Authors: Shaun Ng and Bharat (Dan) Gangwani
Region Head: Bharat (Dan) Gangwani
Editor: Sasthaa GB (Uday)
Japan’s economic slowdown has been a pertinent topic when discussing the success of open market operations and quantitative easing. Its model as a low/negative interest rate economy appears to be the future for many developed countries. This paper begins with an exploration of Japan’s two decades of monetary policy operations to counteract its structural slowdown before identifying the reasons they failed at creating growth and suggests possible solutions that may help.
Japan exhibited strong catch-up growth in the second half of the 20th century. Their post-war economic recovery was an unimaginable miracle to many. Between 1945-56, Japan’s GDP per capita was rising at an average rate of 7.1% yearly (Tetsuji, 2015). By the 1980s, Japan had almost fully caught up with developed nations like the US and Britain. It had established itself as one of the world’s largest and most sophisticated economies.
But almost as quickly as it had shot up, its growth grounded to a halt in the 1990s. By 1994, Japan boasted a GDP of $4.9 trillion. However growth stagnated, so much so that GDP stood at $5.1 trillion in 2018 (The World Bank, 2020). Japan hasn’t seen any real growth for over a decade. This is due to several factors including a rising number of competitors within manufacturing and agriculture, industries where Japan specialised. However, the largest contributor to the inflationary and growth stagnation is their ageing population and its various knock on effects. Let’s take a deeper look at these factors, the measures Japan has taken against them and why they haven’t worked.
Fig.1 Japan: Inflation and GDP Growth, 1998-2019
The Initial Struggle (1991-2007)
Between 1991-2005, Japan was hit with their own banking crisis. The initial cause was an asset bubble burst. This was caused for three reasons. The first was that bank loans were invested into riskier portfolios such as property-related businesses and financial services. Secondly, many commercial banks were holding onto common stock, accumulating capital gains that were unrealised, just to increase their capital base. And lastly, there was an economic slowdown and price deflation in the 1990s that led to higher Non-Performing Loans (NPLs) (Fujii & Kawai, 2010).
In response to the banking crisis, the Asian Financial Crash and consumption tax hikes, the Bank of Japan (BoJ) mandate was revised with the goal of achieving price stability (Westelius, 2020). Its first agenda item was to decrease policy (reverse-discount) interest rate to 0.15%. Several weeks later, after the Japanese economy was still experiencing negative growth, this number was further decreased to zero, adopting what’s called the zero-interest rate policy (ZIRP). This proved to be successful as Japan’s economy started to show promising signs of recovery at the beginning of 2000 – stock prices of information, communication, and technology (ICT) related companies rose sharply. However, the recovery was very fragile, evidenced when the board decided to terminate the ZIRP early.
By Q42000, Japan was back to square one with growth at an all time low. To counter this, the policy rate was again cut from 0.5% to 0.35% in January 2001 (Yoshino et al., 2017). Quantitative Easing was introduced in February 2001, discount rates were cut to 0.25% and policy interest rates were dropped to 0.10%. On top of this, the BoJ started purchasing Japanese Government Bonds (JGBs), amounting to $400 million, every month. Despite these measures, growth remained negative between 2001 and 2003, prompting an increase in the purchase of JGBs and reduction in interest rates.
The impact of Japan’s expansionary monetary policy measures on short-term and long-term interest rates is visible in Fig. 2. The ballooning of Japan’s current account balance is primarily due to the rise in income payments from the foreign assets that Japanese residents started investing in due the dearth of returns available domestically (International Monetary Fund, 2020).
Fig. 2: Japan: Monetary Policy Operations, 1998-2019
A Fading Economy (2008-2016)
Before Japan could fully curb their great stagnation, the 2008 Financial Crisis forced them into even bigger shoes to fill. Overnight lending rates barely managed to stabilise in 2006 but had to be decreased again in 2008 to support financial recovery (Westelius, 2020). Japan saw themselves desperately reinitiating old tricks like quantitative easing and the ZIRP under the Comprehensive Monetary Easing framework to reduce term and risk premia, but their capabilities of implementing such policies were now more limited due to the excessive debt accumulated.
Prime Minister Shinzo Abe came into power in late 2012, putting in play a comprehensive policy package to rescue the Japanese economy. A 2% inflation target was introduced, with hopes of boosting potential growth and increasing competitiveness. Prime Minister Abe aimed to ensure long-run debt sustainability while the BoJ increased the annual purchase of its JGB holdings to 50 trillion yen. The steps were initially successful in boosting growth, but the success was short-lived. As the economy started to worsen in the second half of 2014, BoJ had to increase the annual purchases of JGB yet again to 80 trillion yen. These steps contributed to a massive increase in the money supply in Japanese economy with the BoJ’s balance sheet and long-term positions expanding drastically.
Fig. 4: Expansion in the Monetary Base and Japanese Government Bond Holdings (January 2000-June 2016)
The lack of real growth had the BoJ continuously expanding its JGB purchases (Westelius, 2020). This wasn’t helpful, however. Japanese household savings rate was falling due to an aging population and the lower economic growth rate. Firms were saving more than households, keeping these savings in banks and financial companies. Conventionally, banks lend out the money. But the decreased demand for loans in Japan’s economic climate caused bank lending to diminish and forced the commercial banks to hold onto government bonds instead (Yoshino et al., 2017). All creditworthy borrowers had dried up. Despite access to liquidity with commercial banks, there weren’t any productive opportunities to invest money in which meant that despite the expansion of the money supply by BoJ’s JGB purchases, the money wasn’t entering the economy. In short, Japan was in a liquidity trap.
Financial Innovation: A Chance at Rebirth? (2016 and onwards)
To address this, Japan tried to double down and conduct unprecedented financial engineering. Mainly, it initiated the Negative Interest Rate Policy (NIRP) in the first quarter of 2016. Unlike popular understanding, the negative interest rate was only imposed on excess reserves that commercial banks may deposit at the BoJ at the end of the day which they were unable to lend out. The intention was to put downwards pressure on short-term interest rates and raise inflation expectations, essentially brute-forcing its way through the liquidity trap. Policy rates on excess reserves in Japan have never been positive since.
However, it didn’t turn out just as expected. As seen in Fig. 2, the long-term yield fell below the short-term rate policy rate. Such inversions of the yield curve (long-term rates falling below short-term ones) are usually used to predict incoming recessions since at such a time, the market implies that consumers (and retail investors) do not have sufficient faith in the economy’s short-term prospects, driving the price of long-term bonds up and their returns down. Such a large compression of yields was unexpected by the BoJ.
Growth prospects for the economy weren’t helped by the fact that global growth and financial instability had already put downwards pressure on stock prices, appreciated the yen and led to weak credit demand. Bank loans actually decreased and the financial crunch that commercial banks faced due to negative interest rates on excess reserves was passed on to consumers as higher fees (Kihara, 2020) and pushed banks to engage in riskier practices such as buying and hedging foreign currencies (Yoshino et al., 2017).
By September 2016, BoJ realised that addressing these problems required a change in its policy. After a review of existing monetary policy measures and soaring debt, it pivoted towards greater flexibility in asset purchases and managing the interest rates along the yield curve. The idea was that it was unlikely if not impossible for inflation expectations to rebound as quickly as its previous target of 2% had intended (Yoshino et al., 2017). Hence, it’s objective was now to only focus on generating a consistent positive output gap while being realistic with any inflation targets that it sets. This meant that the BoJ would only emphasise raising consumer expectations about the economy by continuously expanding production without focusing on inflation directly.
These policy objectives were embedded in the new framework it adopted called the Yield Curve Control. The BoJ could now purchase JGBs along the yield curve, allowing it to maintain long-term interest rate above that of the short-term. Between 2016 and 2020, growth and inflation prospects improved slightly, with both stabilising slightly under 1%. At the same time, inflation expectations weren’t lifted permanently.
The little progress that Japan had made was again completely thwarted by the onset of the Coronavirus. Despite its lower restrictions surrounding movement and social distancing compared to other countries and lower incidence of cases and deaths (Kazuto, 2020), prices fell by 0.4% in 2020 YoY. Today, BoJ’s balance sheet stands at 135 percent of Japan’s GDP (Harding, 2020). BoJ also owns 7% of Japan’s equity market (Harding, 2020). Meanwhile it has persisted with its flexible approach towards managing interest rates, recently expanding its band for 10 year bonds from 0+-0.2 to 0+-0.25 percentage points (Harding, 2020).
Why aren’t NIRP and YCC working?
With an aging population, shrinking labour force, low rates of women in the workforce and an unfavourable environment for startups, it’s hard for Japanese creditors to find reliable borrowers despite the liquidity available (Yoshino et al., 2017). Given that 29% of Japan’s population is over the age of 65, corporates that were booming in the 80s and 90s have lost incentives to invest domestically (Harding, 2020). It’s in line with Keynes' accelerator theory which explained that autonomous investment in the economy is driven by a steady rate of economic growth. Due to a lack of investment-worthy opportunities, Japan remains in a liquidity trap with little circulation of the money that commercial banks received through quantitative easing.
Even housing isn’t a suitable investment vehicle for retail investors, which would’ve allowed money to enter the economy through mortgages. Despite the influx of population into Tokyo, leaving behind large swaths of vacant properties in smaller towns, the ease of high rise construction there has prevented a significant rise in property prices since the 90s (Harding, 2020). Simultaneously, the rate of depreciation for properties in Japan is quite high with an average building being replaced every 40 to 50 years, diminishing the need for newer buildings as people opt for lifestyle improvements. Since most existing buildings are easily replaced while new ones are quickly constructed to fulfil demand, the housing prices in Japan are quite stable, making housing an unattractive option for investors.
The long-term sustainability of the BoJ’s policies is questionable. Ross (2019) identified that due to the expansion in BoJ’s balance sheet, debt servicing costs reduced the potential for savings or investment, limiting future economic growth. The aging population also prevents the government from engaging in sustained expansionary fiscal policy since the burden of debt will fall on a smaller workforce in the future. This means that it engages in short term fiscal expansion with the presumption that it’d be eventually paid for by lowering expenditure or raising taxes in the future, as evident in its recurring premature policy normalisation practices (Westelius, 2020). However, this commitment may prevent the stimulus from being completely effective since people may just save the short term windfalls to pay for higher taxes later. This is a sinister catch 22 since the BoJ has often commented that monetary policy is unlikely to be an effective solution for Japan’s slowdown which is structural and demographic in nature (Westelius, 2020). However, structural measures that boost potential growth and competitiveness are likely to incur significant government expenditure.
This lack of monetary and fiscal policy coordination is very apparent in Fig. 5. While the fiscal and monetary policy impulses were in line up until around 2011, the government started down a more conservative path compared to the BoJ after that. Westelius (2020) argues that coordination issues between the government and BoJ don’t only prevent structural issues from being addressed but also reduce the effectiveness of BoJ’s monetary policy measures. This is apparent in the recessions or deflations that followed most premature fiscal policy normalisations (Harding, 2020), as discussed above. Additionally, the low-interest rate environment and aging population concerns have severely cut into the net interest rate margin of banks, affecting their profitability and raising doubts about the future of BoJ’s monetary accommodation (Westelius, 2020).
So what can Japan do?
The primary goal for Japan to escape its liquidity trap is to increase domestic consumption and investment, objectives it came close to achieving under Abenomics and even YCC for a while (Harding, 2020). The low-hanging fruits that it can capture include an increase in the retirement age and removing the protected pension income to ensure retirees compete at market wages, reducing the dependency rate.
Another potential approach is to pass on the negative interest rates to commercial actors who are large depositors, i.e. other companies, rather than just commercial banks (Rogoff, 2020). It’d necessite the preclusion of large scale cash holdings by insurance companies, financial firms and pension firms which Rogoff (2020) argues can be achieved through “various combinations of regulation, a time-varying fee for large-scale re-deposits of cash at the central bank and phasing out large-denomination banknotes.” The negative interest rates, at least in theory, should incentivize financial firms and other key players in the economy to increase investment activities such that they don’t incur a negative yield on their assets. Altavilla et al. (2020) recognize that European banks have been able to pass on negative rates to corporate clients, compelling a reduction in their liquid holdings and an increase in investment.
However, commentators like Skidelsky (2016) argue that negative interest rates may not have the desired effects, even in theory, due to a variety of intervening factors - while causing several undesirable effects. For instance, a reduction in interest rates may be expected to increase investment but it won’t happen if profit expectations fall faster than the rate of interest. In other words, if the rate of return on a company’s assets is even lower elsewhere compared to the negative interest rates then economic growth won’t occur. Investment may also not increase employment if consumption is falling since firms would lack sufficient incentive to invest perpetually. These scenarios are quite evident in contemporary Japan.
There are several other drawbacks of negative interest rates that Skidelsky (2016) recognises as well. These include a reduction in the profitability of banks, encouraging them to take excessive risks which may lead to asset bubbles. Several large sections of the economy turning to cash and pension or insurance companies finding it hard to meet long-term liabilities at fixed rates in a negative interest rate environment. Hence, the pros and cons of passing negative interest rates onto consumers need to be appropriately weighted before such a policy is undertaken.
Lastly, it’s important for Japan to have a serious discussion about immigration and what it means to be Japanese. The topic is explicitly political and the domain of the legislature as much as the economic. However, it’s crucial to note that the challenges Japan faces are demographic and structural in nature which are increasingly difficult to counter in any other way. Falling consumption, productivity and investment opportunities means that Japan is stuck with growing debt which further deteriorates the government’s fiscal potential. Given these facts, immigration of foreign labour would likely boost both consumption and local investment due to productivity gains and is a worthy candidate for consideration as a long-term solution.
Japan’s slowdown is structural in nature, concerning productivity and consumption issues primarily fueled by its aging population. Such a trend is unlikely to be counteracted by monetary policy alone. Even fiscal policy may only bear limited success, especially if undertaken trepidatiously, as suggested by the government’s track record. Due to these reasons, it’s extremely important for monetary and fiscal policies to coordinate and supplement each other’s objectives rather than acting in opposite directions. Additionally, a serious political discussion about immigration is long overdue for Japan to have any prospects for a long-term solution to the slowdown.
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