Decoding Super Mario's negative interest rates: Will ECB's gambit work?

There’s a reason why Mario Draghi, president of the European Central Bank (ECB), is also known as Super Mario, in the media. Who else could have made a historic move like the one he did yesterday (5 June), where the ECB cut interest rates to a record low and in negative territory (-0.10 percent). It also cut its main interest rate, the refinancing rate, from 0.25 per cent to 0.15 per cent.

In the press conference, Draghi said, “For all practical purposes, we have reached the lower bound.”

Of course, a negative interest rate sure is a lower bound. Now, if you are someone’s who’s wondering what on earth is negative interest rate, and how it matters, read on.

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First things first: For the benefit of those who don’t know, the ECB is a central bank, pretty much like our RBI. But, unlike RBI, which is the central bank for India, ECB is central bank for 18 member countries who use the euro as their common currency. The ECB administers monetary policy for the eurozone (18 countries), just like RBI administers monetary policy here.

Negative interest rate: Typically, when you park money with a commercial bank, you earn an interest. Likewise, when banks park cash with the central bank, they make money. Simply put, a negative interest rate means banks will have to pay interest of 0.10 percent to the ECB if they want to park their money with it.

Rationale: The economic situation in Europe has been very messy for a while now. It has three basic issues; first, inflation is very low. Latest data shows that inflation has fallen by 0.5 percent for the year ended May. (We in India are dealing with just the opposite situation, where inflation has been pretty high). Second, growth is sluggish, and third, unemployment numbers are high.

So what can negative rates do: Beginning 11 June, the ECB directive of negative rates will be implemented. This rate cut move will increase liquidity in the system. This will nudge the banks to move some money out of the ECB and actually lend it to rebuild growth. It may help stimulate the eurozone economy.

Banks will lend money or make investments which will give higher returns. The clear choice is between earning a negative return, keeping the money with themselves, and actually earning returns by lending. And, since money will move back into the markets, it will result in stalling deflation.

This move will also impact the value of the euro. In short, it will make the euro a less valuable currency and presumably make exports more competitive than before.

Moses Harding, Group CEO and Chief Economist, Srei Infrastructure Finance Ltd, tweeted yesterday, “Extended easy money policy of #ECB would mean extended #Euro weakness into/below 1.3475; be with trend with trail stop at 1.3615.”

How it will impact India: Experts believe that this money will not only go into rebuilding the eurozone, but will also enter emerging markets like India. The question is whether banks will actually start lending when economic prospects are so uncertain. If it doesn’t work, Mario Draghi may want to do what the US Fed did - quantitative easing: buying back bonds and giving banks easier money.

Read the whole ECB press statement here.