Negative no more

Bank of Japan (BOJ) Governor Kazuo Ueda yesterday announced the long-anticipated abandonment of negative interest rates. The central bank raised the cost of borrowing for the first time in 17 years. The last man standing in the world of ultra loose monetary policy also bade farewell to other novel policies: yield curve control (YCC) and ETF purchases. 

Market reaction was muted. Ueda’s extensive briefings were successful in avoiding any element of surprise and unwanted volatility. Expectation centred only on whether it would happen this month or next. Ueda was also at pains to stress that financial conditions will remain accommodative. Its move to interest rates in a range of 0 to 0.1 percent lags far behind others. 

Nonetheless, Japan bulls saw it as a further sign of the economy’s resurgence. It reflected the central bank’s confidence that the deflation battle is almost over. Long overdue wage increases and the Nikkei’s 34 year high have investors believing in Japan again. Warren Buffet is amongst those betting on its success. 

But Japan still faces a challenging path to renewed prosperity. As Simon Kuznets famously said: 

There are 4 kinds of countries: developed, undeveloped, Japan and Argentina. 

Plagued by deflation and yet beset by the highest level of public debt (250 percent of GDP) amongst advanced economies, the island is an anomaly. Its path back to a normalised rates regime depends on growth. And those hopes face 3 major hurdles: the Yen, “Zombie” companies and demographics.

weak yen

The Yen has been the worst performing G10 currency for 3 years. It has weakened by over 30% against the US dollar over the last 5 years. The gaping yield curve differential between Japanese Government Bonds (JGBs) and US Treasuries is the primary driver of this trend. Today, 10 year JGB yields are 0.7 percent while 10 year US Treasury yields are 4.2 percent. 

Aggressive monetary tightening by the Fed has increased yields, attracting capital flows and strengthening the dollar. Japan’s negative interest rates and its YCC policy (the BOJ buying up government bonds to drive down yields) has had the opposite effect.  

A weak yen has been good for Japan. Its export driven economy benefits from increased competitiveness abroad. Higher company earnings have boosted investor sentiment and brought its stock market out of the doldrums. 

But some analysts fear it’s also the cause of returning inflation. Is this rising cost of imports rather than improving domestic consumption sparking welcome price increases? If they are right, a stronger Yen is a problem. Exporters will struggle and prices will stabilise.
That appreciation isn’t happening yet. The Yen actually fell further as Ueda gave no timeline for further rate rises. The market believes monetary policy will remain loose for some time yet. 
But the BOJ cannot control international policies. Analysts expect Fed rate cuts before the US election. Others speculate that the great new Chinese manufacturing boom, particularly in areas like electric vehicles, could bring about a new era of deflation. As other central banks respond with looser policy, yield curve differentials would shrink and put upward pressure on the Yen.    

“Zombie” Companies 

The BOJ believes inflation is genuine rather than just representing rising import prices. Recent wage inflation encourages this view. Japan’s biggest companies agreed to raise salaries by 5.28 percent earlier this month

Freeing up hefty corporate profits for wages and investment has been a big policy goal of successive governments. It’s partly about changing risk averse corporate cultures but also defeating deflation. When the real value of cash decreases over time, companies secure a positive return by simply hanging onto the asset.

But not all Japanese companies are sitting on such healthy reserves. Richard Koo talks about Japan’s  “balance sheet recession”. After the 1990s crash, companies quickly had to repair balance sheets. They all did this concurrently, leading to a depression as they focused on paying down debts over investment. 

Low interest rates helped firms recover. But it also allowed others to survive when they should really have gone bankrupt. Nicknamed “zombies” as they are being kept on life support, Tokyo Shoko Research estimates they represent around 500,000 enterprises. Just a 0.1 percentage rise in interest rates would increase that number by another 12 percent.

Suddenly you have more companies teetering on the edge of bankruptcy and liable to fold under any further tightening. That’s a lot of employees at risk of redundancy. If that happens, higher unemployment will quickly dampen growth prospects.

Demographics 

And finally, the elephant in the room: demographics. At current birth rates, the Japanese population will disappear by 2500. This impact will be greatest in the next 20 years as the retired far outnumber the working population.     

How can Japan fund this horrible dependency ratio? Pensions and healthcare will be a major burden. Combine that with Prime Minister Fumio Kishida’s promise to rebuild Japan’s military and you have a real fiscal crisis for a highly indebted government. 

With this in mind, former BOJ member Sayuri Shirai believes now is the right time to abandon these loose policy instruments. She praises Ueda’s recent announcement saying “instead of doing it gradually, he just quit everything altogether and that also likely means that this is it.” 

One of few more hawkish voices, Shirai has consistently stressed the urgency of exiting negative interest rates. Doing so now at least buys some time with yields, and therefore borrowing costs, relatively low. 

But that could change quickly. If Japan suddenly finds yields rising, can it withstand the pressure on debt servicing costs? Would it need to beat a hasty retreat to old policies? Or could we see big tax rises? And will these dampen growing business confidence?

can japan ever be normal?

As Javier Milei seeks to disprove Kuznets’ wisdom in Argentina, can Kishida and Ueda chart a similar path in Japan? So far, so good, as the central bank seeks to sneak out of its loose policy without raising alarms. But it has a long way to go. 

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