No. 28 — July 21, 2000


Weekly Review

--- by Douglas Ostrom

For months, Bank of Japan officials have been dropping hints that the central bank soon would end its 17-month policy of maintaining interest rates at zero or thereabouts on the financial instruments it controls most closely. By the week before the July 17 Policy Board meeting, a majority of analysts were predicting that BOJ finally would take the plunge. They noted that the market appeared to be factoring in an increase of roughly a quarter of a percentage point on comparable instruments outside BOJ's direct control.

Instead, the July 17 meeting concluded with the announcement that rates would remain the same — at least for the time being. While neither the minutes of the deliberations that led to that outcome nor the votes on either side of the argument will be made public for several weeks, one obvious reason for the standpat decision suggests itself.

That explanation is rooted, of course, in the July 12 bankruptcy of department store operator Sogo Co., Ltd. and related group companies (see following article). Analysts are virtually unanimous in predicting additional corporate failures, particularly among other technically bankrupt companies that also had hoped that the government would participate in workout plans to keep them afloat. The possibility of a chain reaction of business failures was enough to send shock waves through the Japanese stock market; the shares of construction companies, which are considered the most vulnerable to collapse, were especially affected. By the time of the BOJ meeting five days later, the extent of the slump in overall business confidence was difficult to fathom but arguably had changed enough minds on the Policy Board to defy the conventional wisdom.

The Sogo bankruptcy by itself may not be a sufficient explanation, however. Although 17 of 28 economists polled by Reuters just before the Policy Board meeting predicted that BOJ would leave interest rates unchanged, 10 of 13 surveyed market participants thought that the central bank would lift rates. Those who expected BOJ to act cited the central bank's concern — or obsession, some might say — with maintaining its independence from politicians, who, in the wake of the Sogo bankruptcy, predictably were jawboning in favor of continuing the zero interest-rate policy. Prime Minister Yoshiro Mori, for example, warned BOJ July 14 that a rate hike could rattle the markets. Buttressing the perception that the central bank was resisting this pressure, BOJ Governor Masaru Hayami ended a speech the same day with an allusion to the importance of the bank's independence.

Yet in the end, elected officials appeared to have the upper hand. Over the July 15-16 weekend, a consensus developed around the strong likelihood that the central bank would keep the overnight interbank lending rate close to zero. Asked the morning of the Policy Board meeting if he thought BOJ would switch monetary gears, Economic Planning Agency Director General Taichi Sakaiya told reporters, "[n]o, I don't think so." Given Mr. Sakaiya's response, the markets probably would have interpreted a BOJ rate hike as indicative of a lack of communication among Japan's economic policymaking team and reacted very negatively.

Most analysts believe that the Sogo bankruptcy persuaded the central bank to postpone a rate increase for only a few months at the outside. In fact, BOJ could reverse itself as early as the next Policy Board meeting, set for August 11. A statement that accompanied its July 17 decision contributed to this perception. The release began by noting the overall improvement in economic conditions this year — a view that dovetails with that of EPA, which, in its July economic report, released July 14, used exactly the same relatively upbeat language that it had employed in June (see JEI Report No. 24B, June 23, 2000). The statement added: "Given the above considerations, the majority of the Policy Board views that Japan's economy is coming to a stage where deflationary concerns are dispelled, which the Board have clearly stated as the condition for lifting the zero interest rate policy."

However, making a rare reference to a specific company, BOJ hinted at why it had not acted now:

At the Meeting, however, some views were expressed that before reaching a final decision to lift the zero interest rate policy, it was desirable to ensure the judgment on the firmness of economic conditions including employment and household income. Besides, it was pointed out that the Board needed to see how the commencement of reconstruction proceedings of Sogo Co. could affect market developments and business sentiments.

This comment suggests that but for the Sogo bankruptcy, the Policy Board would have voted to raise rates and, barring a sharp economic reversal, will do so in the near future. However, it also indicates that monetary policy will remain hostage to economic developments, which may include the bankruptcies of some major contractors.

Policy Board members clearly had to deal with contradictory economic forces at their July 17 meeting. The second-largest corporate bankruptcy ever in Japan unquestionably called for some sort of calming action. Yet, several people on the board have advocated higher interest rates in order to discipline Japanese companies. Extremely cheap borrowing costs, it is argued, discourage businesses from taking the necessary steps to restructure. Moreover, low interest rates induce moral hazard because firms are rewarded handsomely if risky investments pay off but barely suffer if they do not. Such asymmetry of risk is thought to create a bias toward excessively dicey investments. This argument implicitly says that Japan needs more Sogo-style bankruptcies to improve resource allocation.

The BOJ decision sends the signal that, for the moment, economic stability takes precedence over economic restructuring. In terms of a now-popular Japanese metaphor, the central bank, having concluded that it can only profitably chase one rabbit at a time, has opted to contain the hare spreading the "chaos and confusion" that could appear in the wake of a major corporate failure.

Mori administration policymakers have clearly indicated that they consider the Sogo bankruptcy — which occurred during a time of zero interest rates — to be an undesirable development; other big bankruptcies in the pipeline could be just as bad. A boost in interest rates, the powers-that-be have warned, would lead to even more corporate failures.

If the government's line of thinking comes to dominate BOJ decisionmaking, then interest-rate boosts will have to wait until the economy recovers to the point that it has lifted, if not all boats, at least a fair number of the currently grounded vessels like Sogo. Given the seemingly equal possibilities that Japan's economy will edge ahead at a percent or two a year or fall prey to another recession, BOJ's zero interest-rate policy, or something very much like it, may be longer-lived than the central bank statement and the consensus forecast suggest.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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