Speech Klaas Knot - “Getting Used to Low Interest Rates”

Datum: 27 februari 2020
Locatie: IBFA lunch, Amsterdam
Spreker: Klaas Knot

Good afternoon and thank you for inviting me to share my views on recent developments in international financial markets with you, the Amsterdam business community. Or what we in central bank terms call: ‘the real economy’.

There are many developments currently affecting our economy and international financial markets. Although geopolitical trade tensions have eased slightly with the US and China signing a phase-one trade deal and the UK finally leaving the EU last January, both sets of negotiations are far from over. 2020 is likely to be a big year in deciding these outcomes. Even so, geopolitical uncertainties are likely to persist.

Another source of uncertainty is the outbreak of the coronavirus, which still has policymakers and financial markets guessing as to the exact impact. We central bankers like acronyms, so I’ll refer to it by its official name: COVID-19. To get some idea of how COVID-19 could affect financial markets we can perhaps look at the SARS outbreak two decades ago. SARS sent ripples across the global economy, wiping 40 billion dollars off world equity markets. But since the SARS outbreak, China has grown from the world’s sixth largest economy, to the second biggest. In 2003 China accounted for 4.2% of the global economy. Now China commands 16.3% of the world’s GDP. Although it is still too early to accurately measure the impact of this pandemic, it is safe to say that the hit to the global economy will be more severe. Particularly as the Chinese economy is so tightly interwoven with the rest of the world.

Given all these uncertainties, from trade tensions, to Brexit and even COVID-19, I have chosen to focus on a topic over which there is greater certainty, namely low interest rates. I am sure you are already dealing with the effects of low interest rates yourselves as the low interest rate environment has consequences for households and the business community alike. And it is likely you will have to do so for many years to come. But before I say more, I would like to discuss how we arrived here.

Interest rates have been on a steady decline for nearly 40 years now. There are several causes for this, most of which are outside the purview of central banks.

To begin with, many countries in Europe have ageing populations. The middle-aged cohort represents an increasing share of the population. And this cohort is building up a lot of savings.We are also going through a period of low economic growth, due to a decline in both population and productivity growth.

Waning capital investments also play a role. Some of this is due to the heightened geopolitical uncertainty I mentioned. It is also partly due to the public and private sector having to reduce their debts and liabilities after the financial crisis.

And finally, there is an increased demand for safe investments which provides negative pressure on interest rates. There are actually several different elements to this. Safe investments, like government bonds, are increasingly bought by older investors looking for more security as they near retirement. Furthermore, the post-crisis regulatory treatment of government bonds is relatively favorable as their risk weights are set to zero.

This makes them attractive for institutional investors bound by new, more stringent, capital requirements. But of course, central banks have played a role too in the low interest rate environment. Unconventional monetary policy measures were deemed necessary to influence the whole constellation of interest rates that are relevant for financing conditions in the euro area, and to ensure price stability across the Monetary Union. Through this unconventional monetary policy, central banks worldwide have driven up the demand for safe assets. At the same time, the supply of safe assets has been relatively constant. When a relatively constant supply is met with increased demand, it inflates the price of assets. This results in lower interest rates.

I have discussed some of the causes of the low interest rates. Now let us look at some of the consequences for the economy, both in terms of benefits and drawbacks. Let me start by highlighting several benefits, which might speak to you as representatives of the Amsterdam business community.

By the end of 2014, growth was sluggish and the economy was showing worrying risks of falling into a deflationary spiral. A recent ECB study shows that unconventional monetary policy measures helped steer us away from such a deflationary scenario. European consumer prices were boosted by an estimated 0.5 percentage points per year between 2015-2018. We should remember that this was not solely due to central banks’ quantitative easing. Negative policy rates and increased liquidity to banks also played a role. Furthermore, these types of model outcomes are prone to error. Which means there is always a degree of uncertainty over the exact impact.

Furthermore, this same study showed that real economic growth also benefited from the ECB’s unconventional policy measures. Lower rates and ample liquidity reduced borrowing rates, and loosened financial conditions. As a result, real GDP is estimated to have grown by an additional 0.3 percentage points per year between 2015-2018.

From an investor’s perspective, low rates have also been helpful, pushing up the values of real estate, bonds and equities to all-time-highs. The effect on equity markets has been particularly visible. Despite geopolitical risks like Brexit and trade tensions affecting global markets, 2019 turned out to be the best year for European stock markets since the turn of the century. European equities gained 25% on average and are back up to – and even surpassing – pre-crisis levels. Our models show that a substantial part of this increase can be attributed to the decline in interest rates.

And finally, I am sure that many business owners in the room might welcome ever lower interest rates with open arms. After all, they mean lower financing costs for your business. More on that later.

But, as our host ABN will probably attest to, we also need to reflect on the drawbacks of this low interest rate environment. Not everyone is so enthusiastic about the low rates. A few weeks ago, you may have received a friendly letter from your bank at your home address telling you that they are not going to pay you any more interest on your savings. This same bank might have sent you a similar letter to your business address, informing you that you will now be charged an interest of 50 basis points over deposits exceeding 1 or 2.5 million euro.

But even with the extremely low interest rate on savings, households in the Netherlands continue to save. They have a total of 368 billion euro in savings built up, 12 billion euro more than a year ago and about twice as high as during the SARS outbreak.

It is precisely because of the low interest rate that people are saving more and more. Recent research from the Bundesbank suggests consumers in some euro area countries will curb their spending in response to lower interest rates. This is because the losses they make on their bank deposits will outweigh any tendency to increase their spending.

The drawbacks of the low interest rates are not only apparent for savers. There are also challenges for banks and other financial institutions. Their traditional business models have come under increased pressure.

Banks are seeing a steady decline in the interest rate margins they are able to earn. The effect is exacerbated the longer rates stay low. This is because as older, higher-yielding loans and investments mature, they are replaced by new assets that generate little yield. Especially Dutch banks, which have a large deposit base, are having their profits squeezed.

Pension funds and insurers face declines in their solvency ratios. The impact is particularly severe for products with guaranteed returns, such as defined benefit pensions and many forms of life insurance. This can also have an effect on the real economy as looming cuts in pension entitlements could drag down consumer confidence, and push savings up even further.

Asset managers and institutional investors also face an incentive to “search for yield” due to the low interest rate environment. This means they take on increasing amount of credit, liquidity and interest rate risk to achieve their return targets. This is understandable from a return perspective, but makes the returns more vulnerable to negative turns in market sentiment.

But what about the impact for the European – or Dutch – business community you might wonder? To be honest, quite a lot academic attention has been paid to the impact of low interest rates on the financing costs of European businesses, but less so on how this affects their financing decisions.

Companies face an increasing divergence between the costs of debt financing — which involves borrowing a fixed sum from a lender and paying it back with interest — and equity financing, which is the sale of a percentage of the business to an investor, in exchange for capital.

On the one hand, companies benefit as the interest paid on corporate bonds has steadily declined along with government bond yields. Over the last two decades this has fallen from an average level of around 6% to around 1% for European companies.

On the other hand, however, the returns investors demand on their equity investments have not followed suit. The so-called required return on equity has remained relatively constant during the last 20 years and still hovers at a substantially higher level of about 9%.

This is quite remarkable, given the search for yield among investors. One would expect that these apparently risk-tolerant investors will bring down the cost of equity. It appears, however, that investors are still risk-averse when it comes to equity, even with all major stock markets near record highs.

If we look more closely, however, we can see that the post-crisis recovery on stock exchanges was driven mostly by a combination of both lower interest rates and higher corporate profit expectations. Not necessarily by yield-eager investors willing to take on ever more risk. What is more, our research shows that there actually was a post-crisis increase in premium investors’ demand for equities. This increase in this equity risk premium has actually proven to be a substantial drag on stock market performance for the past 10 years and as such add to the cost of equity financing.

The equity-risk premium is the average return that investors require over the risk-free rate for accepting the higher variability in returns that are common for equity investments

An increase in the risk premium for equities might not be surprise after looking at the first decade of this century. The dot-com bubble and Financial Crisis both wiped around 55% off the value of European stocks. A euro invested in the Eurostoxx 600 by December 1999, would have shrunk to just 67cents by December 2009. Since then, both the perception of and aversion to economic uncertainty and tail-risk seem to have increased. There are actually market-indicators that show these changes, and both appear highly correlated with the premium for equity risk.

A related factor that might be at play is what behavioral economists refer to as myopic loss aversion: This occurs when investors take a view of their investments that is strongly focused on the short term. This leads them to react too negatively to recent losses, which may leave them blind to long-term benefits.

The impact on how businesses finance their operations also has to be taken into account. Too strong a divergence between the cost of equity and debt, may erode the important role equity financing plays within the real economy. Equity has meaningful shock-absorbing capacity, whereas public equity markets are important as they help to inform us about the stance of the economy.

The bigger the divergence in costs the greater the incentive for businesses to opt for debt issuance. As such, corporate leverage will increase, making companies more exposed to interest rate shocks. This could make our financial system more fragile, exposed to deeper boom-and-bust cycles.

Central banks will have to monitor these developments carefully. Perhaps the best way to address this divergence is by making equity financing more attractive, by removing barriers to investment and issuance, especially in a cross-border European context. To this end, completing the capital markets union will be a great step forward. The capital markets union aims to break down barriers to cross-border investment in the EU, to provide new sources of funding for businesses, and to reduce the cost of raising capital. It should result in a healthy and diverse corporate funding mix. And this would ultimately strengthen our real economy.

Ladies and gentlemen, let me sum up. Interest rates have been low for some years now, and by the looks of it, they will continue to stay low for some years to come. We – and our economy as a whole – may have to start regarding the low interest rate environment as the new normal. Whether we are saving, borrowing, investing, or buying a house.

Low interest rates have been beneficial for inflation, growth and the creation of jobs, and especially asset prices. But as I have explained, there are also drawbacks. And the negative consequences of these drawbacks may get worse the longer interest rates remain as low as they are. We will be monitoring how this plays out in both the financial and the ‘real’ economy.

Well I believe it is now time for the main course. Thank you for listening. After we have finished, I would of course be happy to listen to any questions you might have.