Interest Rates Dip Below Zero For First Time In Japan

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by: Global Risk Insights

The concept of negative rates that originated in Europe has now spread east.

Just as customers of commercial banks earn interest on funds deposited with these banks, commercial banks normally earn interest on funds deposited with central banks. This rate of interest is the central bank's deposit rate and in June 2014, the European Central Bank (ECB) became the first major central bank to push its deposit rate below zero.

Since then, negative rates have been used by other European central banks such as those in Switzerland, Denmark and Sweden. On January 29, the Bank of Japan (BoJ) followed suit and lowered its deposit rate to -0.1%.

Central banks typically lower deposit rates to stimulate growth and inflation. A lower deposit rate means that banks will earn less on funds deposited with the central bank and, hence, may have more incentives to lend out funds to consumers and businesses, who will then use the money for spending and investment.

Japan has struggled with deflation for most of the last two decades. Falling prices tend to push down growth rates as consumers postpone purchases in the hope that prices will fall further. Three years ago, a three-point plan - termed "Abenomics" in reference to Prime Minister Shinzo Abe - was implemented to spur growth and inflation. This involves using monetary stimulus, fiscal stimulus and structural reforms.

A monetary stimulus usually involves reducing interest rates. However, in Japan, interest rates have been near zero for years. Consequently, the BoJ aggressively pursued expansionary monetary policy through quantitative easing (QE).

However, the measures have not been very successful. When the stimulus was launched in early 2013, the BoJ hoped inflation would rise to 2% in two years. It is now nearly three years since the start of the stimulus and inflation is still close to zero. In December, the annual inflation rate was 0.2% - well below the Bank's target.

Furthermore, in its latest Global Economic Prospects report, the World Bank stated that "the recovery remains fragile in Japan despite substantial policy stimulus," and slashed its forecast for GDP growth this year to 1.3% from its June forecast of 1.7%. Japan is projected to grow more slowly than other advanced economies, as shown in the chart below:

Click to enlargeSource: World Bank

The Bank's decision to push rates below zero have probably been triggered by two factors. Firstly, Japan is a major importer of oil, so the slump in oil prices is likely to pass through the economy and depress the prices of other goods.

Secondly, the recent volatility in China is also likely to have influenced the bank's decision. As shown in the chart, China is a major destination for Japanese exports. Consequently, there may be negative spillovers to Japan's exports from a slowdown in the world's second largest economy. A decline in exports is likely to dent growth, and in turn inflation.

Click to enlargeSource: CIA World Factbook

Will the cut in deposit rates avert the deflationary effects of falling oil prices and a potential "hard landing" in China?

This depends on whether or not banks will pass on negative rates to their customers. If they do, then rather than earning interest on deposits with banks, savers will effectively pay banks to hold their cash. In theory, this should discourage saving and encourage consumers and businesses to spend instead. If banks do pass on rates, then this may provide a major impetus to growth and inflation as Japanese corporates tend to save too much, as this graph shows.

Source: Financial Times

However, in the Eurozone and Switzerland, banks have been reluctant to pass on negative rates to their customers. Currently, only large depositors are paying banks to hold their deposits. Banks could lose customers if they impose negative rates on a wider client base as it is theoretically possible for customers to hoard cash rather than paying a bank to hold it for them.

In any case, Japanese banks may be less affected by negative deposit rates than their Eurozone counterparts. Unlike the ECB, the BoJ has adopted a three-tier system which means that banks will effectively only be charged for new funds that they park with the central bank. They will still earn positive or zero rates on a percentage of their reserves deposited with the central bank.

Hence, it is likely that the staggered system and bank's reluctance to impose charges on their customers will limit the effectiveness of the bank's policy in stimulating growth and inflation.

Negative deposit rates can also influence the currency, which can in turn affect growth and inflation. Generally, when a country's central bank reduces interest rates, it leads to a decline in the country's currency as foreign investors find the country's assets less attractive and domestic investors try to invest overseas to take advantage of higher rates. The appreciation of the Swiss franc was one of the main motivators for the Swiss National Banks to push its deposit rate below zero.

The yen declined sharply after the central bank's announcement. A sustained depreciation may make Japanese exports more competitive, which may in turn lead to an upturn in growth and inflation.

The central bank has also promised to unleash other weapons in its armory in order to bring inflation to target. In a speech on February 3, Governor Haruhiko Kuroda stated that "there is no limit to measures for monetary easing" and the the Bank would "continue to devote itself to innovation in monetary policy measures."

It remains to be seen whether these innovations will be necessary. As monetary policy always operates with a lag, it is likely to be some time before the effects of the deposit rate cut are visible in economic data. In the meantime, the Bank's decision to drop rates below zero for the first time in its history may prove a powerful signal that the Bank is committed to bringing inflation up to its target.