Implications of negative interest rates for Asia:

FAVAR approach

Martin Feldkircher, Florian Huber, Pornpinun Chantapacdepong and

Maria Teresa Punzi

Asian Development Bank Institute 19th Annual Conference 2016

Implications of ultra-low and negative interest rates for Asia

1-2 December 2016, ADBI, Tokyo, Japan

The views expressed in this presentation are the views of the author and do not necessarily reflect the views or policies of the Asian Development
Bank Institute (ADBI), the Asian Development Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee
the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not
necessarily be consistent with ADB official terms.
Motivation
I A number of countries have experienced negative real rates over time,
but negative nominal rates are something new.

I Once policy rates are cut to what used to be known as the zero lower
bound, central banks can employ unconventional monetary policy
measures to provide further stimulus if real interest rates are still above
the levels consistent with price stability and full employment.

I Negative nominal policy interest rates are the latest addition to this
unconventional toolkit.

I IMF states (Jose Vinals, Simon Gray and Kelly Eckhold):

Although the experience with negative nominal interest rates is limited,

we tentatively conclude that overall, they help deliver additional
monetary stimulus and easier financial conditions, which support
demand and price stability. Still, there are limits on how far and for how
long negative policy rates can go
Motivation

I Six central banks so far have introduced negative rates that apply to
some amount of the cash balances commercial banks hold with the
central bank (Danish National Bank; European Central Bank; Swiss
National Bank; Swedish Riksbank; Bank of Japan; Hungarian National
Bank).

I Negative rates aim to encourage the private sector to spend more and
support price stability by further easing monetary and financial
conditions.

I For smaller open economies, negative rates can also help discourage
capital inflows and reduce exchange rate appreciation pressures.
Goals of Central Banks

I Negative policy rates have thus far been associated with expanded
central bank balance sheets as a result of quantitative easing or
large-scale foreign exchange purchases. Quantitative easing compresses
yields and term premia.

I Moving policy rates negative aims to lower money market rates and push
down the yield curve further, and boost portfolio substitution effects,
thereby increasing the potency of monetary policy.

I In fact, negative deposit rates tend to have more bite when a large
amount of commercial banks reserves are priced at the negative rate.
NIRP

I Negative real rates have been seen in both advanced and emerging
markets and developing economies when inflation is higher than nominal
interest rates.

I When nominal rates become negative, the transmission mechanism of

monetary policy may also differ as there are non-linearities associated
with the downward stickiness of retail deposit rates.

I The latter are unlikely to fall below zero as retail depositors could switch
to cash to avoid the negative rate.
Transmission Channels
I Through the banking lending channel, wholesale interest rates have
fallen with central bank deposit rates.

I Lower risk-free wholesale rates tend to encourage investors to switch

from low yield government securities to riskier assets such as equities,
corporate bonds, or property.

I In addition, lower wholesale interest rates reduce the cost of funds for
those borrowers such as large corporates who can directly finance in
commercial paper and corporate bond markets.

I The impact of negative central bank rates on the exchange rate has
been mixed. Portfolio rebalancing in some cases has led to cross-border
capital outflows and exchange rate depreciation.

I In some cases central bank actions have had the beneficial effect of
reducing capital inflows while elsewhere other factors have driven the
exchange rate.
Research Questions

I We focus on the international spillover effects of negative interest rate

policy (NIRP) adopted in Japan and in Europe.

I We employ a non-linear factor augmented VAR (FAVAR) model.

Literature

I A lot of research has focused on global spillovers of conventional

monetary policy in advance economies:
I Canova (2005), Kim (2001), Mackowiak (2007), Nobili and Neri (2006)
and Feldkircher and Huber (2016) show that US conventional monetary
policy can generate significant cyclical fluctuations in emerging markets
through a financial channel.

I Rey (2015), Shin (2012) and Bruno and Shin (2015) show that the
conduct of the US monetary policy can affect banking and capital flow
through the interaction of the US policy rate with the commercial banks
balance sheet. Cerutti, Claessens, and Ratnovski (2014)) study how
monetary policy in the US, the UK, EU and Japan spillover to other
countries through the capital flows.
Literature

I A lot of research has focused on global spillovers of unconventional

monetary policy in advance economies:
I Fratzscher, Lo Duca, and Straub (2013) demonstrates that the US
unconventional monetary policy leads to adverse impact to emerging
markets because of the higher pro-cyclicality of portfolio flows induced by
quantitative easing policies.

I Miyajima, Mohanty, and Yetman (2014), using a Panel vector

autoregressive approach, find that quantitative easing in the US lead to
lower long-term bond yield and term premium in Asia.

I Other authors find that the US unconventional monetary policy lead to

lower long-term bond yield and term premium and increasing capital
flows in Asia. See Miyajima, Mohanty, and Yetman (2014), Anaya,
Hachula, and Offermanns (2015) and Chen, Filardo, He, and Zhu (2015).
Literature
I However, literature on the NIRP is quite limited.
I Jobst and Lin (2016) analyzes the implications of the transmission of the
NIRP and bank profitability in the Euro-Area.
I Bech and Malkhozov (2016) study the operational aspects of the
implementation of the NIRP and find that negative interest rates affect
money markets and other interest rates similarly to what positive rates
would do, with the exception of retail deposit rates.
I Hameed and Rose (2016) study the implication on effective exchange
rates and bilateral rates due to the NIRP in Denmark, EU, Japan,
Sweden and Switzerland. They find marginal effect of these policies on
exchange rates.
I Arteta, Kose, Stocker, and Taskin (2016) study the sources and
implications of NIRP through various transmission channels, and find
that similar to unconventional monetary policy measures, NIRP spillovers
to emerging economies through the portfolio re-balancing channel, as
investors search for yields. Arteta, Kose, Stocker, and Taskin (2016)
analyze the implications of the NIRP with event cases.
Data
We focus on the economic and financial impact of the NIRP adopted by the
ECB and by the BOJ on China, Korea, Indonesia, India, Malaysia, Philippines
and Thailand.
Variables Description

IP Manufacturing Production Index (Base 2010=100)

Policy Rate Short-Term Interest Rate
Long Yield 10 Years Government Bond Short-Term Interest Rate
Inflation
REER Real Effective Exchange Rate
HPI House Price Index
Equity Stock Price Index
Debt Flows IIF Portfolio Debt
Equity Flows IIF Portfolio Equity

Period 2005m1 2016m7

Global Factors

Global factor

USCRWTIC Index Bloomberg West Texas Intermediate Crude Oil Spot Price
EUCRBRDT Index Bloomberg European Dated Brent Forties Oseberg Ekofisk Price
PGCRDUBA Index Bloomberg Arabian Gulf Dubai Fateh Crude Oil Spot Price
CESIUSD Index Citigroup Economic Surprise - United States
CESIEUR Index Citigroup Economic Surprise - EU
CESIJPY Index Citigroup Economic Surprise - JP
CESICNY Index Citigroup Economic Surprise Index -China
CESIEM Index Citigroup Economic Surprise Index -Emerging markets
VIX index The Chicago Board Options Exchange Volatility Index
GBIEMCOR Index JPM Government Bond Index: Emerging Markets Global Core
MXEF Index Morgan Stanley Condition Index - Emerging Markets Index
( (a)) Manufacturing Production
Index ( (b)) Inflation

( (d)) Long-term government bond

( (c)) Policy Rate yield
( (a)) Stock Price Index ( (b)) House Price Index
FAVAR Model

I We need a modeling approach that provides a parsimonious

representation of the world economy and at the same time allows for
sufficient flexibility when it comes to analyzing interest rate shocks
within two regimes, namely a regime when interest rates are positive and
a regime with interest rates are negative.

I We adopt a Bayesian factor-augmented VAR model that builds on the

assumption that the global economy is driven by a relatively low number
of dynamic factors that represent global driving forces like the
international business cycle or a global financial cycle.
FAVAR Model
I One key feature of our model is that it effectively discriminates between
a situation where the interest rate in a selected country is positive or
negative.
I In light of this non-linearity if interest rates turn negative, we assume
that an M 1 vector of international macroeconomic variables,
excluding the interest rate to be shocked, yt may be well described by a
set of K  M dynamic factors (as in Stock and Watson, 2011),
(
1/2
0 ft + 0 rit + 0 t , if rit > 0
yt = 1/2 (1)
1 ft + 1 rit + 1 t , if rit 0
I j (j = 0, 1) being regime-specific factor loadings of dimension M K
I j is a M -dimensional coefficient vector that relates the key interest rate
rit to yt .
I j = diag(j1 , . . . , jM ) is a diagonal variance-covariance matrix with
j denoting the matrix square root and t is a standard normally
distributed zero mean error term.
I Eq. (1) implies that we treat rit as an observed factor in the model and
that all the cross-correlation between the elements in yt stems
exclusively from the common factors and are not relegated to j .
FAVAR Model

I We assume that the factors and rit are stacked in a K + 1-dimensional

vector zt and follow a non-linear VAR of order p, i.e.
(
zt1 A1,0 + + ztp Ap,0 + 0.5
0 t if rit > 0
zt = (2)
zt1 A1,1 + + ztp Ap,1 + 0.5
1 t if rit 0

I Ai,j denote (K + 1) (K + 1)-dimensional matrices of lagged

autoregressive coefficients and j denotes a variance-covariance with
j0.5 denoting its matrix square root / Cholesky decomposition.

I Finally, t N (0, IK+1 ) is a Gaussian white noise error.

FAVAR Model

I We adopt a Bayesian approach to estimation and inference.

I We specify suitable priors on the free parameters in the state and

observation equations.

I More specifically, we adopt a standard (conjugate) Minnesota prior (as

in Doan, Litterman and Sims, 1984; Sims and Zha, 1998) on the
autoregressive parameters in Eq. (2), an inverted Wishart prior on j
and a normally distributed prior with zero mean and variance one on the
free elements of j .

I We just fit two separate FAVAR models on two different subsamples of

the data (one with positive interest rates, one with negative interest
rates). So depending on whether interest rates are below zero we move
to the lower regime and vice versa.
Identification

I We identify a negative interest rate in case the policy rate is already into
a positive or negative territory.

I We adopt zero impact restrictions on the factors as in Bernanke, Boivin,

and Eliasz (2005), with short-term interest rates ordered last.

I This identification scheme overidentifies the observation equation and

implies that the first M time series are essentially the factors plus noise.
 CN.long_yield CN.policy_rate CN.mpi

0.3 0.2 0.1 0.0 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 0.000 0.005 0.010 0.015

0
0
0

10
10
10

20
20
20

30
30
30
IP
REU > 0

40
40
40

50
50
50

Long Yield
Policy Rate

60
60
60

3.0 2.5 2.0 1.5 1.0 0.5 0.0 5 4 3 2 1 0 1 0.05 0.00 0.05 0.10

0
0
0

10
10
10

20
20
20

30
30
30
IP
REU < 0

40
40
40

50
50
50

Long Yield
Policy Rate
Impulse responses for China

60
60
60

CN.long_yield CN.policy_rate CN.mpi

0.8 0.6 0.4 0.2 0.0 1.6 1.4 1.2 1.0 0.8 0.03 0.02 0.01 0.00 0.01 0.02

5
5
5

10
10
10
IP
RJP > 0

15
15
15

Long Yield
Policy Rate

20
20
20

5 4 3 2 1 0 15 10 5 0 0.05 0.00 0.05 0.10

5
5
5

10
10
10
IP
RJP < 0

15
15
15

Long Yield
Policy Rate

20
20
20
Impulse responses for China

REU > 0 REU < 0 RJP > 0 RJP < 0

Inflation Inflation Inflation Inflation

0
0.0

0
0.5

1
2

2
1.0
CN.inflation

CN.inflation
1

4
1.5

6
2.0

4
0 10 20 30 40 50 60 0 10 20 30 40 50 60 5 10 15 20 5 10 15 20

REER REER REER REER

0.006

0.00
0.00
0.004

0.010

0.05
0.05
0.002

0.005
CN.reer

CN.reer

0.10
0.000

0.000
0.10
0.002

0.15
0.005
0.004

0.15

0 10 20 30 40 50 60 0 10 20 30 40 50 60 5 10 15 20 5 10 15 20
 CN.stockprice CN.hoCNeprice

0.00 0.01 0.02 0.03 0.000 0.001 0.002 0.003 0.004 0.005 0.006

0
0

10
10

20
20

30
30
REU > 0

40
40

50
50

60
60

Stock Price
House Price

0.1 0.0 0.1 0.2 0.3 0.4 0.10 0.05 0.00

0
0

10
10

20
20

30
30
REU < 0

40
40

50
50
Impulse responses for China

60
60

Stock Price
House Price

CN.stockprice CN.hoCNeprice

0.10 0.08 0.06 0.04 0.02 0.00 0.02 0.005 0.000 0.005 0.010

5
5

10
10
RJP > 0

15
15

20
20

Stock Price
House Price

0.2 0.1 0.0 0.1 0.2 0.3 0.10 0.05 0.00

5
5

10
10
RJP < 0

15
15

20
20

Stock Price
House Price
Impulse responses for India
REU > 0 REU < 0 RJP > 0 RJP < 0
Policy Rate Policy Rate Policy Rate Policy Rate

0.5
0.0

0.5
0.2

0.0
0.0

0.5

0.0

0.5
0.2
IN.policy_rate

IN.policy_rate
1.0

1.0
0.4

0.5
1.5

1.5
0.6

2.0

2.0
1.0
0.8

2.5
2.5
1.0

0 10 20 30 40 50 60 0 10 20 30 40 50 60 5 10 15 20 5 10 15 20

Long Yield Long Yield Long Yield Long Yield

0.2

0.2

0.0
0.0
0.0

0.0

0.2

0.5
IN.long_yield

IN.long_yield
0.2

0.4
0.5

1.0
0.6
0.4

0.8

1.5
1.0
0.6

1.0
0 10 20 30 40 50 60 0 10 20 30 40 50 60 5 10 15 20 5 10 15 20

Inflation Inflation Inflation Inflation

5

0
0.8

5
0.6

10
2
0
0.4

15
IN.inflation

IN.inflation
0.2

20
0
5

25
0.0

30
2
0.2

35
10

0 10 20 30 40 50 60 0 10 20 30 40 50 60 5 10 15 20 5 10 15 20
 IN.equity_net_flow IN.stockprice IN.reer

0.4 0.2 0.0 0.2 0.4 0.6 0.010 0.005 0.000 0.005 0.010 0.015 0.020 0.006 0.004 0.002 0.000 0.002 0.004

0
0
0

10
10
10

20
20
20

30
30
30
REU > 0

40
40
40
REER

50
50
50

60
60
60

Stock Price

Equity Flows
1 0 1 2 3 4 0.0 0.1 0.2 0.3 0.05 0.00 0.05

0
0
0

10
10
10

20
20
20

30
30
30
REU < 0

40
40
40
REER

50
50
50
Impulse responses for India

60
60
60

Stock Price

1.5 1.0
IN.equity_net_flow

0.5 0.0 0.5 1.0

Equity Flows 0.08 0.06 0.04
IN.stockprice

0.02 0.00 0.02 0.020 0.015 0.010

IN.reer

0.005 0.000 0.005

5
5
5

10
10
10
RJP > 0
REER

15
15
15

20
20
20

Stock Price

Equity Flows

4 3 2 1 0 1 2 0.1 0.0 0.1 0.2 0.06 0.04 0.02 0.00 0.02 0.04 0.06 0.08
5
5
5

10
10
10
RJP < 0
REER

15
15
15

20
20
20

Stock Price

Equity Flows
Impulse Responses

Similar to the case of China, Indonesia, Korea, Philippines and Thailand

show:
I A drop in policy rate, long-term yields and inflation for a decreasing
policy rate in Europe, when REU > 0.

I A drop in policy rate, long-term yields and inflation for a decreasing

policy rate in Japan, when RJP < 0.

I The drop is largely amplified when the interest rate lies into a negative
territory (NIRP).
Impulse Responses

Having many results for several countries, in the following we report only
impulse responses where NIRPs have impact.
Impulse responses for Korea

REU > 0 REU < 0 RJP > 0 RJP < 0

Bond Flow Bond Flow Bond Flow Bond Flow
0.0

1.0
2

0
1.5
0.5

5
KR.bond_net_flow

KR.bond_net_flow

2.0
2.5
2

10
1.0

3.0

15
4

3.5
1.5

0 10 20 30 40 50 60 0 10 20 30 40 50 60 5 10 15 20 5 10 15 20
 MY.inflation MY.long_yield MY.policy_rate

1.0 0.5 0.0 0.5 0.5 0.4 0.3 0.2 0.1 0.0 0.4 0.3 0.2 0.1 0.0

0
0
0

10
10
10

20
20
20

30
30
30
REU > 0

40
40
40

50
50
50

Inflation
Long Yield
Policy Rate

60
60
60

1.5 1.0 0.5 0.0 0.5 1.0 0.6 0.4 0.2 0.0 0.2 0.4 1.0 0.8 0.6 0.4 0.2 0.0 0.2 0.4

0
0
0

10
10
10

20
20
20

30
30
30
REU < 0

40
40
40

50
50
50

Inflation
Long Yield
Policy Rate

60
60
60
Impulse responses for Malaysia

MY.inflation MY.long_yield MY.policy_rate

1 0 1 2 0.6 0.4 0.2 0.0 0.2 0.4 0.8 0.6 0.4 0.2 0.0

5
5
5

10
10
10
RJP > 0

15
15
15

Inflation
Long Yield
Policy Rate

20
20
20

1.5 1.0 0.5 0.0 0.5 1.0 0.4 0.2 0.0 0.2 0.4 0.6 0.8 0.0 0.5 1.0 1.5 2.0
5
5
5

10
10
10
RJP < 0

15
15
15

Inflation
Long Yield
Policy Rate

20
20
20
 MY.bond_net_flow MY.stockprice

1.0 0.8 0.6 0.4 0.2 0.0 0.2 0.4 0.005 0.000 0.005 0.010

0
0

10
10

20
20

30
30
REU > 0

40
40

50
50

Bond Flow

60
60
Stock Price

1.0 0.5 0.0 0.5 1.0 1.5 2.0 2.5 0.05 0.00 0.05

0
0

10
10

20
20

30
30
REU > 0

40
40

50
50

Bond Flow

60
60
Stock Price
Impulse responses for Malaysia

MY.bond_net_flow MY.stockprice

1.5 1.0 0.5 0.0 0.5 1.0 0.05 0.04 0.03 0.02 0.01 0.00 0.01

5
5

10
10
RJP > 0

15
15

Bond Flow

20
20
Stock Price

4 3 2 1 0 1 0.15 0.10 0.05 0.00 0.05 0.10

5
5

10
10
RJP < 0

15
15

Bond Flow

20
20
Stock Price
Conclusions
I We estimate a factor-augumented VAR (FAVAR) model to evaluate the
international implications of conventional and uncoventional monetary
policy adopted in advanced economies.

I Our results show that when policy rates lie into a positive territory, i.e.
conventional monetary policy, then both European and Japanese
expansionary monetary policies lead to easier monetary conditions in
Asian economies.

I On the other hand, when interest rates lie into a negative territory, i.e.
unconventional monetary policy, then Asian economies respond with
stronger easier monetary policy conditions when the Japanese authorities
accommodate their monetary policy.

I Concerning other variables, such as exchange rates, asset prices and

capital in flows, a lot of heterogeneity emerges.

I The exchange rate channel and portfolio re-balancing work only for few
countries.