The Bank of Japan’s tricky path to normalisation

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For market watchers, the prospect of Japan’s interest rates rising into positive territory became more unnerving with each passing year. The longer borrowing costs remained below zero, the more traders and investors — at home and abroad — became accustomed to it. A reversal of that status quo risked upsetting financial stability. But on Tuesday, after eight years in the negative, the Bank of Japan governor Kazuo Ueda pulled it off in smooth style. He raised rates from -0.1 per cent, to a range of 0 to 0.1 per cent, and called time on yield curve control. Global markets took it all in their stride.

That is down to the BoJ’s prudent choreography. It gradually loosened its approach to YCC in prior meetings to avoid abrupt market moves. Its decision was well signalled, allowing traders time to price it in. The central bank also decided to continue buying Japanese government bonds and made clear that rates would not march higher any time soon.

Outright tightening still seems far off. Most analysts do not expect recent wage growth to be maintained, and near-term inflationary momentum has waned. The BoJ nonetheless needs to continue to tread carefully. Markets will want to decipher the central bank’s plan for normalisation, so its next steps take on even greater importance. Financial exposures, forged during the BoJ’s ultra-loose era, have not gone away.

First, in the hunt for better than near-zero returns at home, Japanese institutions, including pension funds, life insurance companies and banks, have become major international investors. International portfolio investments were over $4tn at the end of 2023. Japan is the largest foreign holder of US government debt. Higher yields back home could tempt Japanese investors to retrench, reducing demand for US and European government debt in the process. Higher hedging costs have already prompted some to do so. The yen has also been the funding currency for carry trades, where investors borrow in low-cost yen and swap it for higher-yielding dollars.

The second source of risk comes from Japan’s public finances. At around 2.5 times the size of its economy, Japan’s debt is vulnerable to any uptick in yields and reduced bond-buying by the BoJ. Institutional investors with significant asset holdings in Japanese bonds could face losses if domestic rates move higher. For commercial banks, higher rates will boost net interest margins, but regulators are alive to the risk of Silicon Valley Bank-style dynamics from any losses on assets. Indeed, few bankers have experience of a rising rate environment. Borrowers accustomed to low rates could also face difficulty.

Third, in their search for yield some Japanese banks have engaged in riskier lending abroad. For instance, shares in Tokyo-based Aozora Bank recently slumped after it flagged losses tied to its US commercial property book. These exposures could have a knock-on effect at home.

For now, any major repatriation of investments or unwinding of the carry trade is unlikely. US bond yields are still significantly more attractive. A sharp and rapid step-up in the BoJ’s policy rate, which could also drive a significant appreciation in the yen, is off the table too. In any case, the central bank appears willing to intervene to support financial stability. But vigilance is important. Even if Japan’s policy rates do not move unpredictably, America’s might. That will affect spreads, exchange rates, and hedging costs. Other economic shocks could alter Japan’s domestic growth, inflation and public finance outlook.

The BoJ made a significant step on Tuesday. But the journey to normalising Japan’s monetary policy remains a long slog. Financial threats lurking after years of sub-zero rates have so far been tamed — in no small part down to the central bank’s clear and careful approach. That must now continue.