Issues covered in this report

With sustained economic recovery now in sight and amidst a general perception that Japan has escaped from deflation, the Bank of Japan on March 9 discontinued its policy of quantitative monetary easing. The focus of attention now is how soon the Bank will start to raise the policy interest rate, and how fast. The likely trend of long-term interest rates and its impact on the economy are also becoming key issues for policy and business management.

This report predicts the level of the policy interest rate on the basis of the "Taylor Rule" and the trend of long-term interest rates on the basis of the fundamentals. It also considers the impact of such an interest rate system on corporate profits and considers the implications for policy management and business management.

Overview

Assuming that the economy continues to recover at a gentle pace and that the CPI maintains a slow upward trend, there should be room to raise the policy interest rate (unsecured overnight call money) to nearly 1% in 2008, regardless of whether or not interest rates are raised in 2006.Long-term interest rates (yield on 10-year bonds), which has been around 1.6% in recent months, is also likely to rise at gentle annual average of around 0.3 points, and reach the middle of the 2-3% range by the end of fiscal 2008.

In the corporate sector, the volume of interest-bearing liabilities is greater than that of "interest-bearing financial assets" (cash deposits, long-term loans and other assets with a direct influence on interest rate fluctuation; excluding shares) and for this reason, if interest rates rise, the direct effect will be to exert downward pressure on ordinary profit through an increase in net financial expenses. However, thanks to its efforts to restore financial soundness the corporate sector has seen a fall in the volume of its interest-bearing liabilities since the end of the 1990s. For this reason, if long-term interest rates rise at the pace described above, the increase in the net financial expenses of the corporate sector is likely to be of a scale that can be offset by the rise in sales that accompanies economic recovery.

However, the effects will vary according to industrial sector and size of company, reflecting the difference in the pace of diminution in interest-bearing liabilities. In general terms, the impact will be as follows:
(i) By sector, the damage will be relatively greater in the non-manufacturing than in manufacturing industry.
(ii) By size of company, it is likely that there will be no clear differences within non-manufacturing industry, but in manufacturing industry, and particularly in the processing sector, the impact on small and medium-sized companies is likely to be somewhat greater.

Moreover, if the rise in interest rates does not come in conjunction with a an economic recovery, it is likely that, in a number of sectors of both manufacturing and non-manufacturing industry, the effects of income growth will be insufficient to offset the increase in net financial expenses and corporate profits will begin to decline. While this does not warrant excessive anxiety as a short-term risk, the fact that the pattern whereby interest rates stay high and income growth slows tends to occur more easily in a mature economy means that it should be regarded as a serious medium-term risk factor.

The implications of the above analysis are as follows:

Policy implications: In terms of financial policy, as long as the rise in interest rates is a gentle one, matched to the recovery potential of the real economy, it is unlikely that the rise in interest rates will break the back of the economy. However, if the economy does not perform as well as expected, it may be necessary to adopt a more flexible policy stance.

Business management implications: In the short term, companies whose financial position is still on the weak side should take the opportunity of streamlining their operations while there is a prospect of sales growth due to the economic recovery. Companies whose financial position is sound should not be too quick to expand their operations and should strive to establish a financial position that will allow them to weather the economic deceleration that is bound to follow.

For more information on the content of this report, please contact:
Hisashi Yamada / Makoto Ishikawa / Hideki Matsumura the Japan Research Institute, Limited.

Tel: 03-3288-4245 / 4263 / 4524
E-mail：yamada.hisashi@jri.co.jp / ishikawa.makoto@jri.co.jp / matsumura.hideki@jri.co.jp

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