Low rates of return tempt investors to take risks, which can cause economic and financial instability
JAY SURTI is a deputy division chief in the IMF’s Monetary and Capital Markets Department.
Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.
When interest rates are high and inflation is low, investing is a cinch: savers can earn easy returns by simply parking their funds in Treasury bills or similar safe assets. But it becomes much harder when interest rates are low, as they have been in most advanced economies since the global financial crisis of 2008–09 and in some of them for longer still. Fed up with zero or near-zero interest rates, savers may be tempted to experiment with riskier assets or strategies in the hope of higher returns. Economists call this the search for yield.
Individual investors may shift money out of savings accounts and into stock markets. Firms might seek to boost income through speculative investments financed by debt because borrowing is cheap. Financial institutions such as banks and insurance companies may make risky bets to maintain profits or even to survive. But riskier portfolios increase the likelihood of loss. Higher indebtedness means firms are in a more precarious position when confronted by adverse shocks. The result is greater institutional vulnerability and increased likelihood of economic and financial instability.
The ability to take risks and the appetite for doing so vary: households, firms, and financial institutions all act differently. Yet they are influenced by common forces. Especially important is the Treasury bill equilibrium interest rate (the rate of interest at which the amount of money demanded is equal to the amount of money supplied). This safe asset return influences the return on other investments, including long-term government bonds, bank deposits, and company bonds and shares. Returns on these riskier assets tend to rise and fall in line with the safe asset return.
The temptation to search for yield rises when the safe asset return falls to very low levels over a long period of time, as has been the case in Japan and several European economies for the past two decades. For households, this translates into a low return on savings and slower wealth accumulation. It makes it more difficult to fulfill life cycle ambitions such as buying a home, saving for a secure retirement, or passing on wealth to children.
Households will try to compensate by saving more and spending less. (An important exception is Japan, where older and wealthier households, with less of a need to increase precautionary savings and a greater capacity to search for yield, have invested in high-risk emerging market bonds and stocks.) Lower household borrowing and consumption reduce demand for goods and services sold by firms. Corporate sales and profits slide as a result. The financial sector suffers, too. Bank lending to households declines. As interest rates fall to very low levels, the difference between banks’ lending and deposit rates is squeezed. It all combines to drive down profits.
Since the dollar is a global funding currency, the search-for-yield incentives arising from long periods of low interest rates in the United States are not limited to American banks and firms. Firms from other countries may also borrow in the United States to invest at a higher rate of return at home. This carry trade is financially risky since any tightening of monetary policy in the United States (or a domestic shock) could result in a loss-inducing appreciation of the dollar. The “taper tantrum” of 2013 was one example where large emerging market firms experienced carry trade losses due to dollar appreciation. These losses were significant enough to materially dent firms’ market valuations. In some cases, losses increased volatility in domestic financial markets.
Banks that expand abroad may face losses if they do not adapt to new challenges of risk management. A bank’s head office may, for instance, find it most effective to expand into a foreign country by delegating operational decisions to local managers. But the bank then faces the more difficult challenge of providing effective performance incentives. It may be tempted to make pay and promotion contingent on returns that are unrealistically high and so push local managers to take too many risks.
Finally, consolidation of the banking sector through mergers of small banks or their acquisition by larger ones can stifle competition. This may increase borrowing costs especially for households and small businesses, which would find it more expensive to consume and invest—a serious setback for inclusive growth.
The search for yield can have benefits. When risky bets pay off, they increase income from savings and investment when interest rates are low and it is hard to earn a return. They also spread capital to new markets. But policymakers must be alert to the dangers—of speculative debt-financed investment especially. Some bets will inevitably go sour. The consequences for economic and financial stability can be severe when they do.
