Japan: Finding the right policy mix Global Economic Outlook, Q2 2016

Despite the monetary stimulus undertaken by the Bank of Japan, the economy is clearly not recovering in the manner that the government had hoped. Introducing negative rates for the first time, the bank is looking for a new tool to boost inflation.

Japan

Growth

The Japanese economy contracted at an annualized rate of 1.1 percent in the fourth quarter of 2015. Real GDP has declined in five of the last nine quarters, and in two of the last three.1 For all of 2015, real GDP was up only 0.4 percent from the previous year, having not grown at all in 2014. The economy is clearly not recovering in the manner that the government had hoped, especially given the massive monetary stimulus undertaken by the Bank of Japan (BOJ). Consumer spending fell at a rate of 3.4 percent, and public investment fell at a sharp rate of 12.7 percent—indicating that the fiscal stimulus component of Abenomics is not taking place. Plus, exports fell at a rate of 3.3 percent, despite the weakness of the Japanese yen. On the other hand, business investment grew at a rate of 6.3 percent after a long period of no growth. In part, Japan is suffering through a demographic shift, as the working-age population shrinks rapidly. On a per capita basis, Japan’s economy is actually growing at a slow but more reasonable pace. However, Japan could probably grow faster under the right set of circumstances. Fiscal stimulus and market-opening reforms, the second and third “arrows” of Abenomics, would probably help. However, only the first “arrow,” monetary stimulus, has been tried in a significant way. Some observers hope that implementation of the Trans-Pacific Partnership will compel the government to address structural reform issues.

Japan could probably grow faster under the right set of circumstances. Fiscal stimulus and market-opening reforms, the second and third “arrows” of Abenomics, would probably help.

Moving into the first quarter, Japanese exports grew modestly from December to January, while imports fell, leading to an increase in the trade surplus. Yet nominal Japanese exports were down 12.9 percent from a year earlier, and imports down even more steeply, at 18 percent. Exports to China were especially poor, declining 17.5 percent from a year earlier, reflecting the weakness of the Chinese economy. Exports to the United States were down 5.3 percent, while imports from the United States were down 9.7 percent. Exports to the European Union were down 3.6 percent, while imports from the European Union were up 6.0 percent.2 The weakness of exports is despite the fact that the yen is now competitively priced. On the other hand, exports performed better in volume terms: The weak yen has enabled exporters to cut prices, thus boosting volume while reducing nominal revenue. Meanwhile, the recent rise in the yen, from about 120 yen per dollar to about 112 yen per dollar, was fueled by the flight to safety that followed global financial turbulence. If sustained, this increase could have a negative impact on export volume.

Japanese Prime Minister Shinzo Abe recently met with two Nobel Prize–winning US economists known for favoring fiscal stimulus for the Japanese economy.

Fiscal policy

Japanese Prime Minister Shinzo Abe recently met with two Nobel Prize–winning US economists known for favoring fiscal stimulus for the Japanese economy. The economists, Joseph Stiglitz and Paul Krugman, are known for being left of center compared with Abe’s known conservatism. Thus Abe’s decision to meet with them and publicize the meetings suggested that he might be preparing the way for a shift in fiscal policy. In addition, it has been suggested that, as he did when he postponed the last tax increase, he will call a new election in order to obtain a voter mandate for this important shift in policy. When he postponed the tax increase last year, he said that it would not happen again, and that the tax increase set for 2017 would definitely take place. Thus a new mandate might be seen as essential to covering any political risk associated with this shift in policy. On the other hand, failure to postpone the tax increase could lead to yet another recession for Japan’s fragile economy. Stiglitz and Krugman’s view is that monetary policy alone has been inadequate for boosting economic activity, and that a fiscal stimulus is needed as well—not only for Japan but for other developed economies that suffer from weak credit market activity. While this view has gained credence among economists, the International Monetary Fund, and the Organization for Economic Development, it has not been adopted anywhere other than in Canada and, to a lesser extent, in the United States.

Still, Abe has lately reiterated his intention to go ahead with the tax increase. However, he also suggested that there is room for fiscal stimulus as well. As such, he has directed his finance minister to frontload spending planned for the new fiscal year. That would provide a temporary boost to the economy. Yet he continues to indicate an aversion to backtracking from his original pledge to go ahead with the next tax increase, a pledge he solemnly made when he postponed the last tax increase. Meanwhile, it was reported that real (inflation-adjusted) retail sales fell in January. This indicates continued weakness in the consumer sector and shows the potential danger of another tax increase.

Negative interest rates

Not long ago, BOJ Governor Haruhiko Kuroda said that the Bank of Japan (BOJ) will not consider negative interest rates, despite continued very low inflation.3 Recently, however, the BOJ implemented a policy of negative interest rates for the first time. Specifically, the benchmark interest rate was cut to -0.1 percent for new cash reserves. The rate will remain 0.1 percent for existing reserves. Thus banks that receive new deposits will have an incentive to avoid holding excess cash and, instead, to lend that money to the private sector. The bank’s policy committee narrowly approved this decision by a vote of 5 to 4. Kuroda said that “through the minus interest rate combined with quantitative easing, I hope we can support companies and individuals in breaking their deflationary mindset.” In addition, he said that the bank might “cut the interest rate further into negative territory if judged as necessary.” Kuroda also said that the BOJ would leave the pace of asset purchases (quantitative easing) unchanged for now. However, he indicated that the decision to cut rates did not preclude boosting the pace of asset purchases if need be. He noted that the economic slowdown in China, declining oil prices, and global financial market volatility are suppressing inflation and damaging business confidence in Japan.4 He evidently hopes that negative rates will encourage a rebound in credit market activity.

The BOJ is not the first central bank to do this. The central banks of Sweden, Switzerland, and the Eurozone have all tried this recently due to the persistence of deflation or near deflation. The European Central Bank (ECB) initiated negative rates in 2014 when it started charging banks for holding cash reserves with the central bank. That action likely contributed to the acceleration of money supply growth in Europe. However, Europe continued to suffer from low inflation for a prolonged period. Investors were surprised by the BOJ’s action and reacted accordingly. The yen fell sharply against the US dollar, Japanese equities soared, and equity prices in other developed countries increased following the news from Tokyo.

Interestingly, banks are now paying zero interest on deposits. The result is that there has been a surge in sales of safes so that people can store cash at home.

What exactly does a negative interest rate entail, and what impact might it have? The BOJ, like other central banks, allows commercial banks to deposit short-term cash at the central bank, and it pays those banks a modest interest rate for holding that cash. If the BOJ were to set that interest rate relatively high, it would be an incentive for banks to hold more cash with the BOJ, thus reducing the incentive to lend money to the private sector. As such, the money creation that comes about from lending money would be inhibited. Conversely, if the BOJ wants to encourage more bank lending to the private sector, it sets the interest rate at a low level. Yet when there is virtually no inflation (or even deflation) in the economy, even a modest interest rate can seem high in real terms. Thus some central banks choose to set the rate at a negative level in order to encourage more credit creation. This entails requiring that commercial banks actually pay for the privilege of depositing cash with the BOJ. Other central banks that have done this include the ECB and the central banks of Switzerland and Denmark. The latter two banks have set rates at -0.75 and -1.1 percent, respectively.

Currently, the BOJ is struggling to kick-start credit creation in order to boost inflation and to stimulate economic activity. One problem is that, although banks may be willing to lend at very low interest rates, many businesses are reluctant to borrow for fear that deflation will kill the return on any new investment projects. Thus the BOJ is eager to boost expectations of inflation so that businesses feel comfortable investing in new projects. Yet despite two years of massive asset purchases (quantitative easing), expectations have barely budged. Indeed, they have declined due to the impact of declining energy prices. Now, with negative rates, the BOJ is looking for a new tool to boost expectations of inflation.

The implementation of negative interest rates is creating concerns. The program involves charging commercial banks for holding cash reserves with the central bank. The idea is to discourage them from holding excess cash reserves and to encourage them to lend money to the private sector. However, banks must still hold some cash reserves. If they pay a positive interest rate on their deposits, then they lose money on part of their deposits. If, however, they charge individuals to deposit money with them (offer negative rates on deposits), they risk losing deposits as individuals might choose to hold physical cash at home. Interestingly, banks are now paying zero interest on deposits. The result is that there has been a surge in sales of safes so that people can store cash at home. Also, even if banks offer to lend more to businesses at low interest rates, it is not clear that businesses will want to borrow more unless they are convinced that inflation will rebound and demand will improve. Thus the risk exists that negative interest rates will simply hurt bank profitability without doing much to stimulate credit market activity.

Bond yields

Recently, the yield on Japanese 10-year government bonds fell below 0 percent for the first time ever. Indeed this is one of the few 10-year bonds for any country to have a yield below zero. Switzerland’s 10-year bond has a negative yield, but Switzerland has significant deflation. Many lower-maturity bonds in several countries now have negative yields. This includes the two- and five-year bonds for both Germany and Japan. Why did Japan’s 10-year bond yield fall so far? First, the global financial volatility and uncertainty led to a flight to safety, and Japanese bonds are seen as exceptionally safe. Second, lower oil prices have suppressed expectations of inflation in Japan and elsewhere, despite aggressive monetary policy. Third, the BOJ’s decision to impose negative short-term rates means that investors are looking elsewhere to park their funds. Plus, negative policy rates have hurt shares in banks, with investors selling shares and purchasing sovereign bonds. For sovereign debtors, there has never been a better time to borrow money—which leads to the question of fiscal policy. Given the stagnant global economy, now would likely be a good time for governments to issue new bonds to finance infrastructure and other forms of investments.