Sunday, 31 January 2016

Japan's negative rates: the China connection

Japan has just introduced negative rates on reserves, following the example of the Riksbank, the Danish National Bank, the ECB and the Swiss National Bank. The Bank of Japan has of course been doing QE in very large amounts for quite some time now, and interest rates have been close to zero for a long time. But this is its first experiment with negative rates.

The new negative rate framework is complicated, to say the least. The Bank of Japan has helpfully produced a pretty picture to explain it:

The bottom tier is a "basic balance" which is the existing reserve level in the banking system:
The average outstanding balance of current account, which each financial institution held during benchmark reserve maintenance periods from January 2015 to December 2015, corresponds to the existing balance and will be regarded as the basic balance to which a positive interest rate of 0.1 percent will be applied.
So existing reserves will (overall) continue to bear positive interest. Even banks that hold more than their benchmark level may avoid the negative rate, since the Bank of Japan has allowed for a reserve buffer at a zero interest rate:
A zero interest rate will be applied to the sum of the following amounts outstanding.  
a) The amount outstanding of the required reserves held by financial institutions subject to the Reserve Requirement System  
b) The amount outstanding of the Bank's provision of credit through the Loan Support Program and the Funds-Supplying Operation to Support Financial Institutions in Disaster Areas affected by the Great East Japan Earthquake for financial institutions that are using these programs  
c) The balance calculated as a certain ratio of the amount outstanding of its basic balance in (1) (macro add-on).  
The calculation will be made at an appropriate timing, taking account of the fact that the outstanding balances of current accounts at the Bank will increase on an aggregate basis as the asset purchases progress under "QQE with a Negative Interest Rate."  
Banks that manage their reserves cleverly will be able to avoid the negative rate on most of their reserves. Indeed, this seems to be the Bank of Japan's intention, according to a footnote:
A multiple-tier system is intended to prevent an excessive decrease in financial institutions' earnings stemming from the implementation of negative interest rates that could weaken their functions as financial intermediaries.
Those who think that the purpose of negative rates is to encourage banks to lend are now no doubt muttering darkly about bank lobbying and "revolving doors". But the negative rate is not about bank lending. It is in fact a further strengthening of Japan's "quantitative and qualitative easing" (QQE) programme:
The Bank will lower the short end of the yield curve by slashing its deposit rate on current accounts into negative territory and will exert further downward pressure on interest rates across the entire yield curve, in combination with large-scale purchases of JGBs.
And just in case this is not clear, the Bank of Japan explains in a footnote that the purpose of the negative rate is to influence market prices (my emphasis):
A negative interest rate is expected to exert its intended effects on financial markets even under the multiple-tier system where a negative interest rate is applied partially. Transaction prices in financial markets (e.g. interest rates, stock prices, and exchange rates) are determined by marginal losses or gains made in a new transaction. Although a negative interest rate is not applied to the total outstanding balances of current accounts, costs incurred with an increase in the current account balance brought by a new transaction will be minus 0.1 percent if it is applied to a marginal increase in the current account balance. Interest rates and asset prices will be determined in financial markets based on that premise. 
Thus there is no need to penalise banks heavily for holding excess reserves. The negative rate is not primarily intended to encourage banks to lend.

But why is the Bank of Japan so intent on cutting interest rates? After all, it has just produced a pretty upbeat forecast for the Japanese economy. Yes, household spending is weak, and wages are stagnant, but corporate profits are at record highs and unemployment at a record low. Inflation is hovering around zero, but that is largely because of falling oil prices, which is net positive for the Japanese economy as an oil importer. What on earth is this all about?

It's about China, mostly:
Recently, however, global financial markets have been volatile against the backdrop of the further decline in crude oil prices and uncertainty such as over future developments in emerging and commodity-exporting economies, particularly the Chinese economy
The external environment for Japan is becoming increasingly difficult. Central banks across South East Asia are cutting interest rates and putting downwards pressure on their currencies in response to collapsing commodity prices and China's slowing economy. The offshore yuan (CNH) is falling, and China is progressively devaluing the onshore yuan (CNY) in response, in addition to doing various forms of yuan monetary easing. China has now broken the CNY peg to the US dollar, replacing it with a basket of currencies: since CNY is no longer pulled upwards by the US dollar, devaluation seems likely to proceed faster despite China's tightening capital controls.

Japan's exports are suffering from the Chinese slowdown, and from emerging market weakness generally. The trend has been downwards for the last year:

Exports not only to China, but to its other South East Asian export partners - notably South Korea - have fallen significantly. Even exports to the US have recently fallen, despite the strong dollar. And although the balance of trade improved in December, this is only because imports fell even more.

For an economy as short of internal demand as Japan, an external trade collapse is something of a disaster. It has no choice but to respond to monetary easing by its South East Asian trade partners and hope that better times return soon.

Of course, no-one would dream of doing competitive devaluation to gain export advantage, would they? Perish the thought. The Bank of Japan says that the interest rate cut is all about inflation. And indeed it is. Cutting interest rates depresses the exchange rate, and depressing the exchange rate raises inflation. Perfectly legitimate behaviour for an inflation-targeting central bank.

But I'm sorry, they can call this inflation control if they want, but the effect is the same. Deflationary economies desperately seek demand from external sources that they cannot generate at home, and these days they do so by using interest rate cuts and QE to depress the value of the currency while pretending that it is all about stimulating the domestic economy. Japan's move is no different from that of other local central banks: it is externally-driven, and the target is the exchange rate, not domestic interest rates and bank lending. The only difference is that Japan's interest rates were already on the floor because of its long-standing domestic deflation, so protecting against an external economic slowdown inevitably meant negative rates.

This is why Japan has firewalled its banks with a complex three-tier scheme. It has created a structure that will enable it to cut rates far more deeply into negative territory without breaking the banks. There is more, much more, to come.

Related reading:

Yuan vs yen: how China figures into Japan's negative rates - Wall Street Journal
El-Erian says countries weakening currencies in fight for global growth - Reuters


  1. No longer a thing called a Japanese supply chain ending in the west.
    There is a Asian supply chain which is currently in the process of breaking down.

    The growth of EU28 imports into the UK deficit area continues to increase(possibly as a result of the Russia trade sanctions ) , Asian exports to the UK continue to stagnate.

    The increase in surplus EU production for export into the UK black hole with its rising urban population causes local and national commerce in the euro surplus colonies to collapse.

  2. The tale of 2 long and thin islands .
    Both with a highly concentrated urban population.
    Both "compete" for LNG coming out of Qatar.

    However one survives by exporting its wealth.
    The other imports wealth.

    Discuss .

  3. Almost all optical equipment consumed worldwide (cameras , binos ,scopes) is produced in China.
    The situation was completely different in the 1980s.
    I imagine this goes for most industries .

    In the process the Jap talent for execution of perfect design vanished.

  4. A earlier Jap (1950s)execution of the same design .

    If you understand the history of commercial optical design in the 20th century then you understand Japan.
    The imperial Navy lacked range finding as to compensate their optics were superb.
    This adoption of military technology and its conversion into the consumer war economy was a hallmark of the post war period.
    Indeed Johnny Carsons "All American " unitron refractor had superb American build quality but what was little known and not published for obvious reasons was that its optics was Imported Japanese.......

  5. How does Japan's efforts compare with no tiers for ECB negative rates?

  6. > Frances

    Do you think that a situation where the central Bank holds a lot of Government bonds that receive coupon payments serviced by tax payer's deposits , and thus slowly reduce the Deposits in the private sector has any repercussions.

    1. Not 100% sure what you're getting at there.

      It depends what the central bank does with the coupon payments. If they hang onto them, then it is simply a tax. If it refunds them to the Treasury then it is simply a redistribution (ASSUMING Treasury spends more to offset the drain).

    2. Also, some are paid to commercial bank reserve accounts as interest on Reserves.

  7. " . . . and QE to depress the value of the currency while pretending that it is all about stimulating the domestic economy."

    No pretence?

    This is what the 'Friedmanite' Monetarist has to say re QE.

    “In short, although the cash injected into the economy by the Bank of England's quantitative easing may in the first instance be held by pension funds, insurance companies and other financial institutions, it soon passes to profitable companies with strong balance sheets and then to marginal businesses with weak balance sheets, and so on. The cash strains throughout the economy are eliminated, asset prices recover, and demand, output and employment all revive.”

    1. Did you not read what I said about corporate profits and employment in Japan? The Friedmanite model does not apply there. This is about defending against an external price shock when there is chronically weak domestic demand. Other CBs in the region are doing the same, but their interest rates are higher because they don't have the same history of demand deficiency, so no-one paid any attention.

    2. That quotevis a theoretical state!ent. It is not reflected in what actually happened to the money. The largest chunk went via house prices into land prices, the next biggest chunk went into supporting consumer spending through credit cards.

  8. Fascinating! Thanks for the coverage.

    While that may have some impact on forex, and it is maybe the main intent of the measure today, are the banks really firewalled?

    Under such a regime, if the central bank does any measure that either increases total reserves (e.g. more QE) or lowers reserve requirements (e,g. change the reserve ratio) unless I'm missing something this will increase the banking sector's collective excess reserves, and so the higher the differential rate between required and excess reserves, the more incentive there is to lend more (if perhaps in non-economic regulatory arbitrage form) to avoid paying the excess reserve penalty.

    1. Cig, I've covered this extensively elsewhere. Negative rates may at the margin encourage banks to lend, but the risk vs return profile still has to be in their favour. The ECB says bank lending has improved since neg rates were introduced, but is this a direct effect of neg rates (hot potato) or simply because of an improving economy? Also, there is a counterfactual problem. Flat yield curves discourage bank lending, and QE flattens yield curves. Negative rates depress the short end, tilting the curve and hopefully restoring some semblance of normality. This alone should encourage bank lending - but is that simply the lending that banks would have done if QE hadn't squashed their margins? It's WAAY too simple to say that negative rates boost bank lending. Must look at the whole set-up.

    2. This comment has been removed by the author.

    3. Also to have the reserves leave their balance sheet they would have to lend to a borrower who intends to spend the money with a customer of a different bank.

    4. I agree it's hard to disentangle all the effects on bank lending, but then your arguments about aggregate demand and forex effects suffer from a similar entanglement issue.

      In the meantime, I'm trying to understand the basic mechanical effects this new rule introduces (we need to understand that before we can think system level). I'm quite confused so far. The innovation of pricing excess reserve at the margin should remove the floor on rates by avoiding all the bad things that happen if you set a very negative rate on the entire reserves. Now they could set the marginal rate at say -10%.

      What happens then? Do short bonds and the interbank rate go to -10% (Kuroda may hope that people will think that), or is it easy to circumvent and ultimately ignored, with no impact on other short rates, in which case the measure is pure PR? or something in between?

      @Dinero, if a bank creates loans worth the excess reserves times the inverse of the reserve ratio, its excess reserves disappear even if no money moves at all.

    5. The banks did lend more, first they lent more money on almost the same quantity of housing, sobraising land values. Secondly they lent through High Street banks on credit cards, scorecards etc. That simply increased consumption briefly at the expense of increased debt.
      I do not see how either of those can be said to be good for the economy in even the medium turn.

  9. @Frances
    Credit expansion of the car / bank corporates has expanded.

    Irish car sales up another 33% in Jan vs Jan last year ( January is the biggest sale month.

    Up 130% from 2013.

    But it just makes life more expensive and may possibly bail out BP.

    1. The legacy of ECBs policy .
      Increased costs .

      The use of consumer credit to drive inflation has now totally destroyed European and indeed Japanese civilization which was structured as a consumer war economy, selling to the global market post war.

  10. "Cutting interest rates depresses the exchange rate, and depressing the exchange rate raises inflation. "

    I'd have thought it more likely you'd just get a one off price adjustment. That isn't inflation per se.

    1. One off price adjustment is what seems to have happened. Yen dropped when the BoJ announced the negative rate framework, but has since stabilised.

    2. This comment has been removed by a blog administrator.

  11. The primary driver of inflation in the long 20th century was and is consumer and now capex credit.
    We can now see the collapse of the Brazil like economy of production / consumption leads to chronic and massive debt and price deflation

  12. The reduction of prices in Brazil is unexploited by the domestic population (lack of national dividend)
    Other waste based economies expand to exploit the slack.


  14. According to the Irish central bank new credit to resident drones of 1 to 5 years duration has exploded upwards .( this is almost certainly car loans)

    We must always see Ireland as the canary in the scarcity mine.
    The mission of the Irish should they choose to accept it is to raise the price of global oil........I wish I was kidding .
    The level of global centralized planning to the detriment of local regions is truly extraordinary.

  15. From a Social Credit perspective, the greatest problem with the existing economic order is that the conventional financial system is not designed to either recognize or to equitably distribute this free lunch. Instead, it allows the private banking system to use its current monopoly power over money-creation as a form of leverage so that access to the societal profit is only granted on asymmetrical terms. This results in the transfer of wealth, privilege, and power from the common citizenry to the financial elite. Production and consumption, the activities of the real economy, become beholden to the banking system and its operators. While many monetary reformers make the mistake of thinking that this problem is THE problem with the financial system, it is actually a secondary consideration. The more fundamental problem lies with the price system and its failure to monetize, for the full benefit of the consumer and thus on a gratuitous or debt-free basis, the unearned increment of economic association which is already a feature of the physical economy."

    Oliver Heydorn feb 2016.

  16. Without the car / credit hydra oil would be £5 ~a barrel.

    Let observe how credit drives oil consumption in the Irish petri dish.

    lrish central bank data .
    1 to 5 year credit (car loans) reached a Nadir in May 2013
    Car purchases began to recover in 2014.

    See chart 2 in the November 2015 edition of money and credit .

    And now car new car purchases.