Bank of Japan rates pivot cause to cheer in China
BOJ’s shift away from negative interest rates and toward a stronger yen will provide China some much-needed economic relief
TOKYO — Xi Jinping’s inner circle in Beijing is probably breathing a little easier as the Bank of Japan steps away from 23 years of quantitative easing (QE).
On Tuesday (March 19), BOJ Governor Kazuo Ueda ended the globe’s last negative interest rate regime and scrapped Tokyo’s yield-curve-control experiment.
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Read moreIts new range for policy rates is between 0% and 0.1%, pivoting away from the previous -0.1% target. The BOJ’s step was essentially the smallest it could have taken without upending global markets.
The fact Ueda’s team stresses that credit conditions will remain accommodative suggests this is largely a symbolic move with few big financial consequences. Still, the BOJ’s excruciatingly delayed effort to normalize rates now begins in earnest.
Yet you can bet Beijing is paying close attention. No policy step might generate an economic tailwind for China — and tackle deflation — faster than a weaker exchange rate. Yet President Xi’s team has been reluctant to guide the yuan lower to avoid unnerving global investors.
A top Xi priority over the last eight years has been internationalizing the yuan. Manipulating the exchange rate might squander that progress. And draw Washington’s ire as a contentious US election approaches. Here, the specter of a stronger yen will cheer Team Xi.
To the extent that the BOJ is abandoning its zero-interest-rate policy and yield curve control, “and that this shift is likely to drive the yen higher, Chinese policymakers — and financial markets — can breathe a sigh of relief,” says economist Louis Gave at Gavekal Dragonomics.
As Xi and Premier Li Qiang work to shift growth engines from property and investment to technology and higher-value-added industries, it stands to reason that the market for China’s wares will be other emerging markets.
Selling cars, solar panels, batteries, trains, turbines, power plants and high-tech infrastructure will be easier as the currency of Asia’s No 2 economy appreciates.
“If the yen should start to rise, the outlook for China will improve dramatically,” Gave says. “Policy, geopolitics and financial markets will all start pointing in the same direction.”
Risks abound, of course, for Tokyo. One is Japan’s wherewithal to sustain the monetary tightening the nation has been dreading since 2007, the last time the BOJ tried to tweak monetary policy.
Japan barely avoided a recession in the second half of 2023. The economy contracted 3.3% in the July-September quarter year on year and eked out just 0.4% in the last three months of the year.
In January, household spending plunged 6.3% from a year earlier, the sharpest drop in 35 months.
The bull case for Japan centers on the results of this year’s shunto wage negotiation. On Friday, the Japanese Trade Union Confederation, or Rengo, announced an average 5.28% pay hike, the fastest increase in 33 years.
“This can be characterized as a virtuous cycle of rising nominal GDP growth, wages, prices and corporate profits,” says economist Jonathan Garner at Morgan Stanley MUFG.
Stefan Angrick, economist at Moody’s Analytics, adds that “after a dreadful run of economic data through 2023, the shunto surprise is the first good news in a long while. Key to watch in coming weeks will be how these negotiated pay increases translate into economy-wide wage gains and consumer spending.”
Yet it remains unclear how Japan Inc will respond to the BOJ taking the monetary training wheels off the economy with the developed world’s largest debt burden.
Since 1999, when the BOJ first cut interest rates to zero, corporate Japan has been marinating in free money. Even more so in 2000 and 2001 when the central bank pioneered QE.
Since then, the US, Europe, UK, Australia and other major economies also went the QE route, mostly in response to the 2008 Lehman Brothers crisis. All have since exited QE and set about normalizing rates. Except Japan.
Until Tuesday, of course. It now falls to Ueda to wind down the BOJ’s balance sheet in the months ahead without crashing the economy and setting off a global market panic.
One risk is the so-called “yen-carry trade.” Roughly a quarter century of zero rates morphed Japan into the top creditor nation.
It became standard practice for investors to borrow cheaply in yen and deploy those funds in higher-yielding assets around the globe. Sudden zigs in the yen can cause powerful zags in markets from New York to Mumbai to Seoul.
Hence the BOJ’s caution in stepping away from QE more decisively. Part of Ueda’s challenge is finding a way to withdraw from Japanese bond and stock markets without unleashing chaos.
Under Ueda’s predecessor, Haruhiko Kuroda, the BOJ amassed a titanically large balance sheet. First, it bought up more than 50% of all outstanding Japanese government bonds (JGBs). Its influence over the market became so overwhelming that on some days not a single security trades hands.
Next, the Kuroda BOJ cornered the stock market via huge purchases of exchange-traded funds. It became the biggest “whale” in Tokyo shares, bigfooting even the US$1.6 trillion Government Pension Investment Fund.
By 2018, the BOJ achieved another first in central banking circles when its balance sheet topped the size of its US$4.7 trillion economy. Trouble is, no economist or investor can say how the BOJ’s unwinding process might unfold — and where the risks lie for the economy and markets.
One nagging concern for Ueda’s team is what happened the last time the BOJ tried hiking rates. Back in 2006 and 2007, then-governor Toshihiko Fukui managed to end QE and cajole fellow board members to raise official rates twice.
It didn’t go well. Japan’s political and corporate establishments pushed back hard against the Fukui BOJ. Soon after, the economy slid into recession. Once Masaaki Shirakawa replaced Fukui in 2008, his first priority was to slash rates back to zero and restore QE.
Then Kuroda supersized BOJ stimulus efforts to defeat deflation once and for all. In 2013, the year Kuroda took the helm, the Nikkei 225 Stock Average surged 57%. And it kept rallying, to the point where the benchmark is now trading near its all-time 1989 high.
Though the Nikkei’s 49% jump over the last 12 months partly reflects improving corporate governance in Japan, the BOJ’s largess is a major driver. It follows that the hard part is only just beginning.
It’s an open question how the broader financial system will withstand rising JGB yields. If 10-year rates rose to, say, 2% or even 3%, no one can say what it might mean for banks, companies, local governments, pension and insurance funds, endowments, universities, the postal system and retirees.
JGBs are the main financial assets held by these interests and others.
For years, economists buzzed about a “mutually assured destruction” dynamic with which Ueda’s team must not contend. The other issue is the implications for a national debt that’s roughly 265% of GDP. Given Japan’s shrinking and aging population, any surge in borrowing costs would alter the fiscal calculus for Prime Minister Fumio Kishida’s administration.
The onus now is on Kishida’s government to accelerate economic reforms to cut bureaucracy, modernize rigid labor markets, rekindle innovation, increase productivity and empower women. Such moves and others will dictate whether the vast majority of Japanese companies hike wages.
“The wage growth we have seen, especially from the Rengo wage talks, has provided confidence that this is the opportunity to end the zero-interest-rate policy with the support of government officials,” says Howe Chung Wan, head of Asian fixed income at Principal Asset Management.
At this current juncture, he says, “Japan large corporates still have room to hike pay, given corporates sales and revenue are up higher and wages still have room to catch up. There will be a point where higher pay will squeeze corporate margins, but that’s at least another year later. Smaller companies, however, may not have the same ability to pay what large corporates do.”
Given the glacial pace of economic upgrades in Tokyo, Ueda arguably has the hardest job in global economics. One of his biggest challenges is the fragile state of Japan’s regional banking system. Namely, the risk of a Silicon Valley Bank-like blowup amongst Japan’s 100-plus regional lenders.
SVB’s crash in early 2023 is back in the news as New York Community Bancorp stumbles. Japan’s vast network of medium-sized lenders service rapidly aging communities in sparsely populated areas of the country. That squeezed profits well before the banking shocks of the last 15 years, including fallout from the 2008 global crisis.
The exodus of Japanese companies and talent to Tokyo is leaving less business to go around. Despite hard times, Japan’s regional banks have been reluctant to merge, perpetuating this financial overcapacity.
With profit opportunities limited, many spent the last decade hoarding government and corporate bonds instead of lending the BOJ’s credit. It was a similar practice that helped blow up SVB and New York-based Signature Bank.
In September, Japan’s Financial Services Agency announced plans to stress-test at least 20 banks to surface any SVB-like landmines across the nation. Part of the worry is the specter of similar social media-fueled bank runs.
Yet the broader implications of a BOJ misstep will keep the global financial system on its toes.
As Padhraic Garvey, economist at ING Bank, notes, “there have been occasions in the past decades where movements in Japanese government bonds have had a material effect on the wider bond market.”
There are two elements to watch, Garvey says. “First, the likely unshackling of the 10-year JGB opens a vacuum to the upside, and an issue is how far into that vacuum do JGBs venture,” he notes.
“Second, the loosening of the reins on the front end through ultimate policy tightening questions the carry trade that has bolstered performance of spread for an extended period of time.”
Garvey adds that “our gut tells us there is more room for movement in longer-term rates, versus the policy rate, but moves are not likely to be significant.”
For now, traders and investors are scrutinizing the BOJ’s every utterance for hints of what’s ahead. So far, Ueda’s team isn’t saying much.
“With decreased clarity of forward guidance especially the pace of rate hikes and the terminate rates, as well as the end of yield curve control, we are monitoring any developments at long end of the curve – maturities over 10 years – and change in demands for overseas bond investments,” says Kensuke Niihara, Japan chief investment officer at State Street Global Advisors.
Yet arguably no major economy is more interested in that forward guidance from Tokyo than China, which stands to benefit significantly from a rising yen this year. A firmer yen could increase Chinese competitiveness without Beijing policymakers having to lift a finger – and make China the real winner as the BOJ finally calls it quits on QE.
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