Challenge

Interest rates are on rapid-rise trajectories across the developed world, transforming the economic landscape for everyday citizens and impacting everything from inflation to investments.

One major central bank is bucking the trend. The Bank of Japan has kept rates near zero since the late 1990s, and is maintaining its -0.1% level. The negative rate makes Japan an outlier even among other stalwarts of low-rate policies. The Swiss National Bank, for example, ended a seven-year era of negative rates with a hike to 0.5% in September 2022.

But what if a global economic slowdown forced Japan’s outlier status to change, and all major economies cut interest rates to zero?

A recent PGIM survey found that such a slowdown—and resultant broad adoption of a zero-interest rate policy (ZIRP)—is a top tail risk for institutional investors in Japan. While the probability of such an event is extremely low, it carries outsized potential to upend markets.

Impact

Because Japan’s interest rate is already negative, there’s little room for rate cuts that could match other central banks’ reductions, says Norihiro Yamaguchi, Senior Economist at Oxford Economics.

“You can raise the interest rate as far as you want, but you cannot lower it as far as you want,” he explains. “There is a floor even in the negative interest rate policy.”

Japan’s rate would therefore be much closer to other central bank rates than it is today—and this shift, Yamaguchi says, would cause the yen to appreciate significantly and create challenges for the Bank of Japan.

Even if the crisis that triggered rate drops didn’t impact Japan directly, it would still take its toll. In an echo of the Global Financial Crisis, Japan’s market could hold its ground while others collapse, but recessions in the US or eurozone would drag Japan’s economy into recession, too.

“The repercussions for the real economy will be significant, because we are an export-oriented economy,” he explains. “Exports will go down and investment will become sluggish.”

This, in turn, would put pressure on the profitability of Japanese companies, Yamaguchi cautions. In his view, the equity market would surely suffer.

Institutional investors would also find it difficult to make profits from currency hedging operations in countries struggling with the slowdown, as Yamaguchi expects that long-term rates would decline sooner and more significantly than short-term ones.

The damage wouldn’t be limited to Japan, however; the global economy would also feel the sting of these fallouts.

“The repercussions will probably be felt in the financial markets outside of Japan, because it will lead to some unwinding of the yen carry trades,” Yamaguchi predicts. “That will put pressure on Japanese institutional investors to bring back money from the outside.”

Dominoes will topple as Japanese investors pull money out of other countries. In one scenario, Japan swiftly retreats from the US Treasury market—and as the nation holds the largest amount of Treasuries of any foreign country, to the tune of over $1.2 trillion USD, the exit triggers a sharp US bond market liquidity crunch.

Takeaway

According to Yamaguchi, the BOJ has maintained its negative rate for myriad reasons—the potential growth rate for Japan is basically zero, he says, and the rate policy should be based on potential growth rate and inflation expectations. Unlike the eurozone or the United States, which is battling inflation in the realm of 8%, Japan’s inflation rate is just under 4%.

“The economy just started to recover—it’s not overheating,” Yamaguchi notes. “Inflation is exceeding the target, but it will prove temporary, because the wage is very sticky here; a wage price spiral is not happening.”

Yamaguchi says that for all these reasons, Japanese economists feel confident that the Bank of Japan will maintain its rates—which means that in the remote chance that other central banks did revert to ZIRP in the next couple of years, the scenario would likely unfold much as Yamaguchi describes.

Despite its low probability, Yamaguchi believes there’s value in envisioning the potential ripple effects, especially in this era of unpredictability.

“Constructing these different kinds of stress scenarios is important to help navigate a volatile environment,” he advises. “At the beginning of Covid, everyone was concerned about deflation. When former US Treasury Secretary Larry Summers said that inflation was coming, no one believed him, but it happened. That is a very good example that things can easily go in both directions.”