Effect of Low and Negative Interest Rates: Evidence from Indian and Sri Lankan Economies

Abstract

Interest rates are critical to any economy. Usually the central bank of a country supervises and tries to control the interest rates but there is always an element of uncontrollable effects: local or international. A central bank adopts a monetary strategy to affect various macroeconomic parameters such as inflation, exchange rate (ER), economic growth and many others. A country may decide to adopt Ultra-low Interest Rate Policy (ULIRP) or Negative Interest Rate Policy (NIRP) or a policy with moderate/high rate of interest. In today’s global business scenario, economies are connected and influence one another. The US and UK economies have seen a very low and negative interest rates historically, at least in recent past. Indian and Sri Lankan economies are integrated with the US and UK economies and thus are affected by their prevailing interest rates. The effect of low and zero interest rate policy of a country (USA and UK) on interest rates and economy of co-integrated economies (India and Sri Lanka) have been studied in this research. The objective of this study is to understand the implications of ULIRPs and NIRPs in the context of Indian and Sri Lankan economies. Two significant conclusions of the research are that Indian and Sri Lankan economies are affected by the US and UK policies and that they are affected at a lag of eight years.

Keywords

Low interest rates negative interest rates GDP inflation macroeconomic variables

Introduction

European countries are currently maintaining low and negative interest rates and if this goes on much longer, we’ll be living in the world of “free money.”¹

See data.worldbank.org

Central banks can influence interest rates through the rates they charge banks and through changes in the money supply, Ardoin and Rodriguez (2017). The central bank of a country, such as the Reserve Bank of India (RBI) and Central Bank of Sri Lanka (CBSL), may adopt different types of monetary policies in their respective countries to effect various macroeconomic parameters such as inflation, exchange rate (ER), and economic growth. A negative interest rate means that a customer will pay to deposit money or will get almost zero return on deposits in case of ultra-low interest rates (ULIR).

A central bank may decide to adopt an Ultra-Low Interest Rate Policy (ULIRP) or a Negative Interest Rate Policy (NIRP) or a policy with moderate/high rate of interest as per the economic interest and rationale of the respective country. Liquidity in banking system is dependent upon the policy enforced by the central bank which uses Cash Reserve Ratio (CRR) and repo rates very frequently to affect the liquidity (Ahmad & Nasrin, 2017). The interest rate policy of a country may affect the interest rates and other parameters of co-integrated economies. The economies of the United States of America (USA) and the United Kingdom (UK) have seen a very low and negative interest rates historically (Table 1). Indian and Sri Lankan economies are integrated with the US and UK economies and thus are affected by their prevailing interest rates (Table 2).

The almost zero rates or ULIR are a tool to bolster an economy but it also poses serious collateral damages and challenges for banks, insurers, pension funds, and savers in terms of managing assets, liabilities, and liquidity. The rationale is that by making mortgages and other loans available at low rates may eventually revive economic growth. Consequently, a bank which does business through interest rates suffer reduced profits, policies of investment funds are disrupted, banking and insurance services may become expensive and financing institutions go for cost cutting. A fall in interest rates have implications on bond prices also as existing bonds become expensive and raising new money becomes less expensive. Countries follow a ULIRP to discourage deposits, often charging money for deposits, and pump every penny available into the economy with a hope of economic revival and counter deflation. Another significant implication of ULIR is on the international money supply. Investment funds may look outward to economies such as India and China to invest and earn better returns. In a way the ULIRP may affect the local and international economies in multiple ways. The implications and effectiveness of such a policy needs to be studied for better policy making and economic stability. India, the USA, and Sri Lanka are major trade partners (Table 2). The ULIRPs in the USA is expected to boost local economy and simultaneously some capital will flow out of the economy, probably to India and Sri Lanka. As a result of local US economy, Indian and Sri Lankan economy is supposed to get a boost of money supply. The USA may increase its import from India and Sri Lanka, enhancing their exports and in return gets its economy moving. Another aspect of this ULIR dynamics is that because of differential interest rate policies by different countries, funds flowing to other economies may affect the local economy through fluctuations in interest rates, ERs, gross domestic product (GDP) growth and inflation.

Negative ERs have consequences such as flow of funds to other countries with higher returns, depreciation of ER and enhanced exports (Humphrey, 2015). Negative interest rates are not only here to stay for the future, but until inflation targets are achieved, more central banks are expected to adopt them to remain competitive (Twomey, 2016).

Literature Review

The decision to bring rates into negative territory is related to the desire to stimulate the economy by making it costly for banks to hold excess reserves of cash (Coppola, 2013). Negative interest rates in the US has compelled negative interest rates in Japan particularly in foreign portfolio investments, Goyal and McKinnon (2003). Perold (2012) studied the effect of negative real interest rates on investment and spending policies and found that over 15 years (1997–2012) real yields have declined significantly which has reduced investor’s purchasing power. The interactions between and among interest rates and ERs are of great importance to financial market analysts (Mills, 1991). Nominal interest rates cannot be negative although real interest can be (Black, 1995). Szelągowska (2015) defends low interest rates in Poland in the current scenario with the reason that such a policy along with quantitative easing should help the economy in long term. Maddaloni and Peydro (2011) hold the opinion that low short-term interest results in low lending standards rather than low long-term interest rates.

Like ULIR, similar is the dynamics with negative interest rates or a NIRP of countries. Ilgmann and Menner (2011) in their research studied the history of negative nominal interest rates including the ancient “taxing money” proposal of “Silvio Gesell” and extending up to proposals that received popular attention in the wake of the financial crisis of 2008. They demonstrated that these “taxing money” proposals highlight a serious policy issue. According to Arteta, Kose, Stocker and Taskin (2016), the spillover implications of negative interest rates for emerging market and developing economies are mostly similar to those of other unconventional monetary policy measures. The researchers are also of the opinion that NIRP has its advantage but it should be handled wisely.

Since ULIRP and NIRP have become significant in recent times, a new area of research is open for South Asian countries like India and Sri Lanka. This research gap is addressed in this study.

Table 1.

Countries and Interest Rates as in 2015

Country Name	2015
Ukraine	–13.12
Sierra Leone	–5.74
UK	–1.31 (for 2014)
Egypt, Arab Rep.	0.62
Israel	0.76
Macao, China	0.83
Mexico	0.89
Hong Kong, China	1.02
Hungary	1.11
Chile	1.14
Republic of Korea	1.29
Myanmar	1.52
The Bahamas	1.57
Iceland	1.63
USA	2.24
Swaziland	2.48

Source: World Bank data.

Table 2.

Largest Exporter and Importer for Respective Countries for 2015

Imports (percentage of total)
Sri Lanka	China—20.6%, UAE—7.1%, Singapore—5.9%, India—24.6%, Japan—5.7% (2015)
India	Saudi Arabia—5.4%, Switzerland—5.3%, UAE—5.5%, USA—5.1% (2015), China—15.4%
Exports (percentage of total)
Sri Lanka	USA—26.1%, UK—9%, India—7.2%, Germany—4.3% (2015)
India	UAE—11.4%, Hong Kong—4.6% (2015), USA—15.2%

Source: www.cia.gov

Research Methodology

The objective of the research is to understand the dynamics of ULIRPs and NIRPs on the economies of India and Sri Lanka in context of the US and UK economies. To work on this premise, use of relevant data becomes critical. The relevant time series data was downloaded from the World Bank website²

See www.bloomberg.com

which sources its database from organizations such as International Monetary Fund (IMF), United Nations Conference on Trade and Development (UNCTD) and official national sources. The time period of data used in the research is 1960–2015, annual data as available with the source. Gretl software and SPSS software (16.0) was used for econometrics-based analysis. A similar methodology was used by Mills (1991). List of variables used in the study is given in Table 3.

Table 3.

List of Variables Used in the Research

Variable	Unit	Gretl code
Interest rates for the UK	%	UKIR
Interest rates for The USA	%	USIR
Inflation rate for India	%	InflationIndia
GDP growth rate for India	%	GDPINDI
Foreign exchange rate for India	Amount	ERINDIA
Inflation rate for Sri Lanka	%	InflationSL
GDP growth rate for Sri Lanka	%	GDPSL
Foreign exchange rate for Sri Lanka	Amount	ERSL
Interest rates for India	%	IRINDIA
Interest rates for Sri Lanka	%	IRSL
Foreign Direct Investment (FDI) for India	Amount	FDIINDI
FDI for Sri Lanka	Amount	FDISL

Source: Authors’ compilation.

The explanation of the variables used in the research is given as follows:

Foreign ER: It refers to the official ER determined by national authorities of respective country. It is calculated as an annual average based on monthly averages (local currency units relative to the US dollar).

Foreign Direct Investment (FDI): It refers to direct investment equity flows in the reporting economy. It is the sum of equity capital, reinvestment of earnings, and other capital.

Inflation: It is measured as the annual growth rate of the GDP implicit deflator showing the rate of price change in the economy as a whole.

GDP growth: Annual percentage growth rate of GDP at market prices based on constant local currency. Aggregates are based on constant 2010 US dollars.

Real interest rate is the lending interest rate adjusted for inflation as measured by the GDP deflator.

Data Analysis

Figure 1 compares the historical interest rates for the US, UK, Indian, and Sri Lankan economies. It broadly indicates that the UK, US, and Indian rates have moved in the same direction whereas Sri Lankan rates have shown more extreme fluctuation over the time period and falling below zero for three times. Also observed is the movement of rates during the time period from 2008 to 2011 (subprime crisis period) where all the rates are either become negative or very low and all the four rates indicated a positive trend post 2011, indicating the positive co-integration effect of the four economies.

Figure 1.

Source: Authors’ interpretation.

Figure 2.

Source: Authors’ interpretation.

Figure 3.

Source: Authors’ interpretation.

Figure 2 indicates that somewhere in the late 1970s inflation in India was very high and FDI was very low. At the same time interest rates in India (Figure 1) and the UK were negative and in the USA, it was very low. Indian Rupee ERs are observed to be constantly becoming weak against US Dollar, occasionally improving. The FDI flow dropped twice after the subprime crisis but picked up in the later part of the time period.

Figure 3 indicates three inflation peaks for Sri Lankan economy and a stationary series for GDP growth rate. The ERs are observed to be constantly becoming weak against US Dollar, occasionally becoming strong during later time period. The FDI flow in Sri Lankan economy dropped during the Asian Financial crisis in 1997 and during the subprime crisis of 2008–2009.

Table 4.

Summary Statistics, Using the Observations for 1960–2015

Variable	Mean	Median	Minimum	Maximum

UKIR	1.74	2.22	–12.24	6.35
USIR	4.33	4.74	–1.28	8.72
InflationIndia	7.65	7.53	–7.63	28.60
GDPINDI	5.29	5.71	–5.24	10.26
ERINDIA	24.20	13.44	4.76	64.15
InflationSL	8.41	7.63	–1.54	26.15
GDPSL	4.87	5.01	–1.55	9.14
ERSL	47.55	30.63	4.76	135.86
FDIINDI	8.90E + 09	2.14E + 09	–3.61E + 07	4.42E + 10
FDISL	2.26E + 08	9.17E + 07	–1.22E + 06	9.56E + 08

Variable	Standard Deviation	Coefficient of Variation	Skewness	Kurtosis
UKIR	3.75	2.16	–1.38	2.83
USIR	2.44	0.56	–0.18	–0.91
InflationIndia	5.07	0.66	0.85	4.57
GDPINDI	3.09	0.59	–1.06	1.46
ERINDIA	18.76	0.78	0.52	–1.26
InflationSL	5.95	0.71	0.72	0.46
GDPSL	2.03	0.42	–0.69	1.15
ERSL	43.48	0.91	0.66	–1.03
FDIINDI	1.39E+10	1.56	1.41	0.44
FDISL	2.90E+08	1.28	1.43	0.79

Source: Authors’ calculation.

The Coefficient of Variation is observed as high for FDI flow for both India and Sri Lanka and the UK interest rates, thus, making them most volatile of the given parameters (table 4).

Table 5.

Correlation Coefficients for All Variables

	UK.IR	US.IR	Inflation India	GDP India	ER India	IR India	FDI India	Inflation SL	GDP SL	ER SL	IR SL
UK.IR	1.00	0.76	0.20	–0.18	–0.02	0.45	–0.29	0.22	–0.27	–0.06	0.23
US.IR	0.76	1.00	0.30	–0.18	–0.34	0.27	–0.44	0.43	–0.21	–0.38	–0.02
Inflation India	0.20	0.30	1.00	–0.01	–0.02	–0.41	0.10	0.29	0.11	–0.01	–0.15
GDP India	–0.18	–0.18	–0.01	1.00	0.44	0.20	0.27	0.11	0.29	0.45	–0.14
ER India	–0.02	–0.34	–0.02	0.44	1.00	–0.12	0.71	0.08	0.21	0.97	0.15
IR India	0.45	0.27	–0.41	0.20	–0.12	1.00	–0.27	–0.11	–0.48	–0.21	0.40
FDI India	–0.29	–0.44	0.10	0.27	0.71	–0.27	1.00	–0.18	0.26	0.82	–0.05
Inflation SL	0.22	0.43	0.29	0.11	0.08	–0.11	–0.18	1.00	0.14	0.13	–0.44
GDP SL	0.27	–0.21	0.11	0.29	0.21	0.48	0.26	0.14	1.00	0.26	–0.23
ER SL	0.06	–0.38	–0.01	0.45	0.97	–0.21	0.82	0.13	0.26	1.00	0.00
IR SL	0.23	–0.02	–0.15	–0.14	0.15	0.40	–0.05	–0.44	–0.23	0.00	1.00
FDI SL	0.22	–0.43	0.00	0.30	0.80	0.32	0.89	–0.12	0.38	0.86	–0.01

Source: Authors’ calculation.

The correlation analysis of the variables revealed imperative information. Analyzing the correlation coefficients (Table 5), it was observed that the UK and the US interest rates are high and positively correlated among themselves and have equal, low, negative relationship with GDP of India, Indian raters, and FDI. This implies that if the USA and UK follow ULIRP or NIRP, the FDI and GDP will get a boost in India, maybe because of inflow of investments to India. A similar type of relation is observed between the UK and the US interest rates and Sri Lankan variables of GDP, FDI, and foreign ER. This negative effect is not established with Sri Lankan interest rates which is almost zero with the US and positive with UK rates and is moderate, positive, with Indian interest rates. The correlation of the UK and US interest rates with inflation of Indian and Sri Lankan economy is moderate and positive indicating that an increase in rates signals economic growth which may pull inflation upwards.

The transmission of interest rate effect may have a lag effect which is further analyzed by estimating vector autoregression (VAR) systems.

Co-integration and Regression Analysis

Interest rates of India and Sri Lanka were regressed over the UK and US interest rates by running the ordinary least square (OLS) method of regression. The result for the same is given in Table 6. Here, Durbin–Watson (D–W) statistic is used to analyze autocorrelations in the regressions. The D–W statistic is a number that tests for autocorrelation in the residuals from a statistical regression analysis where this statistic ranges between 0 and 4 and a value near 2 indicates absence of autocorrelation in the regression.

Table 6.

Results of Co-integration Analysis

Sr.No.	Dependent Variable	Independent Variable	Co-integration and Level	R-squared at Level 0 (%)	D–W Statistic	Significant at 5% Level
1	IRINDIA	UKIR	Yes, Level 0	20	2.15	Yes
2	IRINDIA	USIR	Yes, Level 1	7	1.77	No
3	IRSL	UKIR	Yes, Level 1	5	1.92	No
4	IRSL	USIR	Yes, Level 1	0	1.84	No

Source: Authors’ calculation.

Vector Autoregression (VAR) Analysis

To understand the lag effect of interest rates, VAR methodology is followed based on Sims (1980). VAR based analysis was done for interest rates for Indian and Sri Lankan economies separately. The findings from the analysis is given in Table 7. The VAR systems were generated at various lags and the optimum regression equation was selected as 8 based on Akaike information criterion (AIC) and R-squared values. For Lag 9 onwards VAR could not be generated for both countries because of lack of sufficient degrees of freedom. Apart from D–W statistic, heteroskedasticity (non-constant variance in error term in regressions) is also analyzed for respective VAR systems. The VAR systems can be said as a type of unrestricted VAR and this VAR based analysis is in line with the process adopted by Clements and Mizon (1991).

Table 7.

Summary of VAR Systems

Sr.No.	Dependent Variable	Independent Variable	R-squared (%)	D–W Statistic	Optimum Lag	ARCH Effect Present
1	IRINDIA	UKIR, USIR	95	3.3	8	No
2	IRSL	UKIR, USIR	82	2.81	8	No

Source: Authors’ calculation.

Conclusions

An attempt is made in the research to understand the dynamics of ULIRPs and NIRPs (prevailing in the USA and the UK) on the interest rates and economies of India and Sri Lanka. Overall it was found that the two developed economies (the USA and the UK) are co-integrated at level zero or one with the two developing economies (India and Sri Lanka) and surely the interest rates of former two economies have a pass-through effect on interest rates, GDP growth, Inflation, Foreign raters, and FDI flows on the latter two economies. ULIRPs and NIRPs negatively affect GDP, FDI, and ERs in India and Sri Lanka but positively affect inflation in the two economies. It is observed that there is a lag effect of interest rates pass through process on Indian and Sri Lankan economies and this lag was estimated at 8 years by using the VAR technique. This lag was similar for Indian and Sri Lankan economies. This implies that Indian and Sri Lankan economies are connected with the US and UK economies, similarly, at least in context of interest rate pass through effect. Also, it is observed that FDI has been most volatile among all variables for both India and Sri Lanka and it is negatively correlated with UK and USA interest rates, indicating that when USA and UK adopts ULIRPs and NIRPs, the money flows to countries such as India and Sri Lanka. This validates the very premise of this research.

One significant policy implication from this research is that in integrated economies, when a country follows NIRP or ULIRP, the other economy should expect inflow of investments and boost of economy in medium to long term.

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