What is Negative Interest Rate?

Full Question: What is negative interest rate? Is it Helping Japan?

Interest rate is a very important economic tool in the hands of central banks. A high interest rate discourages business from borrowing and thus adds as brakes on the economy. Conversely low interest rates are supposed to spur borrowing (presumed for fresh investment) and consequently boost the economy and growth.

Interest rate is not a tool in isolation. The governments have other tools. Creating more liquidity in the system to encourage businesses to borrow and invest. Printing money, given very technical sounding name to camouflage the dirty act, ‘Quantitative Easing’ has been used for a few years in a row by the US and now being repeated by Europe and Japan, is an extreme measure of the liquidity tool.

Cutting down tax rates is a fiscal measure to promote growth.

All these and other techniques have been used governments to spur growth some times very effectively and some times with poor results. Tools have limitations. They are not panacea.

Coming back to your question “Is it helping Japan?”, it seems it is not helping much. Japan and many mature economies have been languishing for the last few years. In fact, in my opinion, the global economy has actually not recovered properly since the global economic collapse post Lehman Brothers incident in 2008. All the stimulus packages have just managed to prop up otherwise slump economies.

We must appreciate that various monetary and fiscal tools are temporary jigs that can address a sudden temporary glitch in an otherwise sound economy; they can not address deep fundamental issues like saturated economies.

US, Europe, Japan and China have reached saturation after rapid economic progress. These countries can no more grow at a rapid pace internally. For a few more decades they managed to grow by helping other developing and under developed countries. While there is tremendous potential to grow on the back of developing and underdeveloped countries there are severe limitations too! Many of these countries do not have the wherewithal to pay for the development. Many other do not have required political stability. All these factors limit the possibility of internal growth based on external activity.

In conclusion, in my opinion, in the face of many complex global challenges, low interest rates have not been helping Japan. I doubt wether rates helped other countries either. The US is showing signs of growth but we cannot attribute this to low interest rates or other measures alone. Perhaps after a prolonged recession she has returned to natural growth?

Please Note: This is almost a reproduction of the question I had answered on the website ‘Quora’, which I thought could be useful to the visitors to this blog site also.

What Is Basis Points?

We, general public use the percentage for denoting the interest. We say that the rate of interest on saving account obtainable in India is 6% or six percent per annum. For us, who deal with relatively small quantum of funds, the percentage measure serves the purpose quite well. However in the bigger financial world of institutional transactions involving millions of dollars, one hundredth of a percentage counts and makes a huge difference. Hence, they introduced a much finer measure called ‘Basis Point’. One hundred basis points make one percentage or one basis point is one hundredth of a percentage or 0.01%.

A two basis point interest on a loan of a billion dollars is $200,000 per annum, quite a significant sum.

Risk Comes from Not Knowing What You are Doing

Businessman jumping across the mountain taking risk

Driving an automobile is Not Risky; driving, without adequate training is – not only to the driver but also to all other unsuspecting road users, and that is why my Guru, Warren Buffett said, “Risk Comes from Not Knowing What You are Doing”.

Often I have heard people proclaim, sporting an, “I Know Everything” smile, that they diligently avoid investing in stocks, as it is Highly Risky.  On questioning how they had come to such a conclusion, they would invariably attribute the wisdom to their parents, teacher, colleague or friend. When questioned where they would prefer to invest, they would retort, with authority, “Corporate Fixed Deposits and Bonds – Rock Solid Safety”.  Sadly, after a few years, I have seen many of them Loose both Capital and Interest, and repent their poor investment decisions.

The moral of the story is, Risk or the Lack of It, does not lie in any particular instrument, but lack of knowledge.  A fixed deposit with a government bank in India indeed is as solid as rock, there is no doubt, but with an interest rate around 7% per annum and inflation near or above the rate of return, the “Value” of your investment is bound to be eroded for sure, over a period of 15 to 20 years.

On the other hand, if an investor had invested Rs.1,00,000 ($ 1470) in “NIFTY 50” in January 1995 and had simply forgotten about it, today in June 2016, it would have grown to Rs.809,400, a growth of 709% or a Compounded Annual Growth Rate (CAGR) of a whopping 32.99% per annum.  Even after an assumed, high, inflation rate of 10%, the investor would be left with a net return of 22.99%, Compounded Every Year!  So, Where Does Risk Lie? Not in the “Instrument”, certainly, but in “Ignorance”.