Negative rates, the Japanese way
Maxime Alimi is part of the research & investment strategy team at AXA Investment Managers.
The negative interest rate regime in Japan is likely to circumvent banks and target currency and market financing.
It has three main implications: i) the Bank of Japan has room to cut further and is likely to use it; ii) significant risks of financial market disruptions and iii) financial repression for institutional investors.
The decision by the Bank of Japan (BoJ) to introduce negative interest rates in late January took the market by surprise and received a rather cold welcome.
Since then, Japanese government bond (JGB) yields have collapsed but the Japanese yen has appreciated sharply and equity markets sold off in the midst of rising global volatility.
In our view, the BoJ played a role in the recent market correction as it sharpened the market’s pessimistic assessment of central banks’ potency to address sluggish growth and inflation. The BoJ’s decision was taken under pressure, was the source of considerable dissent among the Policy Board and failed to provide a convincing rationale.
As a result, it appeared to some market participants that this was evidence of the BoJ losing its battle against deflation. Since then, the BoJ has polished its message about negative interest rates, having learnt from its critics and from the European experience.
The outcome is an original model for negative rates that we attempt to lay out.
It is especially important as the ECB is also considering a tiered system for deposit interest rates in the euro area and may take a close look at the BoJ’s scheme.
A good place to start is by comparing the stylised graphical description of the tiered system in January and now. The pink area representing the share of bank reserves charged at negative interest rates has become much smaller, with an indication that its size is not intended to grow much above ¥10trn.
Accordingly, the definition of the second tier – the macro add-on balance – was adjusted to include ‘add-ons decided at the monetary policy meetings’. In other words, the BoJ has full discretion to increase the tier charged at 0% so as to limit the size of the third tier. As a result, Japanese banks have, and will continue to have, only a very small share of their reserves effectively taxed, unlike in Europe.
The system is designed to ensure that banks bear very little of the cost associated with negative rates and that the policy rate level only influences the marginal cost of lending, not the average cost.
The consequence is that banks are very unlikely to pass on negative rates to their clients either through deposits or loans. The rate charged at the second tier, 0%, will provide a hard floor to bank interest rates as long as financial institutions are reasonably confident that the BoJ will increase the macro add-on balance alongside bank reserves.
However, limited acceptance of large deposits from corporates and institutional clients is likely.