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Denmark: Ground Zero For The Failure Of Negative Interest Rates In Europe

Copenhagen_-_the_little_mermaid_statue_-_2013Denmark was the first country to begin the experimentation with negative interest rates back in July of 2012. The Danish central bank applied a negative rate for deposits that banks would place with them. The objective at the time was to defend their currency against the Euro. Both Denmark and Switzerland would later resort to extreme negative interest rates in 2015 (-0.75), in an effort to stymie investors who sought their AAA rated assets.

Switzerland felt compelled to eventually abandon the cap that was in place against the Euro, but Denmark was able to maintain theirs. The introduction of negative interest rates was able to arrest the appreciation of the Danish krone. If this is the measure of success, then the Danish experiment with negative interest rates worked. However, the government there is now dealing with a number of unintended consequences.

An interest rate set below zero puts pressure on the banking system, which forced Danish regulators to make special accommodations for their domestic financial industry. However, distortions have resulted in the credit markets.

Copenhagen, Capital of Denmark.

Copenhagen, Capital of Denmark.

Short term mortgage rates are negative and property valuations have increased enormously. This is especially evident in the capital region of Copenhagen. There are a number of analysts who fear a repeat of the housing collapse which struck Denmark in 2008, along with numerous other countries.

Insurance companies and pension plans are also struggling to stay profitable in an environment of zero and negative interest rates. Many of them have limited options for investment set by law or precedence.

Others have been forced into far riskier investments, that will have disastrous consequences when equity markets begin to deteriorate again. This has become a worldwide issue, as more nations keep reducing interest rates in a race to the bottom, moving ever closer to a full blown currency war.

Headquarters of the European Central Bank in Frankfurt, Germany

Headquarters of the European Central Bank in Frankfurt, Germany

Elsewhere negative interest rates have been failing to deliver a number of promised objectives made by central banks. The ECB (European Central Bank) in particular was using interest rates set below zero as a way to stoke inflation. This was seen to be crucial as a way to stimulate the economy.

In March of this year, the ECB cut its deposit rate by 10 additional basis points to -0.40%. At the same time it eased the impact on the struggling banks, with cheaper short term loans and longer term liquidity at negative interest rates. The end result of what they are doing, is to pay lenders to increase available credit to both companies and individuals.

The main refinancing rate was also cut by 5 basis points to 0%.

Mario Draghi, the current President of the ECB

Mario Draghi, the current President of the ECB

The other policy tool has been quantitative easing. This is where a central bank prints money, so it can purchase government bonds and other assets to increase the circulation of cash in the economy. The ECB is now expanding this role by moving into high quality corporate bonds as well.

The ECB also unexpectedly increased the asset purchases from 60 billion Euros to 80 billion a month. This is the monthly equivalent of $68.65 billion to $91.54 billion USD (United States dollar).

Negative interest rates do weaken the national currency, but it has mostly failed to stimulate further lending in the long run. Rates that are at zero or below, have fueled more market turmoil by creating distortions in investment and business decisions. It also causes consumers to hoard cash as fears of further financial and economic instability increase.

Denmark Map

Denmark Map

Banks in Denmark as in Sweden have abstained from passing on the costs of negative interest rates to their customers, because it would cause them to lose business. Clients have adjusted somewhat to the era of negative interest rates, by shifting funds from regular deposit accounts into asset management services. This has at least allowed the banks, to find new sources to generate income.

However, the financial industry as a whole is in trouble in Europe, Japan and elsewhere as negative interest rates take hold. The IMF (International Monetary Fund) had already stated over a year ago that the business model for most global banks is now unsound, given current market conditions.

This is slightly less true in the United States, where interest rates have remained at 0.50% since December of 2015. They had been at a record low of 0.25%, since the end of 2008. The same can be said for banks in Canada and the United Kingdom where interest rates are also at 0.50%. It is important to note here, that Australia still maintains a rate of 2% and the domestic economy is still growing.

Individual investors and investment companies have been forced into equities and stocks, as the only way to generate reasonable returns. These type of assets are as aforementioned, far riskier. Wild swings and gyrations in the markets, have become the norm in a destabilized global financial system.

Euro banknotes

Euro banknotes

Normal savings and bonds have become so low in a number of countries, that it makes little sense to investment in them. Bonds are sold in Germany for just 0.3% interest and in the Netherlands for 0.5%.

Unlike the central banks in Denmark and Sweden, both Germany and the Netherlands as part of the Euro-zone have become increasingly critical of the activist policies of the ECB. Not only have they criticized the central bank for low rates of interest, which they claim punishes savers in Northern Europe, the sentiment is that it rewards the profligacy spending in Mediterranean Europe.

Although it is true that the nations of Greece, France, Italy, Portugal and Spain have benefited from lower interest rates, the Euro-zone as a whole has some fundamental problems that the ECB believes it can help manage.

Member States of the European Union

Member States of the European Union

Economic growth in Europe has been sub-par ever since the financial crisis in 2008. Although the economy has picked up somewhat recently, overall unemployment remains exceptionally high at 10.2%.

Youthful joblessness still remains above 20%. The only major exception has been in Germany, where unemployment is now down to a 35 year low of 6.2%. This is a post reunification record.

The continent is also suffering from excessively low inflation, which can only be partly attributed to sharply lower oil prices. Earlier this year it dipped below zero. Deflation is beginning to grip a number of countries within the European Union.

Even core inflation, which excludes volatile energy prices has been at 1% or below for a long time. Producer prices for goods and services is even lower.

Wages are stuck at annual gains of just 1%, putting a damper on consumer spending. Along with inflation, it is all indicative of low demand throughout the entire European economy.

There is also considerable weakness on the demand side as well. Productivity has been exceptionally low for years. The average rate has only been 0.50%, since the start of the new century. The problem is not so much in the industrial sector which has been expanding by a healthy 2%, but rather in services. This sector has totally lacked sufficient investment and innovation for an extended period of time by law and tradition.

Long-term interest rates (secondary market yields of government bonds with maturities of close to ten years) of all eurozone countries except Estonia, Latvia and Lithuania.[1] A yield being more than 4% points higher compared to the lowest comparable yield among the eurozone states, i.e. yields above 6% in September 2011, indicates that financial institutions have serious doubts about credit-worthiness of the state.

Long-term interest rates (secondary market yields of government bonds with maturities of close to ten years) of most Euro-zone countries  A yield being more than 4% points higher compared to the lowest comparable yield among the Euro-zone states, i.e. yields above 6% in September 2011, indicates that financial institutions have serious doubts about credit-worthiness of the state.

Structural reforms have been lagging across Europe for years. It has inhibited growth on a massive scale. Subsidies to various sectors along with too many regulations, has inhibited creativity and innovation across the board.

The debt crisis still haunts many European capitals. Budgetary rules put in place at the insistence of Germany, keeps public debt spending at 3% or below on an annual basis. Of course there is a regular violation of these European Union budgetary rules, but it has created an atmosphere of austerity.

The recent explosion in sovereign debt has been unprecedented. Debt in relation to GDP (Gross Domestic Product) now exceeds 100% in numerous countries across Europe.

There is also the specter in many European countries of far too much debt, at both the household and corporate level as well. This only puts increasing pressure on the banking system.

There are many banks especially in Southern Europe, that carry bad loans worth hundreds of billions of Euros. These institutions are either unable or unwilling, to substantially increase lending which would help stimulate the economy.

All of these phenomena have contributed to a lack of business confidence throughout Europe. The ongoing struggle of individual countries and the European Union as a whole to solve the economic and financial crisis, has not sufficiently assured investors.

Euro Group President Jeroen Dijsselbloem

Euro Group President Jeroen Dijsselbloem

Monetary policy alone cannot solve the myriad of problems that are inhibiting growth, whether that is in Denmark or anywhere else on the Continent. It also creates distortions in the distribution of both assets and income. Low and negative interest rates are conducive to having individuals, companies, and banks in taking much higher risks in order to generate profits.

Additionally, the low cost of money can easily lead to bubbles in assets, whether it is in stocks or real estate. The devaluation of the Euro has helped the European export market (especially Germany) by making goods produced there far cheaper on the global market. However, it cannot alone be seen as a panacea for the larger economy.

The question for investors, bankers and consumers at this point is how much lower can interest rates go, before all confidence in the financial system is totally eroded? The central banks have begun a destructive downward spiral in interest rates and quantitative easing that seems to be unending. Will they eventually be able to reverse direction, before a total monetary collapse is not yet known.

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