Japan’s big gamble on negative interest rates
Bank of Japan (BOJ) Governor, Haruhiko Kuroda, might seem an odd choice for the role of Peter Pan, but he is clearly familiar with the children’s story, having referenced it last year when speaking about the challenges facing the BOJ as it seeks to generate inflation in the Japanese economy.
“I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘the moment you doubt whether you can fly, you cease forever to be able to do it,’” said Kuroda in June 2015. But Japan is not Pan’s Neverland even if the BOJ’s, albeit nuanced, recourse to a negative interest rate policy (NIRP) is an attempt to make inflation take off.
Japan is a rapidly ageing population, and their reaction to the BOJ decision might not quite be what Kuroda and his fellow policy-setters envisage
While there’s no room for doubt at the BOJ as it pursues its policy ends, its current NIRP, where a minus 0.1 per cent rate is imposed on one element of reserves placed with it by financial institutions, may prove a key turning point for Abenomics, the monetary and fiscal policy mix that has dominated Japanese official thinking since Shinzo Abe’s 2012 election victory.
Demographics will play a part.
In the novel penned by Scottish author J.M. Barrie, Neverland is populated by Peter Pan, the boy who never grew up, and his band of child followers. However, Japan is a rapidly ageing population, and their reaction to the BOJ decision might not quite be what Kuroda and his fellow policy-setters envisage.
William White, chairman of the Economic and Development Review Committee at the Paris-headquartered Organization for Economic Co-operation and Development (OECD) has strong opinions on the issue of NIRP.
“The expectation [with NIRP] is that this will lead to lower lending rates,” White said on February 9, “but you can easily think of a story where this is not the outcome because those negative interest rates cut the banks’ profit margins. And then the question is what will the banks do to restore them?”
Banks could lower their deposit rates but if this is not possible, as it would lead to customers withdrawing funds, “then what is possible is increasing the lending rate,” White argued.
“What you end up with is a counterintuitive but highly plausible alternative description of what these policies are going to give you. So in the end they may end up being contractionary and not expansionary,” he said.
Clearly the Bank of Japan would disagree with White’s scenario as would Japan’s Finance Minister, Taro Aso, who expects the BOJ’s NIRP “to have a positive effect on consumption and investment.”
White again has a contrary view.
“There are lots of reasons why lower interest rates might produce lower consumption, he said, “for example, think about the people who are saving for an annuity or a pension for when they retire. If the roll-up rate is going down, aside from working longer, the only solution is to save more.”
As for Japan’s financial sector, the BOJ’s NIRP will cost the Japanese banks several billion dollars in profits according to rating agency Standard & Poor’s and might lead to some ratings reviews, presumably with a view to downgrades. Whether or not that will make Japan’s lenders more or less likely to lend more into the Japanese economy remains to be seen.
At any rate, Japan’s economy had already shrunk more than expected in the fourth quarter of 2015, contracting 1.4 per cent on an annualised basis, so if White is right, and again the BOJ would undoubtedly disagree, NIRP could worsen the situation.
This all matters both in Japan, but globally too, and not just because of the size of the Japanese economy. If investors begin to doubt the effectiveness of Abenomics, of which BOJ monetary policy is a key component, there are potentially major implications for the yen’s value.
The yen has slid in value in tandem with the roll-out of Abenomics. It could therefore, and again counter-intuitively, strengthen appreciably if investors conclude that the policy mix, that Japan has adopted, has reached the end of its useful shelf-life.
Yen strength, occasioned by the unwinding of Abenomics-related plays that had involved selling the Japanese currency, could snowball.
Currency traders with long experience in the yen, will recall that when the Japanese economy suffers, Japan’s currency has a tendency to strengthen anyway as local investors bring money home.
The Bank of Japan has its reasons for taking the path that it has but there are risks its policies will not fly amid unforeseen outcomes. As it says in “Peter Pan,” while “all are keeping a sharp look-out in front… none suspects that the danger may be creeping up from behind.”
