BOJ’s Small Rate Hike May Have Big Ripple Effect Around the World

The Bank of Japan finally ended an eight-year experiment with negative interest rates that has left more than $4 trillion in funds hunting for higher returns abroad. What comes nextthreatens to shake up money flows in Japan and across the world.

One of the biggest questionsis what happens to that big ball of money stashed overseas in assets including US government bonds، European power stations and Singapore equities. So far، markets have taken Japan’s first interest-rate hike since 2007 in stride،as the yield differential stillremains wide with other major economies. The yen even weakened slightly، with traders citing the BOJ’s promise to keep conditions accommodative as a sign there won’t be rapid tightening ahead. But the longer term effect is less certain.

Stocks hitting record highs

Within Japan، concerns persist about thefallout on consumers،businesses and government finances. Japanese stocks have recently hit record highsand workers won their biggest wage gains in three decades، fueling hopes that the nation can sustainably boost consumption and leave behind deflationandeconomic stagnation.

But the prospect of higher borrowing costs is also weighing on households، particularly as prices have been rising faster than wages. The economy narrowly avoided a recession at the end oflast year، slipping behind Germany to become the world’s fourth-largest in dollar terms. The stock boom is also partly the result of aweak yen، which has lost over 20%of its value against the dollar since Japan adoptednegative rates in 2016.

“The large-scale monetary easing policy served its purpose،” Governor Kazuo Ueda said Tuesday as he announced the end of the most aggressive monetary stimulus program in modern history.

Here’s what it means for everyone frominvestors and CEOs to Japanese taxpayersand Prime Minister Fumio Kishida، who faces a leadership contest later this year:

JapanGovernment Bonds

The most obviousconcern iswhat happens to Japan’sgovernment debt، which is worth more than250% of gross domestic product —the highest among developed nations.

The BOJ said it will continue to buy long-term government bonds as needed، even after it also scrappedthe yield curve control program and endedits purchases of exchange-traded funds. But Ueda، who took the reins of the central bank 11 months ago، said that trimming backthe BOJ’s balance sheet was something he needed to consider even if he didn’t disclose a timeframe.

“I wouldlike to consider atsome point in the future lowering the amount of our government bond purchases،” he said.

The BOJ owns around 54% ofthe nation’s government bonds، compared with some 12% in 2013 before the central bank began its massive purchases of JGBs. Debt-servingcosts alreadyexceeded25 trillion yen ($168 billion) in fiscal 2023، around three times Japan’s annual spending ondefense.Higher rates will now make this costlier.

Yen Repatriation

The yen has fallen around 10% against the dollar in the past year، the most among the 16 major currencies tracked by Bloomberg، as other central banks tightened policy to rein in inflation. Investors have seen the yenas a popular vehicle for carry tradesagainst higher-yielding currencies، especially in emerging markets. The BOJ’s shift could change this.

But the even bigger fear has been a reversal in the flow of trillions of dollars in Japanese investments،which market players had feared could send shockwaves through the global economy. Japanese investors are the biggest foreign holders of US government debt، with more than $1.1 trillion at the end of August.They also own significant stakes in Australian debt and Dutch bonds.

Investors are hoping that any further BOJ rate hikes will beslow and non-disruptive، limiting the likelihood of any destabilizing repatriation of funds.ABloombergpollfound that only 40% of respondents sawa BOJ move as prompting large salesof foreign assets.Analysts said the BOJ had already given markets plenty of warning about an eventual shift.

“The Bank of Japan has been very clever with its messaging، and markets have had a year to digest what the implications will be for global markets،”said Stephen Miller، a four-decade markets veteran and consultant at GSFM in Sydney. “To some extent، global investors have even pre-empted the move.'”

Japanese Businesses

A stock market rally in February sent the blue-chip Nikkei 225 to a record high، overtaking levels reached in 1989 during the peak of Japan's asset-market bubble. The gauge climbed further in March to break through the psychologically significant 40،000 level، bolstered by signs that companies are getting serious about improving shareholder value as well as an endorsement from overseas investors including Warren Buffett.

Price gains، wage hikes and higher borrowing costs meanthe return of a more normal business cycle for Japan’s 3.7 million companies. For the first time in decades، workers are demanding —and winning —pay raises.And businesses are relearning how to pass on higher costs to customers.

But higher rates will deal a blow to highly indebted enterprisesthat have effectively been kept on life support thanks to decades of ultra-loose monetary policy.Tokyo Shoko Research estimates that about 565،000 companies are “zombie” firms struggling to pay off debts from profits alone، and a0.1 percentage point rate rise would increase that number by about 12% to 632،000.

That means more bankruptcies are likely in the months ahead. The number of companies declaring insolvency has already risen for 23 straight months، climbing 23% in February from a year earlier. Small- and medium-sized businesses، which make up 90% of enterprises in Japan، will be the hardest hit.

Bank Margins

One beneficiary of tighter credit will be Japan's banking sector، which has long complained that the BOJ's ultra-low rates weighed on their earnings.

Banks including Mitsubishi UFJ Financial Group Inc.، Sumitomo Mitsui Financial Group Inc. and Mizuho Financial Group Inc. are all set to enjoy a boost tolending income.With the bulk of loans based on floating rates، the changes inBOJ policy rates are likely to have an immediate impact. For instance، MUFG has said that net interest income at its core banking unit will increase by at least 35 billion yenif the BOJ raises its policy rate to 0% from minus 0.1%.

On the trading front،securities firms are expected to profit from increased client volumes onfixed income and currency trading desks. Rates traders across Tokyo، who deal in government bonds and other securities linked to interest rates، are expected to profit the most.

''The bond trading draught in Japan is finally over،'' said Mark Williams، alecturer in finance at Boston University who wrote Uncontrolled Risk، a book about the 2008 global financial crisis. ''The anticipation of higher central bank rates and increased bond price volatilityhas already translated into greater trading volume. These rate hikes in the world’s third-largest bond market will supercharge trading profit opportunities.''

Consumer Impact

The BOJ's benchmark rate of -0.1% had been a pillar of its easy policy under former Governor Haruhiko Kuroda، who adopted a "shock-and-awe" program of unconventional easing and massive asset purchases in a bid to spur price gains. Initially intended to last just a couple ofyears، such easing became difficult to abandon due to fears of triggering a jumpin rates or sending the economy back into deflation.

Worriespersist that the central bank’s pivot، rather than heralding an era of strong growth، could set back consumer confidence.A rapidly aging population and shrinking workforce mean economic growth is likely to remain subdued، leaving many consumers cautious about spending and investing. Despite salary gains to come from recentunion negotiations، overall wagegrowth still lags behind consumer inflation.A survey by public broadcaster NHK this month found that morethan 80% of Japanese peopledidn't feel the economy was improving.

That’s why the BOJ has been so cautious about shifting back to normal policy، even as it became the last major central bank with negative rates.It wasn’t until the supply shocks triggered by Covid-19 and Russia’s war in Ukraine that inflation crept above the BOJ’s 2% target and stayed there.The bank has misjudged timing before.

Tightening in 1989-1990 helped trigger the burstingof Japan's asset bubble، and crushed the economy for more than a decade. The BOJ then hiked rates in 2000 when prices were still falling،in a move later seen as premature. One board member who voted against the decision at the time was Ueda.

Political Impact

Weighed down by scandals and the lowestapproval ratings in decades، Prime Minister Fumio Kishida now has an opportunity to officially declare Japan’s deflation over — a long-sought goal that his predecessors failed to achieve after agreeing to a joint policy accord with the central bank in 2013.

Bigger paychecks، along with one-off tax cuts starting in June، mighthelp Kishida shift the public’s attention to economic positives and awayfrom a series of scandals within his long-ruling Liberal Democratic Party، including slush funds andties with a fringe religious group.Reversing the poor poll resultswill be crucial for Kishida to stay in power through September،when the LDP holds a leadership contest. Some expect ageneral election shortly afterward.

The prime minister is likely to tout the BOJ move as positive for his vision of a growth model in which prices، wages and investments all rise hand in hand. But any negative fallout on the broader population could further damage support for his cabinet.

The BOJ’s move will increase government borrowing costs، making it harder to counter economic shocks with debt-fueled stimulus measures. Kishida may be forced to make the case forunpopular items like tax hikes for a promised surge in defense spending. And even as he claims credit for lifting Japan out of a deflationary spiral، this may not convincevoters who are seeing inflation erodetheir household budgets.