The Very Basis of Finance Turned on Its Head

Hands up those familiar with the central tenet of corporate finance, the venerable “time value of money”. I imagine that will be all of you. Good, because the global economy being what it is right now, it looks like we are turning that concept on its head.


Money has time value because it represents a store of worth and that store has to be compensated. I can spend money now, or I can choose to spend it later. Because spending it later incurs an opportunity cost, which is a fancy term for “a missed pleasure”, I need to be compensated for said foregone opportunity. Hence an interest rate. If you require me to forego benefiting from spending cash now, you’ll need to pay me for it.

It’s a concept as old as money itself — place some with me and I will pay you interest on it until I return it to you.

So what are we to make of the current yield curve for Germanyand Switzerland, which shows a negative interest rate out to the two-year for Germany and five-year for Switzerland? A negative interest rate?!

Pay me 100 euros and I’ll pay you back 95. In other words, pay me to take cash off you. One is, quite literally, better off placing the cash under the mattress. Of course this can’t happen when one is talking about trillions of euros held continent-wide.

How and why has this come about? Quiet simply because the continuing recession, allied with the on-going euro zone crisis, has resulted in everyone looking for a “safe haven” in which to place their cash.

In the United States the three-month Treasury bill traded with a negative yield in 2009, a pure safe haven play. Likewise, the Swiss market.

In the euro zone there are now substantial cash inflows to the German sovereign because of additional complications, namely the worries about redenomination risk in the event of euro break-up.

A negative interest rate is similar to deflation in that it is bad for the economy. Turning the orthodox principles of corporate finance on their head does not make for a benign environment in which to make business investment decisions or plan capital projects. If there is one indicator that should begin to signal to EU governments that we are approaching the time when euro zone integration needs to be agreed, then this is it — the negative time value of money now prevailing in European safe haven countries.

Pay me and I’ll take your cash off you.

More than stagflation, rising unemployment or some arbitrary 7 percent bond yield, the real danger signal for EU governments is that there is no longer a time value of euros.

Who knows, given the United Kingdom’s genuine AAA-rated safe-haven status, we may even see this phenomenon occur over here. Eurozone travails will infect just about everyone sooner or later…

Professor Moorad Choudhry is Treasurer, Corporate Banking Division, Royal Bank of Scotland.

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