Changing of the Guards

Ichiro Suzuki

After a quarter century of printing money almost ceaselessly, the Bank of Japan has reversed its direction under Governor Kazuo Ueda. The BOJ has scrapped its zero interest rate policy, as inflation has returned after three decades. Having been stuck at zero or even lower interest rate since the latter half of the last decade, yields of the ten-year government bonds have been rising fast and are in the north of 1.5% by mid-March. Make no mistake, real interest rates in Japan are still negative with prices rising faster than 2%, but the gap is narrowing. 

In sharp contrast to Japan in recent months, long-term interest rates in China have been falling steadily for almost ten years, from over 4.5% all the way down to the south of 2% today. Breaking the 2% barrier to the south, China’s ten-year yields at one point were where those of Japan are today. Since then, they made a rebound in response to President Xi Jinping’s speech at the Two Sessions earlier in March. The Chinese president showed his determination to lift the ailing domestic economy. He made it clear that the ratio of government deficit to GDP be raised to 4% from 3% today. The statement sounded bolder than expected and led market participants to close their long positions on bonds, for now. 

While the benchmark ten-year yields are yet to be crossed between China and Japan, it has already happened on longer-maturity bonds. Yields of 30-year Japanese government bonds have leapt to 2.6% in March topping China’s 2.0%. China’s 30-year yields did rebounded from 1.8% in response to President Xi’s speech, but those of Japan rose truly fast. Developments in Europe might have affected an outlook in Japan. The February election in Germany has made a sea change in the country’s fiscal policy, ditching the constitutional ban on deficits, in the face of Donald Trump’s utter lack of interest in European security. Friedrich Mers may be rising on a historic occasion that is uniting Europe in defense of democracy. The market speculates that the same kind of pressure on national security is going to be felt in Japan. The country has long kept its defense budget at 1% of GDP and is trying to raise it to 2% or higher in order to make it fit to the circumstances of the 2020s. It is far from clear how such an outlay is going to be financed. Japan has an economy that grows only marginally with rapidly aging population that boosts welfare costs. Japan’s finances are going to be under pressure anyway. On top of it, politics is no longer as stable as it once was, requiring greater risk premium on its sovereign debt. Ten-year yields at 1.5%, therefore, is only a stepping stone. The world of interest rates is going through a regime change. Japan has left the age of zero interest rates for good. 

On the other hand, it is doubtful that China has seen its bottom interest rates. Xi Jinping still might not have a full grasp of what’s wrong with an environment where prices don’t rise, or decline. China’s industrial policy is worsening its economic woes rather than alleviating it. It tolerates mild deflation through excessive competition among a number of players that struggle to generate profits. Such an environment of survival of the fittest allows great champions to emerge. BYD is a case in point. In this process, however, they keep cranking out products that are priced way too low for what they offer. That is good for consumers but low profitability as a result of rampant excess capacity doesn’t allow wages and salaries to rise. Management has a strong incentive to keep costs as low as possible. China’s trade partners, notably the U.S., have been complaining about China’s export of deflation through excess capacity. While Xi Jinping not surprisingly has a deaf ear to such complaints, the Chinese economy is suffering amid persisting slow growth. 

Potential growth rate of the Japanese economy is probably 0.5% or less than 1% at best in most optimistic estimates. Few take the Chinese Communist Party’s number for the country’s potential growth, but it is still considerably higher than that of Japan. 30 year yields for Japan, however, are higher than those of China. Japan’s growth is limited to 0.5% increasingly due to supply constraints whereas China’s growth is under pressure despite the growth rate close to 5% according to the CCP, because of too much capacity. Despite far higher growth, China is replacing Japan as a deflation’s champion.

About the author: Mr. Suzuki is a retired banker based in Tokyo, Japan.