January 29, 2016, 17:00 JST

BoJ opens the negative rate floodgate

BoJ surprised the market by taking an easing action on January 29. It was a bold move, introducing a negative central bank policy rate for the first time in Japan’s history. From February onward, the BoJ will levy a 0.1% charge on the excess reserve held by financial institutions. The negative interest rate will be levied only on the incremental increase in their excess reserve over what they had on average in 2015. In effect, financial institutions will be playing the equivalent of the card game Old Maid in which players keep swapping cards to avoid a Joker card. As the BoJ injects liquidity in the money market, the financial institutions will be trying to get rid of the liquidity by buying assets to avoid paying 0.1% interest rate on their liquidity. Such aversion to excess liquidity will drive the money market rate downward and should lead to a flattening in the yield curve. In our view, the yen yield curve will probably go through a sizable flattening in the next few months. We will not be surprised to see negative yield spreading to long term interest rates in Japan., Now that the BoJ has opened the floodgate of negative rates, markets will respond to negative economic news by pricing in further cuts in the central bank policy rate.   

What will be the impact on the market and the economy?

In our view, the governor Kuroda was correct to overpower the dissenters on his board. Three years into Abenomics, the initial euphoria is long gone, and there are increasing skepticism over the seriousness of the Japanese policy makers over if they are even trying to achieve the goals, let alone if they could actually achieve them. The skepticism is especially damaging for the BoJ as the concept of credibility is particularly important for central banks. A monetary policy works largely through the central bank’s ability to influence the expectation of the market and of the general participants in the economy. The market has been somewhat skeptical, even at the beginning of governor Kuroda’s tenure at the BoJ, and in recent months, there is almost a consensus among economic forecasters that he will not be able to achieve his goals. Today’s action should help him regain some of the lost credibility.

How much of a silver bullet is the move?

While we consider the BoJ action today as a step in the right direction, it is definitely not a silver bullet that could instantly kill the deflation risk. In our view, there is a significant risk of a global economic downturn in 2016 and the BoJ alone cannot turn the global economic tide. Having said that, the step today is still a significant move as it opened wide the possibility of negative interest rates, breaking the so called zero bound. When we consider the dire long term economic outlook of Japan, for example the rapidly shrinking working population in Japan and the accompanying negative growth implication, a negative long term interest rate seems only natural for Japan.

In our view, negative interest rates should be effective in drawing out demands on goods and services. Who wouldn't want a negative interest rate on their housing loans? 

The BoJ action today was also a pre-emptive move against yen appreciation. Despite the favorable corporate pofit and exchange rate environment, Japanese manufacturers have been surprisingly cautious in investing in Japan. While their profit has already surpassed that of their recent peak in 2008, the level of capital investment is still some 10% lower than the previous peak. The possibility that yen could suddently start to appreciate, as it did happen in 2007-9, is one fear factor holding back Japanese manufacturers from investing in Japan. By showing that the BoJ is willing to drive down the short term interest to counter any sudden appreciation in yen should help mitigate such risk of a sudden and unstoppable yen appreciation.  

What will be the impact on financial institutions?

The total amount the BoJ will charge on the excess reserve will not be large. As of January 20 2016, there was a total of 256 trillion yen current deposits on the BoJ accounts, up from the average of 223 trillion yen in 2015. That’s an incremental increase of 33 trillion yen. If the financial institutions were to pay 0.1% on this incremental increase, that’s 0.033 trillion yen on an annual term, less than 0.3% of the recurring profit of 13 trillion yen Japanese financial institutions made in FY2014. Toward the end of 2016, the incremental increase will probably grow to 100 trillion yen, but the levy will still be less than 1% of their recurring profit. The negative interest rate should not have significant adverse effects on financial institutions, other than encourage them to exit the JGB market and do what they should be good at, lending to individuals and to businesses.