Introduction program that Japan has been following for



Generally when economies face stagnant conditions,
central bankers often resort to lower borrowing rates in order to provide a
stimulus to economic activity. This has been a widely accepted practise for
many decades and has more often than not produced results ranging from moderate
to above-satisfactory. But today the conditions under which central bankers
function are changing rapidly. In a fragile yet interdependent world economic
and financial structure, monetary policy has become an important tool deciding
the course and growth of nations. But the challenges that countries now face
are more dynamic and complicated than ever before. In the current global
scenario, many of the tried and tested tools of monetary policy are repeatedly
failing or proving to be redundant. It is under such trying conditions and circumstances
that many central bankers are forced to think outside the box and implement
unorthodox monetary policies and measures.

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In February 2016 the Bank of Japan, facing a
relentless battle against deflation and a depreciating Yen, decided to venture
into negative territory. Governor Haruhiko Kuroda’s decision to adopt a Negative
Interest Rate Policy (NIRP) came as a surprise to many and received mixed
reactions from various fronts. His argument was that reduction in real interest
rates will stimulate investment and spending, both of which is currently at
record lows in Japan. The NIRP is just another part of the QQE- Qualitative and
Quantitave Easing program that Japan has been following for a long time.

The aim of this study is to establish a relationship between negative
interest rates and liquidity in the economy, if there is any and also evaluate
it quantitatively.

A brief review of the
problems facing the Japanese Economy


The Japanese economy has faced sluggish growth and
recession for a long time now and there is no end in sight. With debts
mounting, rate of deflation increasing and the value of the yen sliding
continuously, the Bank of Japan (BOJ) has a lot to worry about.

In order to combat deflation, the Government and the
Bank of Japan together issued an inflation target of 2% in 2013. To achieve
this end, the BOJ adopted a policy of aggressive bond buying in order to
increase the monetary base. According to data found in the BOJ portal the BOJ
purchases Government bonds worth 8-12 trillion Yen per month and it has no
ideas of slowing down its purchases in the near future. This has lead to a
mammoth increase in the bond holdings of the BOJ and also the monetary base of
the Japanese economy. Fig.1. shows the graphic representation of how the
monetary base has grown exponentially in the past three years.

Fig.1: Expansion in the Monetary
Base and Japanese Government Bond Holdings

Unfortunately for Japan, a massive increase in its
monetary base did not lead to a satisfactory increase in economic activity. There
was no sudden spurt in investment and consumption. The economy was still
stagnant. Fig.2 shows how even though Japanese banks were flush with money,
there was no significant lending activity. Therefore as a last resort, the BOJ
decided to adopt the NIRP three years later in 2016. Japan is the fifth country
in the world to do so, after the Euro-zone, Switzerland, Denmark and Sweden.

Negative Interest Rates


The very idea of negative interest rates is
unorthodox and baffling. It essentially means that if one wishes to deposit
money in the bank, the depositor needs to pay the bank interest rather than the
other way around. Fortunately the central bankers aren’t THAT desperate, the
negative interest rate applies only to excess reserves that banks hold with the
central bank ( in the case of Japan )

What do central bankers hope to achieve from
negative interest rates? The measure has more to do with desperately trying to
spur lending activity then to earn interest on the excess reserves. Since the
multiple rounds of aggressive QQE policy of the BOJ, banks in Japan have
accumulated a gargantuan amount of money as excess reserves with the Bank of
Japan. This, in effect, undermined the monetary policy measures of the BOJ. The
QQE measures of pumping money into the economy stand redundant if the excess
money is once again deposited with the central bank as excess reserves, instead
of being given out as loans. The BOJ sought to solve this problem but imposing
a negative interest rate on the reserves that institutions hold in excess of
the required amount. Negative interest rates would force banks to hold lesser
reserves with the BOJ and hence use the money for other purposes, preferably giving
out loans.

The following table shows the excess reserves held
by institutions with the BOJ in excess of the required ratios. The data was
taken from the BOJ statistics portal for the years 2008-2017. The values are
expressed as monthly averages.


  Excess Reserves




We can see from the table that in the last two
years, 2016 & 2017, the excess reserves held with the BOJ have dropped
drastically due to the introduction of the NIRP. But the real question is
whether these excess reserves are converted into loans and lending activity,
for therein lies the success of the policy.

Analysing the Relation between
NIRP and Liquidity


For the purpose of this study, we measure liquidity
in terms of the lending activity of the banks and not in terms of the monetary
base. This is because the BOJ defines its monetary base as follows:

Monetary Base = Banknotes & Coins in circulation
+ Current Account Balances

Since Current Account Balances also includes the
excess reserves held by institutions with the BOJ, it will not give us a clear
picture of money in the economy, i.e.: Money given out as loans for investment
and consumption. Hence the analysis is carried on with the data on the lending
activity of commercial banks at different levels of interest rates. This will
enable us to analyse the effects of the NIRP with greater accuracy.

The following table shows the data on outstanding
loans and discounted bills of regional banks in Japan from 2008-2016. The data
was collected from the BOJ statistics portal.



  Lending Activity   




Using the data obtained we proceed to evaluate the
variables using correlation analysis. For the purpose of calculation The rate
of interest was considered the independent variable and the amount of loans
outstanding and bills discounted were taken as the dependant variable.

Upon calculation, the correlation coefficient (r) is
found to be -0.688. Hence we find that the two variables are moderately
negatively correlated during this period. The coefficient of determination is
found to be 0.473. This means that about 47% of the variability observed in
lending activity can be explained by changes in the interest rate. Therefore
53% of the variability is due to factors other than the ROI.

Using the same data, regression analysis was carried
out in order to represent the relationship graphically. The regression line was
found to be:

? = -6.146X +



From the above analysis it is clear that the NIRP
has been only moderately successful in stimulating the economy and spurring
lending activity. Though the BOJ has succeeded in forcing banks to reduce their
reserve holdings, it has not been very successful in encouraging investment and
spending. Most of the money with banks continues to be ‘Idle Money’ which is
not being put to any use. This is mainly because there are many structural problems
in the Japanese economy which are subduing growth and economic activity. There
is only so much that banks can do if there are no takers for the banks money.  Unless there are businesses and households
willing to spend or invest, the availability of easy, cheap loans is of no use.
In such a situation interest rates do not play a substantial role in
determining the level of consumption and spending in the economy. No matter how
low the BOJ pushes interest rates, the economy cannot be revived unless the
structural bottlenecks are addressed. Hence the BOJ’s QQE policy and NIRP may
have increased the monetary base, but it has not led to a substantial increase
in liquidity ( as per our definition ). Though it cannot be denied that
negative interest rates have lead to a moderate increase in bank lending, it
has not been successful to the extent that the BOJ initially aspired.


Reasons for Failure of
the NIRP


The bank of Japan has, over the years, received a
lot of flak for the failure of its monetary policy to stimulate the economy and
save the depreciating Yen. But unfortunately monetary policy is being used as a
veil to hide deeper problems within the Japanese economy. One of the principal problems
facing the Japanese economy is its vertical IS curve (Investment-Saving curve) Fig.3
represents the same graphically.

Fig.3: Vertical IS curve in Japan

Note: LM – Liquidity preference/ Money supply


Investment remains depressed even though interest
rates remained very low. The fact that interest rates are unable to bring about
satisfactory changes in investment is just a reinstatement of the vertical IS
curve. There are several causes for the vertical IS curve:

Excess capacity created during the
bubble period

FDI outflow from Japan to other Asian

Falling Prices

Waning corporate interest in Investment

Other factors affecting the Japanese economy include
an ageing populating, shrinking labour force and low levels of technological
developments. Hence, the Japanese economy has to focus on fixing its structural
problems in the long run without expecting long lasting changes from aggressive
monetary policies. They have a long way to go before they can save the Yen,
ease the deflationary pressure on the economy and stimulate economic activity.




ADBI Working Paper Series  – The Effectiveness of Japan’s Negative
Interest Rate Policy (Naoyuki Yoshino, FarhadTaghizadeh–Hesary, and Hiroaki

ADBI Working Paper Series – Causes and
Remedies for Japan’s Long-Lasting Recession (Naoyuki Yoshino and Farhad

Bank of Japan Time-series database

Bank of Japan Statistics portal

” Negative interest rates are the next
stage in global stimulus” – Dent
Jr., Harry


Revisiting Monetary Policy in a Low Inflation Low Utilisation Scenario” Blinder,
Alan S

BIS Quarterly Review – “How have Central Banks Implemented Negative
Policy Rates?” (Linnemann Bech, Morten; Malkhozov,