The term “negative interest rates” was introduced into the Canadian vocabulary on December 8, 2015, when the Bank of Canada announced that it would be willing to use this “unconventional monetary policy tool” in the event of economic crisis. With the current benchmark interest rate of 0.5% already near historic lows, this announcement suggests that it has the potential to drop much lower – even below zero. The Bank of Canada stated that the effective lower limit, or “lower bound”, is now set at negative 0.5%.
While the Bank of Canada stressed that there are no current plans to take such a drastic step, this possible foray into negative territory is not unprecedented in developed countries. The European Central Bank cut its key interest rate below zero in 2014 and has since been joined by the central banks of Denmark, Sweden, Switzerland and, most recently, Japan. Switzerland currently has the lowest rate at negative 0.75%.
The impetus for setting a negative interest rate is to counteract economic stagnation by encouraging lending and borrowing. A negative rate would mean that commercial banks incur a cost (rather than earn interest) on deposits of its excess reserves at the central bank. As this penalizes commercial banks for holding onto too much cash, commercial banks would theoretically lend more money to their customers. Based on the European experience, commercial banks may also pass this negative interest rate onto their corporate customers, forcing them to pay for their deposits. In response, customers would theoretically be more inclined to spend and invest their cash, thereby reinvigorating the economy.
Impact on M&A
In theory, negative interest rates should generally encourage dealmaking activity. In a negative interest rate environment, holding cash would offer poor returns or may even come at a cost. Many companies have taken advantage of low interest rates over the past few years to issue debt and are sitting on substantial piles of cash. As interest rates go negative, companies would be incentivized to use their cash towards more active purposes, including M&A.
This incentive is especially compelling given that negative interest rates would likely come at a time of economic crisis. In such a climate, investor sentiment would be at a low since it would generally be more difficult for corporations to generate organic revenue growth through their usual operations. Strategic transactions could provide the much needed boost to placate investors.
In particular, negative interest rates would likely lead to more M&A deals being financed with debt, given the reduced borrowing costs. For example, private equity sponsors, which tend to be highly leveraged and focus primarily on net returns in considering a deal, would likely be more willing to pay a higher price in a transaction since they can finance the transaction at a lower cost.
Further, negative interest rates can help alleviate concerns about the long-term nature of M&A transactions. Since M&A requires significant upfront investment and could take years before increased returns are realized, the time value of money typically creates an opportunity cost for investing in M&A. At low or negative interest rates, this opportunity cost would be reduced.
In reality, there is considerable uncertainty about how negative interest rates will play out in the M&A market. While the purpose of this monetary policy tool is to stimulate the economy, commentators warn that the strategy could backfire. Reducing interest rates to negative levels is a tool of last resort and could send a signal of the central bank’s panic and desperation. Combined with the current economic environment of falling oil prices and currency, risk averse companies may be reluctant to engage in M&A in such volatile circumstances and may prefer to “hide their money under their mattresses”.
The key question is, therefore, whether the advantages of M&A will offset the fall in corporate confidence in such a recessed economy. Hopefully this question will never need to be answered. The Bank of Canada insists that the economy is on track to return to full capacity around mid-2017, given previous interest rate cuts and the weakened Canadian dollar.
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