Japan’s central bank raised interest rates last week for the first time in seventeen
years, ending the world’s only remaining negative interest rate regime.
The Bank of Japan also abandoned its yield curve control policy which has been in place
since 2016, which saw it buying Japanese government bonds to keep longer term interest rates from
rising.
It has however maintained bond buying at the same pace for now.
If Japanese rates were to continue to rise, it could have global repercussions as the
Yen’s stability and low interest rates have given it a role in international finance that
might be about to change.
Negative interest rates are when central banks require their counterparties to pay to store
their excess cash at the institution.
Following a 7-2 vote last week, it was announced that the central bank would guide Japan’s
overnight interest rate to a range of about zero to 0.1 per cent.
Obviously, this is not a huge rate hike, the prior benchmark rate had been minus 0.1 per
cent.
It is maybe more important symbolically than anything else.
Japan has a long history of central banking innovations – or unconventional monetary
policies - which were introduced after the Japanese asset price bubble burst in the 1990’s.
While Japan was not the first country to introduce negative interest rates (that honor goes to
Sweden) it was the first country to introduce zero interest rates in 1999.
The bank of Japan also pioneered asset purchase programs – known as quantitative easing
along with the yield curve control policy, both of which became widely used by central
banks around the world in the wake of the global financial crisis.
The Bank of Japan went a bit further than other central banks buying up stock market
funds and real estate linked securities in what it referred to as qualitative easing.
The negative interest policy which has just ended involved applying different interest
rates to different tiers of bank reserves in order to prevent the banks from hoarding
cash.
Achieving the 2% inflation target is finally getting within reach in Japan due to recent
wage inflation.
Japan’s largest federation of trade unions recently negotiated a weighted average 3.7%
increase in base pay.
This was stronger than last year’s wage gains, which were the steepest in thirty years.
The Bank of Japan has said that they expect higher incomes to lead to a virtuous spiral
with domestic demand fueling inflation.
They say that their long-held goal of stable 2% inflation is finally “within sight”.
There were no shock waves associated with the announcement as the decision was widely
expected and well telegraphed.
“Core-core inflation - which excludes fresh food and energy prices - and is closely watched
by the BOJ as a better gauge of trend inflation has been above the 2% target for more than
a year, but policymakers took it easy believing that some of this inflation was largely imported
from overseas.
The low-return environment in Japan has pushed Japanese investors into being amongst the
biggest capital exporters in the world: they own over a trillion dollars of US Treasuries
and half a trillion Euro bonds.
Now that domestic yields in Japan might be on the rise, will they stop investing as much
abroad?
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Japanese banks and institutions have over the years become big foreign investors.
Decades of ultra-low interest rates encouraged yield-seeking Japanese investors to keep their
savings overseas, particularly in foreign bonds.
Commerzbank estimates that Japanese investors own more than $2tn in foreign bonds and international
investments are estimated to be around four trillion dollars in total.
Low interest rates combined with the yen’s stability made it the currency of choice for
carry trades, where an investor borrows in Yen to fund investments in other countries
where interest rates and expected returns are much higher.
This style of investment can (of course) be quite risky.
Big currency moves can wipe out returns and force investors to unwind their trades.
For this reason, the Yen usually rallies during times of market stress, as investors exit
these trades and repatriate their money to Japan.
Japan is the largest foreign holder of US government debt and in a world of higher Japanese
interest rates money that has been invested abroad could be brought back to Japan, impacting
the demand for US treasuries and Euro denominated bonds.
US bonds have already become less attractive to Japanese investors, as when they buy Treasuries,
they usually don’t want to run the foreign exchange risk and thus hedge it out.
After hedging US Treasuries are the most expensive, they’ve been in decades for Japanese investors,
and for this reason this trade has been unwinding over the last two years.
John Authers at Bloomberg points out that since the beginning of 2020, a carry trade
of borrowing in yen and investing in the Mexican peso, where rates are above 11% has made a
far bigger profit than an investment in the S&P 500.
Samurai bonds are yen denominated bonds issued by foreign entities in Japan, allowing non-Japanese
governments and corporations to secure capital from Japanese investors – often at lower
rates than they would get in their home markets.
In recent years, highly indebted African countries like Kenya, Egypt and Rwanda have issued Samurai
bonds.
This debt has mostly been issued at fixed interest rates which means that the change
in interest rate should not affect the borrowers, but if the yen were to appreciate against
their currencies, it would be more expensive to pay back these loans.
For these reasons, developments in Japan matter for global markets.
Japan’s debt reached $8.6 trillion dollars at the end of last year.
At 255 percent of GDP that is more than twice the debt to GDP ratio of the United States
and is the highest in the developed world.
The future pace of rate increases will depend on a number of factors such as whether businesses
and households can handle higher borrowing costs than they have become accustomed to.
Servicing Japan’s massive government debt is already a struggle which will become more
difficult once negative interest rates and yield-curve control have been abandoned.
For Japanese banks, higher interest rates can be expected to boost net interest margins,
and the FT points out that Japanese banks have performed very well over the last year
in expectation of this interest rate hike with shares in Mitsubishi UFJ Financial Group
up more than 80 per cent in the last year.
Large Japanese companies have 49 per cent cash on their balance sheets as a proportion
of net assets, according to the same article and higher interest rates would help these
companies too.
Should rates continue higher, investors in Japanese bonds could face losses not unlike
what we saw when US rates rose rapidly last year.
According to the Wall Street Journal, Japan’s Financial Services Agency warned regional
banks in mid-July that they should be ready to respond flexibly to rapid interest-rate
fluctuations.
Very few Japanese bankers have any experience in a rising interest rate environment.
Japan’s share of global GDP in Purchasing Price Parity terms fell from 9% in 1990 to
under 4% today and while deflation slowly made Japan relatively poorer, it actually
worked out well for certain salaried workers who made a steady income while prices fell
around 1 percent per year.
In the new inflationary environment wages have been rising slower than retail prices,
frustrating these Japanese workers.
The past 30 years have seen many false dawns in Japan.
The Economist points out that while price inflation is still above 2%, it is already
falling.
They argue that for the trend to continue, Japan needs reforms that raise productivity
and boost the potential growth rate, otherwise deflation could return.
Japan is faced with some big structural problems – an ageing population, low growth and high
public debt.
While all developed countries are aging, none are doing so as fast as Japan.
Around the turn of the century the phrase Japan’s 2025 problem was coined.
It referred to how by 2025, all six and a half million of Japan’s baby boom generation
would be 75 or older.
Japan in 2025 would become a super-aged society the likes of which has not been seen before.
Based on current projections, by 2050 there will be almost the same number of workers
in Japan as retirees.
The elderly in Japan vote for, and get old-age benefits, and many young Japanese people don’t
vote - aware that their numbers are not sufficient to counterweight the votes of the elderly
population.
In a country with high debt the high number of elderly people can be expected to put extreme
strain on the economy, welfare programs and retirement plans
My friend Manoj at Talking Heads Macro argues that the Bank of Japan’s optimism that wage
negotiations would deliver stronger nominal (and real) wage growth leading to consumption
growth might be wrong.
He argues that Japan’s real wages have fallen over the last two years and that consumption
growth will only come after households have recouped the purchasing power they lost due
to inflation.
He says that households will need several quarters of wages outstripping prices before
the wage level catches up with the price level.
Only then will they feel that their wages can be used for broad-based consumption…
that time is not now.
For the time being, a sharp increase in Japanese interest rates seems unlikely.
Japanese policymakers have been careful to signal they are not embarking on a tightening
cycle and that the central bank is prepared to intervene to support financial stability
if needed.
Wages are still quite weak in Japan and further wage growth would be needed for inflation
to remain on target.
The BOJ referred to extremely high uncertainty in their outlook meaning that they just don’t
know if they are on track with inflation or not.
A lot will depend on what happens if the US federal reserve starts cutting rates as the
difference between Japanese interest rates and US interest rates is quite wide at present.
If the Fed started cutting rates, narrowing that gap, the yen could start to rise as Japanese
rates become relatively more attractive.
This would make imports cheaper, putting downward pressure on prices.
All of Japan’s big structural challenges remain the same, and to quote Robin Harding
from The FT “it is not clear if there is any stable equilibrium where Japan chugs along
with consistently positive interest rates and inflation at its 2 per cent target.
The Bank of Japan has signed an armistice with unconventional monetary policy, not a
peace treaty”.
If you enjoyed today’s video, you should watch the one on how Japan’s economic miracle
turned into three lost decades next.
Don’t forget to check out our sponsor Opera using the link in the video description.
Have a great day and talk to you again soon.
Bye.