Where Banks Pay Borrowers to Borrow Money
Reviewed By Hitoshi URABE
"Where Banks Pay Borrowers to Borrow Money"
(by Ken Belson) New York Times
It may be true, as the article says, that people often think of zero interest the way physicists do the speed of light, as an absolute limit. But theories have emerged to discuss the possibilities of things to move faster than the speed of light, and in case of zero interest, the "head-scratching" phenomena have occurred in the past, outside Japan.
In Egypt five thousand years ago, a certain type of money was what we now call warehouse receipts. You would take you produce, say, wheat to a warehouse and receive a certificate with a value written in numbers. You could use it to purchase your needs, or take it back to the warehouse for a refund, in which case you would receive an amount less than what is written on the certificate. Note this is not a direct result out of deterioration of the goods, but it was already known and agreed upon up front that the value would decrease as the time passes.
Similar scene was observed in medieval days of Europe also, but it was only a few decades ago when Switzerland introduced negative interest in an attempt to penalize short-term inflow of funds from abroad seeking shelter from the turbulence of foreign exchange market outside. Even in Japan, in late 70's, for similar reasons, negative interest was about to be applied. Bank of Japan required 100% reserve to be deposited at the central bank for yen deposits received by commercial banks from foreigners, which meant any such deposit would be a money losing transaction for a bank, allowing banks to charge certain fees relative to the balance of the deposits.
Having said that, however, negative interests are rare for various reasons, and what is going on in Japan, as reported, is certainly weird. But first, we must understand what exactly is going on.
Let us stick in some numbers for clarity. Suppose you are a bank, having ample dollars and are looking to lend or invest it, and there is someone who is looking for dollars in exchange for their abundant yen. And suppose the market rate of interest for US dollars is 3% p.a. and 0% for yen. Now, you and that someone arrange a swap agreement, for a year, to make the story simple. You would give this someone one dollar and receive 100 yen (again, to make the calculations simple), with a promise that a year from now, you would repay 100 yen and receive 1.03 dollars. This is a very legitimate transaction if other factors were not involved. If that someone happens to be of a concern in terms of credibility, and if you were to make a loan, you would certainly do not do so at the market rate of 3%. You would add a risk premium of, say, 2% to make it 5% for the fund to be made available to this someone.
Accordingly, to make it into a swap agreement, you would ask for 1.05 dollars to be repaid at maturity of the arrangement in the above example. In effect, you are making 2% more than if you were simply lending in the normal market. And for the yen you have in your hands for a year, this 2% margin provides you with a variety of options. The simplest would be to just lend the yen in the interbank market. It would still mean you earn 2%, out of that swap.
But there is a problem. As a lender, you have set credit limits to each of the counterparts you lend your money to. And suppose there is nobody in the market to whom you can lend any more because the line is full. The next thing you could do is to leave the yen as cash in a vault, which for a bank it means leaving it in the books of Bank of Japan. But what happens if the amount of money you leave in the books at Bank of Japan exceed your credit line to that central bank?
Then you look around in the market again, and alas, there is a borrower whom you still have room in your credit line but reluctant to borrow at the market rate of 0%. You might as well give up a certain portion of the margin and lend it at a negative rate of 'minus 0.5%' which would still leave you with a profit of 1.5%.
Thus, the mechanism is fairly simple. But the concern or even the fear implied is significant. This phenomenon is illustrative of the fact that Japan's commercial banks are lowly rated, but it further indicates that even the central bank has become a subject of anxiety, which could shift toward the currency, yen, for its credibility to be questioned. Among many unpleasant consequences anticipated if this really happens, monetary measures, already very limited in its flexibility as a policy tool, would inevitably become even less effective.