Japan rising from negative interest rates

Japan made history for implementing negative interest rates as a long-term intervention to prop up its aging economy. It recorded another milestone when the Bank of Japan (BOJ) raised interest rates from -0.1 per cent to a 0-0.1 per cent target range in March 2024 for the first time in 17 years, followed by an aggressive rate hike to 0.25 per cent in its 30-31 July meeting. 

The long-time manufacturing powerhouse already lost its place as the third-largest economy in the world to Germany after ending 2023 with a soft 1.9 per cent expansion. Japan has so far sustained three straight quarters of GDP growth in 2024, albeit softening from 3.1 per cent in January-March to 0.9 per cent for July-September.  

Signs point to a mild recovery in the manufacturing sector beginning May 2024 when the Purchasing Managers’ Index breached the 50-point threshold and sustained in June, indicating that domestic factories are producing closer to their full capacity. However, this was reversed in succeeding months to December as factories again produced below potential. 

Odd one out

The BOJ has made a name as a deviant central bank with its eight-year negative interest rate regime that essentially penalized banks and their depositors for saving money. The policy, which had been in place since 2016, was meant to stoke consumption and investments to boost economic activity. However, ultra-low interest rates did not translate to rapid expansion, with Japan’s real GDP growing by a mere 1.6 per cent from 2016 to 2022 as small increases in total output had been wiped out by the pandemic-induced recession. 

The negative interest rate regime drove out portfolio investments, which reversed a USD 268.04 billion in net inflows in 2016 to a USD 195.68 billion net outflow in 2021 according to World Bank data. Global investors were not keen on investing in low-yielding stocks and bonds when other central banks were raising rates.

BOJ’s rate hike has always been a question of when, not if, as the country struggled with low growth, deflation, and sluggish wage increases. The 2.1 per cent average increase in Japanese salaries recorded in 2023 had been the final piece which the central bank had been waiting for to raise the policy rate. By that time, GDP growth had been outpaced by rising consumer prices in the last two years. Japan was the last country to exit the negative rate regime – a move that is being regarded as “too little, too late” as the cheap rates did not translate to a major growth boost, as seen in Graph 1, with recent expansions largely attributable to base effects. 

The BOJ had been cautious about raising interest rates, so the July hike came as a shock. Japan’s central bank also announced further reductions in its bond buying program to guide yields closer to 0.25 per cent, which provided an immediate lift to the weakening yen. High corporate profits are expected to lift growth prospects this year despite an increase in interest rates. 

Global impact

Positive interest rates mean that banks would start paying a humble amount to savers again while borrowing rates would be a tad higher. The central bank also announced it is abandoning its massive bond-buying activities for 10-year Japanese government bonds under its yield curve control, a monetary tool that sought to keep long-term interest rates below 1 per cent. Will this restore the appetite of global investors towards Japanese instruments? 

The rate hike came as markets anticipate interest rate reductions elsewhere, especially in the US, after combating an era of high inflation in 2022-2023. Nonnegative interest rates within Japan could trigger Japanese investors to unwind their placements on foreign bonds including US Treasuries, but this is unlikely to lead to large capital repatriations as yields in the US remain more attractive thus far. The 12 per cent stock market crash seen on 5 August illustrates the knee-jerk reaction of global investors dumping Japanese listed firms given renewed fears of a US recession. 

All eyes are on the US Federal Reserve as it cuts interest rates, which already amounted to a full percentage point between September-December 2024. 

A weak yen against the dollar, which breached the JPY 161 per USD 1 level in early July before appreciating to JPY 140 to USD 1 following the second rate hike, is likely to persist as US returns remain more competitive. The weak yen has been providing support to the exports sector, which grew for nine straight months to August. However, the yen depreciation is raising the cost of gross government debt, which accounted for 250 per cent of GDP in 2023, according to the International Monetary Fund. For comparison, the US’ debt-to-GDP ratio is at 119 per cent in the same period. 

As illustrated in Graph 2, Japan’s 10-year bonds responded to both rate hikes with even lower yields initially after the BOJ’s announcement, opening opportunities for investors looking to diversify their long-term asset holdings. However, it remains well below the interest rate on US Treasury bonds. 

These trends suggest that a substantial rise in returns on Japanese bonds is unlikely to come soon as these will depend on the timing and magnitude of the BOJ’s next moves, coupled with monetary policy decisions elsewhere. 

BOJ Governor Kazuo Ueda sees the need to tread carefully to observe if Japan’s GDP growth and within-target inflation will hold before delivering another rate hike. Ueda, now branded as a hawkish central bank chief, expects higher wages to fuel increased consumer spending that will, in turn, prop up faster economic activity. Japan’s aging population and preference for household saving, however, limit the promise of increased private consumption.

This original article has been produced in-house for Lundgreen’s Investor Insights by on-the-ground contributors of the region. The insight provided is informed with accurate data from reliable sources and has gone through various processes to ensure that the information upholds the integrity and values of the Lundgreen’s brand.