Denmark's Discovery to Economic Growth?

In this week's FinMail we take a look at negative interest rate home loans in Denmark and what does it mean? We also take a look at what leads an economy to have central bank interest rates in negative.

The Story

Do you ever imagine borrowing a home loan from a bank and only pay the same amount that you borrowed without any interest?

Unbelievable?

Do you ever imagine borrowing a home loan from a bank and pay less than what you actually borrowed?

Impossible?

Banks in Denmark made it possible and believable for home loan borrowers. Nordea Bank is offering homeowners in Denmark 20 years home loan at a 0% interest rate. That means you just pay back what you borrow in installments. It is basically No-Cost EMI but stretched over 20 years. Even more surprising news is Jyske Bank, the third-largest bank in Denmark has gone even a step further. It has launched the world's first negative interest rate home loans. Yes! It is true. It is offering 10 year home loans at -0.5% interest. That essentially means that you need to pay less than what you would borrow.

Once thought out to be an impossible thing will soon become a reality in many developed countries because soon many countries will also start offering home loans at 0% interest rates. This is because Governments all around the world have been reducing their Monetary Policy rates to boost up their economy which has been kicked down due to the pandemic. Denmark has a history of having negative central bank rates for the longest time (12+ years) than any other country in the world. Danish homeowners have been already enjoying low borrowing rates in the past and a few years ago, 20 years of bonds were also issued with 0% coupons as investors were looking for a safe place to park their money. As regards to borrowing money, this is the first time that such an event happened.

Why is this surprising?

We all know that the rate that the bank offers to a depositor in the bank is lower than the rate that the bank charges from a borrower. So for example, if you want to deposit some amount in your savings account you'll be given 3.5% interest and if you want to apply for a home loan, you'll be charged 7.5%. The difference is the profit of the bank. So negative deposit Interest rates are common. You are charged for depositing money in the bank and that is common in countries like Japan, Sweden, and Switzerland. But this is the first instance that borrowing is made available at negative rates. It is because aggregate demand is falling all around the world as economies are not yet bolted out of the locks that happened due to the Pandemic. Countries are struggling hard to ramp up their demand in order to promote economic growth.

And what is the one way to ramp up demand so fast? Of course, pulling down the interest rates of central banks. And what if the central bank rates are already in line at 0%? There's no other way but to pull it down even further and push it into the negative zone.

What is the reason for Negative Interest Rates in an economy?

Japan, Denmark, Sweden, Switzerland are the countries that have a history of negative interest rates. But what can be the reason? If we look at the countries again, we observe is that all of the countries are developed economies. People living in these countries usually have a high standard of living and also such countries usually don't have to deal with problems like poverty or unemployment levels on a large scale.

Also, the population growth in these countries is minimal or negative. For instance, Japan is witnessing a negative population growth rate since 2011. Denmark's population growth rate is 0.4%. India's Population growth rate is 1.0%. It was 2.3% in 1971 and 2.0% in 1992, suggesting that as a nation prospers, its population growth rates decline. So in a developed economy, the number of consumers of products and services rises at a very low rate or does not rise at all.

So low consumption growth rate plus low population growth affects the GDP by pulling down the aggregate demand of the economy. Take a look at the GDP numbers in 2019 of these economies:-

Japan 0.9%

Denmark 2.8%

Sweden 1.3%

So how does a nation make sure that the people keep spending more and more each year?

Simple, make borrowing easy for people, make access to money easy to people, make savings costly (you get less rate of return in savings). And how is it possible?

Negative Interest Rates or Zero Interest Rates.

How does an economy move from High and Positive Interest Rates to Low and Zero/Negative Interest Rates?

To understand this, let us take an example. Let us imagine that you are in the best pizza place in the town and you are there today for the best dinner of your life. You have been fasting since morning so that you can enjoy your Pizza Party. To add more happiness to this, let us assume that this Pizza Party is your friend's Birthday Treat which means you don't even have to pay regardless of how much you eat. We told you, you are there for the best dinner of your life. So you order a nice cheesy pizza and start gorging on that sizzling, hot, juicy pizza. Your first piece gets finished within seconds, the second piece in seconds, and piece by piece you start getting slow because your tummy starts to get filled. You order a second pizza, no problem you will eat it but at a slow pace. And piece by piece you will reach a point where you can't eat more.

This is called the 'Law of Diminishing Marginal Utility'.

As your consumption increases, your satisfaction with each additional piece of pizza decreases.

Now, at a macroeconomic level, when a country is in the developing stage, it is in need of huge capital, labor, and resources to be able to grow fast. The needs of the country's residents are also large because of their shift from poor to middle class to higher income levels. This growth happens fast when the country is in a developing stage. It keeps growing to a developed economy when slowly its consumption growth levels start decreasing. It is because there is sufficient growth in various sectors of the economy and consumption is there but at a normal level.

In short, as an economy grows, the pace at which it grows will start decreasing. And thus in developed economies, the consumption growth is low, and so the aggregate demand will be less. If the demand growth is low, the nation's economic growth will be low (GDP Growth). In worse case, there will be no growth and the economy will become stagnant. So to boost the growth of consumption, interest rates are brought down to motivate people to spend more, borrow more, and consume more.

But even then if there is no rise in the demands, the country starts pulling the interest rates to a point that keeping money in the banks will be costly, as in if you deposit your money in the banks, you will be charged interest which will demotivate people to deposit money but to spend it. And the extreme step would be to allow people to borrow at no cost or even at a negative interest rate to incite the people to spend and to consume more. And this is how an economy enters from a high-interest rate scenario to a low/negative interest rate scenario through decades of growth.

So what do you think? Do Negative Interest Rates guarantees a rise in demand and effectively promote economic growth?

Tweet your thoughts to us at @YourFinMan.

That is it for this week's FinMail. Keep Learning and we will see you next week.