Negative interest rates make it expensive to hold large cash reserves, writes Izabella Kaminska

I know Switzerland is renowned as a tax haven but this is surely a step too far?

To be fair, they are not actually cutting tax levels. They are just discouraging early payment of taxes.

Why would anyone pay the tax authorities early if they didn’t have to?

The canton of Zug, one of the country’s lowest-tax jurisdictions, always offered discounts for early payment of tax bills. But the country’s negative interest rates make it expensive for cantons to hold large cash reserves these days.

Hold on – how did Switzerland end up with negative interest rates?

It all started when the global financial crisis kicked off a round of “currency wars” — competitive devaluation by states pursuing economic stimulus by, say, making their exports cheaper than those of their competitors. At the same time the Swiss National Bank was left struggling to prevent its currency from strengthening as foreigners flocked to buy the country’s assets, perceived to be safe. In 2011, aiming to weaken the franc, the SNB announced it would hold the currency down at a value it considered fair. To keep it weak, the central bank began buying euros with freshly minted Swiss francs any time the exchange rate with the single currency threatened to fall below a certain floor.

And what’s that got to do with negative rates?

Defending the floor proved harder than expected. One consequence was the SNB’s accumulation of large euro-denominated reserves, which then had to be invested in euro-denominated assets. This inadvertently turned the central bank into one of the most aggressive buyers of European sovereign bonds at a time when they were considered high risk.

Oops. Unintended consequences?

Right. Then, by 2015, the diminishing number of safe European bond assets meant the SNB was forced to bid more aggressively for those left. Since the SNB itself was pushing up prices — and bond yields move inversely to bond prices — the central bank found itself having to acquire either European sovereign bonds with ever more negative yields, or ever-riskier euro-denominated assets. It didn’t really want to do either.

Second, the European Central Bank had by then begun its own bond-buying scheme, creating a potentially infinite number of euros for the SNB to buy; and an unlimited number of high-risk euro assets it might need to absorb.

It was stuck between a rock and a hard place, then?

Indeed. The central bank decided that it made more sense to abandon the exchange rate floor and instead use negative rates to make the country’s currency and sovereign debt less attractive to foreigners.

And how does that work?

In the first instance, the policy turns any cash reserves in the Swiss banking system into depreciating assets. To remain profitable, banks are then forced to pass the depreciation costs on to customers, hitting them with fees for holding big cash reserves in the banking system. This might appear to be unfair to savers; but economists would argue that, during an economic malaise, any strategy limiting the effects of the paradox of thrift is probably worthwhile.

Sorry, the paradox of what?

It’s the idea that you can’t build up financial savings without building up equivalent financial debt. So what happens if everyone wants to save but no one has the capacity to borrow? There are two ways to reconcile the mismatch in the economy. One is to encourage more people to take on debt, even if they’re unlikely to pay it back. The other is to encourage savers to spend their money on goods and services in the “real economy”, boosting demand, which in turn creates jobs — which makes people less risky to lend to. Either way, capital has to be transferred from those with savings to those without.

And negative rates do that?

They make it expensive to hold cash so encourage the cash-rich to transfer funds into riskier investments; or, alternatively, to spend. Either way the local economy gets a boost. And it becomes less attractive for foreigners to hold francs. That’s the theory, anyway.

What about taxes?

One of the Alice Through the Looking Glass consequences is that negative rates create a hot potato effect that encourages early payment of tax — since that makes the negative-yielding cash someone else’s problem. In Zug, they’re even cutting charges on overdue taxes, encouraging people not just to pay on time but late.
Sounds like the days when just having money made you money are over.

In Zug, for now, anyway.