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Monday, April 3, 2006

JAPANESE PERSPECTIVES

Things to watch as BOJ restores interest rates


The Bank of Tokyo-Mitsubishi UFJ, Japan's biggest banking group, raised the rates it offers on time deposits with a maturity of one year or over on March 20. The increase varies according to the size of the deposit and the length of maturity. The annual rate for a five-year deposit under 3 million yen, for example, has climbed to 0.23 percent from 0.1 percent. The rate hike, the bank's first in about five years, was copied by many other financial firms. It was spurred by criticism that Japanese banks weren't raising the rates on deposits as quickly as the rates for loans, which fluctuate in accordance with the market.

Another recent trend is that both companies and individuals are raising long-term funds by such means as issuing corporate bonds and housing loans with fixed long-term rates. There are two major factors behind this trend.

One is that the three excesses that emerged from the collapse of the bubble economy in the early 1990s -- employment, equipment and debt -- have been trimmed, paving the way for the real economy to expand.

The other is the recent rise in long-term interest rates that followed the lifting of the Bank of Japan's so-called quantitative easing policy on March 9.

In short, the recovery of Japan's real economy and the change in monetary policy have revived the interest rate function -- a component of the economy that the BOJ chose to freeze in order to battle its crippling nemesis deflation.

It will likely be some time before the BOJ reduces the enormous pile of deposits it has been asking commercial banks to keep in its current account as part of the effort -- a number that bubbled to over 30 trillion yen as it raised its liquidity target over the past five years. This should eventually drop below 10 trillion yen.

The next question is when the BOJ will lift its policy of anchoring short-term interest rates near zero -- a decision that will reflect economic trends and price indicators.

In addition to growing demands for funds, however, Japanese companies are moving to hire more workers. Also, a Land, Infrastructure and Transport Ministry report released March 23 said land prices in the commercial districts of Tokyo, Osaka and Nagoya have risen for the first time in 15 years.

There are three things to watch when trying to assess future trends in interest rates.

First is the argument -- as explained by the BOJ to the Diet recently -- that while more than 300 trillion yen in household income that could have been earned from deposit interest was lost due to its "zero-interest-rate" policy, the burden on borrowers was also accordingly reduced.

This is misleading, because borrowers continued to pay interest on their debts -- albeit at reduced levels -- while suffering from deflation that reduced the value of their assets.

What is at stake is not just nominal interest rates, but real interest rates -- market rates minus price fluctuations. Today's depositors will suffer as consumer prices rise at a rate of 0.5 percent while the central bank continues the zero-interest-rate policy.

The BOJ will thus face political pressures, but it must not pass the burdens of the public sector -- the nation's largest borrowers -- onto depositors by leaving that policy unchanged. This is where the central bank's independence will come into question. The BOJ should keep a close watch over real interest rates as it tries to assess when to start raising its own rates.

Second, the profit margins of Japanese financial institutions are still much smaller than those of their counterparts in the United States.

According to statistics compiled by the Japanese Bankers' Association, the average profit margin on loans made by major Japanese banks is 1.64 percent -- much lower than the 5.53 percent earned in the U.S.

There are various reasons for this gap, but the fundamental problem is that Japan just has too many banks -- including the state-run postal savings system.

While the banks have been engaged in fierce competition in their bloated industry, there has been a distinct lack of discussion on what kind of profit margin is appropriate under international standards. The Japanese banking industry has been effectively reorganized into three megabanking groups in a short period of time, but there will be more realignment in coming years.

The third thing to watch for is the international impact of the BOJ ending its ultraloose monetary policy, which provided liquidity not only domestically, but throughout the world.

A large amount of yen-denominated funds have been raised by taking advantage of Japan's virtually zero interest rates to borrow and reinvest in currency-denominated tools bearing higher interest. There will naturally be a backlash once expectations rise for a more expensive yen. The large daily fluctuations in exchange rates recently are evidence the market is already becoming jittery about the future of the yen interest rate.

Teruhiko Mano is a professor at Seigakuin University Graduate School.


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