The Economist on Japan 6

The Economist on Japan 6

Walking on eggshells

Dec 19th 2006 | TOKYO
From The Economist print edition
Although the recovery is still fragile, Japan should brace itself for interest-rate rises


TOSHIHIKO FUKUI, the wily governor of the Bank of Japan (BoJ), would dearly like to raise interest rates. But he decided on December 19th that holding off was the wise thing to do. Under Mr Fukui's stewardship, the BoJ has regained much of its lost credibility—thanks to the no-nonsense way it has purged a decade's-worth of dud loans from the banking system and created the conditions for the economy's continuing, albeit wobbly, recovery. In the process, the central bank has earned respect in political circles. And that has translated into less government meddling.

But with the new government of Shinzo Abe, the prime minister, hoping the fragile rebound will continue at least until next summer's upper-house election, the BoJ is treading cautiously. Mr Abe's office says that no pressure was put on Mr Fukui to hold rates when he was called in last week for a friendly chat. But it was made subtly clear that were the bank to slam on the brakes, then it would feel the wrath of the ruling Liberal Democratic Party. No one in political and financial circles will ever let the BoJ forget how it raised the key rate in 2000 from zero to 0.25%—only to lower it again six months later when the increase made deflation even worse.

The central bank is also sensitive to criticism that this summer it prematurely announced the end of Japan's debilitating era of deflation. After six years of essentially free money, the BoJ sneaked in a quick interest-rate rise—from zero to 0.25%—in July, hoping that this would not stop inflation inching higher. In fact, the core consumer-price index has drifted between zero and 0.1%. In Japan the core CPI includes energy prices but not those of food. After stripping out energy, inflation was actually negative in the past few months.

That has not stopped the central bank from making plans to raise its key unsecured overnight call rate to 0.5%. It is concerned about the amount companies have been pouring into capital investment. The rebound in commercial-property prices in Tokyo and other large cities has driven capital spending to new heights. Thanks to the rising value of their properties, against which they can secure loans, smaller firms now find it easier to borrow for investment—as their bigger brethren do. As a result, capital investment has gone through the roof. And although GDP growth for 2005 has lately been revised down (from 2.6% to 1.9%), it is thanks only to exports and capital investment that the economy has continued to expand since the recovery got under way in 2002.

The central bank is glad that the surge in capital spending has been there to support the economy, but it is anxious that things should not get out of hand. It is mindful of the way cheap money in the 1980s stoked up such a firestorm of investment in the private sector that stock and land prices soared. When the bubble burst in 1990, bad debts brought the banking system close to collapse and the nation fell into a decade of recession and deflation. After living through such a trauma, Mr Fukui is adamant that runaway investment should never again be allowed to wreak such havoc on the economy.

He is also concerned about the way Japan has been supplying much of the world's liquidity. With the Federal Reserve's key rate at 5.25% and the European Central Bank's main rate of 3.5%, the BoJ's ultra-low 0.25% has fuelled an unhealthy boom in the yen carry trade—as investors borrow cheaply in Japan to invest in higher-yielding assets overseas. Mr Fukui believes the dangers of keeping such a loose monetary policy for so long outweigh any short-term gains, and the sooner “normalcy” is achieved the better.

The BoJ had hoped that another small 25 basis-point rise could have been made at its monetary-policy board meeting on December 18th and 19th. The central bank's own quarterly Tankan survey of business sentiment, released on December 15th, confirmed that corporate Japan remains upbeat about future profits, with confidence spreading from large manufacturers to smaller firms. The survey also showed that job prospects and capital spending are rising as well. The one thing that prevented the nine-member policy board from recommending a rate increase was the lacklustre spending by consumers, reflected in the waning confidence of the big retailers.

Everything from inclement weather to job insecurity has been blamed for consumers' reluctance to spend. Yet even as company profits have soared (up a further 15% in the last quarter), wages have barely risen. As a result, households have had to dip into their savings to make ends meet. The Cabinet Office gives warning that the once-lauded savings rate, which peaked at 23% of household income in 1973, is now down to a Western-like 2.7%. With retirement beckoning for so many, there is a limit to how far Japan's ageing people are prepared to raid their piggy banks today. And since consumer spending accounts for 57% of Japan's GDP, growth will remain puny until companies spread more of their profits around.

Some firms may have started to do just that. The job market is tightening and company balance sheets are strong. Bankruptcies declined a further 15% in November compared with October, while overdue debts fell a solid 32%. All told, liabilities were down 50% on a year ago. As the economy approaches something like full employment, wages can go only one way—up.

Some people argue that private consumption is actually far stronger than the official figures suggest. The data are notoriously unreliable and are invariably adjusted months later. For what it is worth, the Cabinet Office's consumer-confidence survey rose in November for the second straight month. One way or another, the BoJ should have a clearer idea about how much people have been spending—and whether to risk raising its key borrowing rate—from late January onwards. But one thing is clear: Mr Fukui will eventually raise rates in the Year of the Boar—and not just once but probably several times. And that is something Mr Abe's government will have to get used to.