomics’—will not be able to reverse this deterioration in the next two to three years.” (Source: “S&P downgrades Japan, doubts Abenomics can soon reverse deterioration,” Reuters, September 16, 2015.) If the Japanese economy doesn’t recover, the world risks an economic crisis in 2016.

It seems Japan is suffering from the same malaise affecting China, a notion corroborated by the rise of debt. In other words, in 2016 both Japan and China could face recession if not outright economic collapse. The contagion will spread quickly to the rest of the world, making a U.S. stock market crash inevitable.

Of course, Japan is still the world’s third-largest economy and the world’s largest creditor. Japan also boasts a diversified economy and stable political and financial systems according to S&P. Still, the BoJ’s boldness has backfired.

Andrew Garthwaite, an analyst at Credit Suisse, observed that in 1989, the Bank of Japan raised interest rates: “At the time, it wanted to induce a 20% devaluation of home prices in Japan. Prices eventually fell 80%, or four times more than the BoJ had hoped. And this example illustrates that when a central bank’s actions are designed to create a specific effect in financial markets, the effects can be exaggerated in ways that ultimately lead to worse outcomes.” (Source: “The Fed is going to raise rates for 2 reasons,” Business Insider, December 10, 2016.)

The negative interest rate could prove unsustainable for Japanese banks. They will turn to riskier investments to make up for the shortfall. Meanwhile, there are no assurances that in a bearish Chinese environment, lower-priced Japanese goods will sell more.

Japan’s negative interest rate could backfire.