13 April 2016
<QQE with a Negative Interest Rate: Follow-up Report>

Risks and Challenges for BOJ after breaking through ZLB— Accelerate move toward establishing a “Cashless Society” 1
JCER Financial Research Team 2
Kazumasa IWATA (President of JCER)
Ikuko FUEDA-SAMIKAWA (Principal Economist)
Eriko TAKAHASHI (Economist)
1. Why Negative Interest Rate Policy (NIRP)?――Reasons Behind the BOJ’s New Measure
Declining Oil Prices and Slowdown in Emerging Markets Delay 2% Inflation Target Date
It was on Friday, January 29, 2016, just after noon when the Nikkei reported breaking news that the
Bank of Japan (BOJ) was considering the introduction of a Negative Interest Rate Policy (NIRP). The
news came as a big surprise amongst market participants as just the week before, BOJ Governor
Haruhiko Kuroda insisted at the Committee on Audit of the House of Councilors that he had “neverthought of introducing NIRP”. Nevertheless, with the downward pressure on Japan’s economy as wellas the inflation rate, the BOJ had no choice but to take further action. Against the backdrop of
declining oil prices and uncertainty over future developments in emerging and commodity-exporting
economies, particularly China, risk-off behavior among investors accelerated globally and Japan
became susceptible to falling back into deflation. After having started the “Quantitative andQualitative Monetary Easing (QQE)” in April 2013, the BOJ expanded its monetary policy in October
2014 by increasing the monetary base to an annual pace of 80 trillion yen, up from the previous 60~70
trillion yen. It then introduced the “Supplementary Measures for QQE” in December 2015. This
included adding foreign currency-denominated loans and housing loans to the range of assets acceptedfrom banks as eligible collateral and extending the average remaining maturity of its Japanese
Government Bond (JGB) purchases. However, as there was no sign of Japan overcoming deflation but
rather an increasing risk of turning back to deflation, the Bank went ahead and finally introduced the“QQE with a Negative Interest Rate” (Fig.1-1).

1This report is based on a previous report released in Japanese on March 8, 2016.
Research Supervisor: Kazumasa IWATA (President), Lead Researcher: Ikuko SAMIKAWA (Principal Economist),Principal Contributor: Eriko TAKAHASHI (Economist), Trainee Economists: Hidetada KATO (Sumitomo Mitsui Trust
Bank), Hisao KITAMURA (Mitsubishi Corporation), Takuya KIMOTSUKI (Japan Finance Corporation（Small and Medium
Enterprise Unit)), Motoki TAKAHASHI (Nikkei), Shotaro TAJIMA (Japan Housing Finance Agency), Shuta NOUCHI(Secretariat of the House of Councillors).
2

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Japan Center for Economic Research
Financial Research Team

13 April 2016

Fig.1-1 Timeline to QQE with a Negative Interest Rate

Source: BOJ

From January 2016, the BOJ increased the frequency of publication of the “Outlook and Risk
Assessment of the Economy and Prices (the Outlook Report)” from the previous semiannual basis to aquarterly basis (usually in January, April, July, and October). The report presents the BOJ's outlook
for developments in economic activity and prices, and outlines its views on the future course ofmonetary policy. In the January 2016 Outlook Report, the BOJ pushed back the timing of achieving
its 2% price target from “around the second half of fiscal 2016” to “around the first half of fiscal
2017”. This was the third consecutive postponement of the target date for reaching 2% inflation(Fig.1-2). Upon the start of QQE, the Bank stated that it would “achieve the price stability target oftwo percent in terms of the year-on-year rate of change in the consumer price index (CPI) at theearliest possible time, with a time horizon of about two years”. If the 2% target is achieved by the firsthalf of FY2017, it will have in fact have taken at least four years in total.
Fig.1-2 BOJ Outlook Report Forecasts
2.5(%) 【FY15 Inflation Forecast】

2.5

2.0

(%) 【FY16 Inflation Forecast】

2.2(%) 【FY17 Inflation Forecast】

2.0

2.0

1.8

1.5

1.5

1.6

1.0

1.4

1.0
0.5

1.2
0.5

0.0
(Quarterly)

-0.5
13:2

14:2

15:2

0.0
16:1

1.0
(Quarterly)
14:2
14:4
15:2
Maximum
Median(Quarterly)

0.8

15:416:1
Minimum

15:2

15:3

15:4

16:1

Source: BOJ

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13 April 2016

The further declining of crude oil prices as well as the slowdown of commodity-exporting andemerging economies are detrimental to the BOJ's goal of achieving the 2% price stability target(Fig.1-3). Domestic prices, particularly the core CPI inflation rate (all items excluding volatile fresh
food prices), have been stable since 2015 at around 0%.
Fig.1-3 Spot Oil and Oil Futures
140(USD/bbl)

110
100

120

90

100

Dubai crude oil
NY crude oil futures
(WTI)

80

80

70

60

60
50

40
20

(USD/bbl)

40

Dubai, crude oil (mth avg)
NY crude oil futures (WTI, mth avg)

0
06/01
08/01
10/01
Source: NEEDS-FinancialQuest

12/01(Monthly)
14/01

30

20
16/02
16/01 14/07(Daily)
15/01

15/07

16/02
16/02

JGB Purchasing Limits
Why did the BOJ decide to take additional measures by introducing NIRP, rather than byquantitative easing, further accelerating the pace of increase in the monetary base, or by qualitativeeasing, extending the average remaining maturity of JGB purchases? One possible explanation would
be that JGB purchasing for overcoming deflation was reaching its limits. If the BOJ had increased theamount of purchasing JGBs, the limit date would have come earlier. As Hideo Hayakawa, Senior
Executive Fellow of Fujitsu Research Institute, points out, “it will be difficult to continue the current
QQE scheme, which was initially intended to be a short-term decisive battle, and the BOJ now needs
to implement a more sustainable policy framework.” In December 2015, the BOJ announced the“Supplementary Measures for QQE” in which it expanded the eligible collateral for the BOJ’s
provision of credit to include foreign currency-denominated loans and housing loans, and extended theaverage remaining maturity of JGB purchases from about 7-10 years to 7-12 years. The Bank, holding
about 300 trillion yen worth of JGBs in its balance sheet, would have faced difficulty in conducting
outright purchases of JGBs when the QQE program is extended and the liquidity of JGB market
declines. It might come to terms with “operation underbidding” (Fig.1-4). The Supplementary
Measures of December 2015 may have been introduced with the intention of maneuvering aroundsuch an underbidding.

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13 April 2016

Fig.1-4 BOJ’s JGB Holdings to Reach 300 trillion yen?
350

(Trillion yen)

QQE
(Apr 2013~Now)

QE(Mar 2001~Mar 2006)

300
250

(Years)7.0
6.5

Comprehensive Easing(Oct 2010~Mar 2013)

200

6.0
5.5

150

5.0

100

4.5

50
0

7.5

4.0
(Monthly)

3.5
02/01 03/01 04/01 05/01 06/01 07/01 08/01 09/01 10/01 11/01 12/01 13/01 14/01 15/01 16/01
～1Y

1Y～3Y

3Y～5Y

5Y～7Y

7Y～10Y

10Y～15Y

15Y～

Average Remaining Maturity

Source: BOJ, MOF

JCER Financial Research Team points out that since there is a limit to the amount of JGBs thatJapanese financial institutions can sell, the BOJ’s JGB purchasing limits could be reached as early as
mid-2017. The Supplementary Measures enabled the Bank to conduct JGB purchases in a flexible
manner in accordance with financial market conditions; however, it was not enough to postpone thetime limit of JGB purchases. In order to achieve its target of increasing monetary base by 80 trillion
yen annually, the Bank needs to buy about 120 trillion yen worth of JGBs in FY2016, as some of the
JGBs the Bank holds will be redeemed; this more or less matches the amount of JGBs that theGovernment is scheduled to issue in FY2016 (Fig.1-5). With rumors spreading about the limit ofquantitative expansion, it seems that the BOJ had no option but to shift the axis of its monetary policy
from quantity to interest rate. If the Bank had increased its JGB purchases, it could have faced aquantitative limit before reaching its 2% inflation target. To prepare for a long drawn-out battle, itneeded to break through the Zero Lower Bound (ZLB) of nominal interest rates and to drive the policy
rate into negative territory.
Fig.1-5 JGB Purchases to match Planned Issuance in FY2016
140(Trillion yen)
132

120
100

137

129

132

111

80

67

60

110

88

40
20

127

119

23

27

47

45

0
2010

11
12
BOJ JGB purchases (Before QQE)BOJ JGB purchases (QQE2 & after)

120

13

14
BOJ JGB purchases (QQE)
JGB issuance15

16 (FY)

Source: BOJ, MOF

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13 April 2016

Under the QQE, the BOJ induced a further decline in interest rates across the yield curve throughpurchasing massive amounts of long-term JGBs. It also aimed to drastically change market
expectations by underpinning the Bank’s strong commitment in achieving the 2% price stability target.
After purchasing JGBs for three years, however, inflation expectations have not risen. Consequently,
the BOJ has not only continued its large-scale purchases of JGBs, exerting further downward pressure
on interest rates across the entire yield curve, but it also made the decision to slash the deposit rate on
current accounts into negative territory in order to lower the short end of the yield curve. The Fisher
equation in Fig.1-6 explains the relationship between nominal interest rates and real interest rates. If
the BOJ is successful in cutting real interest rates by putting downward pressure on nominal interest
rates and by lowering the short-term interest rate below zero, it would be able to stimulate both
corporate business investment and housing investment.
Fig.1-6 The Fisher Equation

Debates over Implementing Negative Interest Rate Policy (NIRP)
A number of central banks in Europe such as the Swiss National Bank, the Riksbank in Sweden,
the Danmarks Nationalbank and the European Central Bank (ECB) have already implemented NIRP,
with the aim of countering currency appreciation, deterring the decline of import prices andovercoming deflation. The ECB introduced NIRP first and subsequently quantitative easing (QE),
while the opposite applied to the BOJ, which expanded its balance sheet under the QQE first and thenimplemented NIRP. At the end of January 2016, the BOJ’s total assets swelled to 396.4 trillion yen,which is roughly 70% of Japan’s nominal GDP, whereas the ratio is only 20~30% for both the Federal
Reserve Board (FRB) and ECB (Fig.1-7). Since Japan’s QQE aims at increasing the amount of current
account held by financial institutions, the policy is criticized as being incompatible with NIRP, whichcharges interest on the current account. It is important to carefully review whether the polices aremutually sustainable in the long run.

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13 April 2016

Fig.1-7 BOJ Introduced Negative Rates while Balance Sheet Bloated(% of nominal GDP)

80
70

BOJ

60

FRB

ECB

50
40
30
20
10

(Quarterly)

0
05:1
06:1
07:1
Source: BOJ, FRB, ECB

08:1

09:1

10:1

11:1

12:1

13:1

14:1

15:1 15:4

BOJ’s Negative Interest Rate Policy (NIRP) – Multiple-Tier Structure
Under the QQE, the BOJ currently purchases JGBs from the market at an annual pace of 80 trillion
yen. At the end of January 2016, the BOJ’s monetary base stood at 358.8 trillion yen, of which
financial institutions' current account deposits make up 259.3 trillion yen, over 70% of the total(Fig.1-8).
Fig.1-8 BOJ’s Monetary Base
400

(Trillion yen)
Current account balances

350

QQE

Coins in circulation

300

Banknotes in circulation

250
200
150
100
50
0
07/01

(Monthly)
08/01

09/01

10/01

11/01

12/01

13/01

14/01

15/01

16/01

Source: BOJ

The monetary base has expanded to 2.5 times the level it was at before QQE (end-March 2013), andthe current account balances to 4.5 times. Clearly, the monetary base is being boosted by the large
increase in current account balances.
Up until now, the BOJ paid 0.1% interest annually on excess reserve (current account balances lessrequired reserve). In 2015, the interest paid to financial institutions by the BOJ totaled approximately
212 billion yen; we calculate this by subtracting the required reserve (8.7 trillion yen) from theaverage cumulative current account balance from January through December 2015 (220.6 trillion yen),and multiply the remainder (212.0 trillion yen) by 0.1%. Under the QQE with a negative interest rate,

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this interest rate has been lowered to -0.1% (applied to part of the current account balances).
The BOJ introduced a new scheme, the three-tier system, under which different interest rates apply
to different tiers (Fig.1-9). From the period starting 16 February 2016 and onward, a +0.1% interest
rate will be applied to the “basic balance”, 0% on the “macro add-on balance”, and -0.1% on the“policy-rate balance”.
Fig.1-9 Multiple-Tier System of NIRP

Source: BOJ

The BOJ adopted a multiple-tier system to minimize the impact of NIRP on bank profits. Since+0.1% interest will be applied to the basic balance (210 trillion yen), financial institutions will receivea total of 210 billion yen in interest from the BOJ. Meanwhile, the interest rate applied to thepolicy-rate balance (10 trillion yen) will become -0.1%, therefore banks will have to pay the BOJ 10
billion yen in interest annually. The BOJ states that it will maintain the macro add-on balance atapproximately 10~30 trillion yen (20 trillion yen on average), which suggest the interest paid to the
BOJ by financial institutions will total 20 billion yen annually.
The proportion of the policy-rate balance (to which a negative interest rate will be imposed) to theoutstanding balance of the current account stood at 9% at the start of the Bank’s NIRP. This is not aparticularly high proportion compared to the four other European central banks that have adopted
NIRP (Sweden: 100%, ECB: 85 %, Denmark: 76%, Switzerland: 36%).
By adopting a multiple-tier system, it is anticipated that money market transactions will besustained (Nakano et al., 2016). If, for example, 0% interest is applied to a certain amount of thecurrent account balance, and if the balance exceeds this threshold, -0.1% interest is applied, it would
be more efficient for financial institutions to use the excess funds in the call market at -0.05% rather
than pay the BOJ -0.1% interest. On the other hand, for banks whose current accounts at the BOJ isless than the threshold amount, profits can be made by trading in the call market at -0.05% andhttp://www.jcer.or.jp/

Japan Center for Economic Research
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13 April 2016

keeping funds in their current accounts at the BOJ at 0% interest. Consequently, money market
trading functions can be maintained. With the newly-adopted multiple-tier system, financial
institutions will be able to mutually adjust for an excess/lack of funds, therefore, it is unlikely that
NIRP will cause dysfunction in the money market.

2. What has happened? — Market Reaction and Experiences of Europe
How did the market react to BOJ’s surprise announcement of its NIRP? Governor Kuroda explainedat the Lower House Budget Committee meeting on February 15, 2016, that the announcement has“displayed its desired effects by pushing down the entire yield curve”, hence market reaction looks to
be favorable so far (Fig.2-1). Furthermore, shorter maturities were pushed down further in the monthafter the NIRP announcement, than the 2 years and 9 months after the start of QQE in April 2013.
Fig.2-1 Entire Yield Curve is Pushed Down
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
-0.2

(%)
Mar 2013 (Pre-QQE)
Jan 2016 (Before NIRP announcement)
Feb 2016 (After NIRP annoucement)

12
Note: Monthly averages
Source: Bloomberg(Year)
3

4

5

6

7

8

9

10

15

20

30

40

In the government bond market, volatility has been increasing. The S&P/JPX JGB VIX index,
which represents the expected volatility of the long-term JGB futures price, showed a sharp increase
to twice the level under the influence of the NIRP (Fig.2-2 top-left). There was also a substantial risein February in the bid-ask spread (Fig.2-2 top-right), which represents the difference between the ask
price and the bid price of JGBs, as well as the ratio of the price range and the traded volume (Fig.2-4
bottom-left), which is the ratio of the price change and the amount of buying and selling. This is
assumed to be because financial institutions, which were not able to foresee the impact of the NIRP,
held off trading. Each transaction may have had a greater influence on the JGB price after the NIRP
announcement amid a general decrease in the trading volume of actual government bonds (Fig.2-4
bottom-right). The Bond Market Survey published by the Bank of Japan on March 1 also showed thatthe DI that indicates the liquidity and functionality of the bond market dropped by 20 points from theprevious survey conducted three months ago.
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Fig.2-2 JGB Volatility Surges After NIRP Announcement
6.0(Point)5.0(Bid-ask spread)【L-T JGB Bid/Ask Spread】 (L-T Rate)10
0.8
Bid/Ask SpreadTightness
L-T Rate (RHS)
8
0.6【S&P/JPX JGB VIX】

Volatility

4.0

6

0.4

3.0

4

0.2

2.0

2
(Daily)0.0(Daily)

0
-0.2
15/01
15/07
16/0116/02
15/07
16/0116/02【L-T JGB Futures Price Range to【JGB Quarterly Transaction Volume】(2012=100) Transaction Volume Ratio】(YoY, %point)
40
250
MediumVolume
30
Long
200
20
Super long
10
150
Total
0
100
-10
-20
50
Resiliency(Daily) -30(Quarterly)
0
-40
15/01
15/07
16/01 16/02
12:1 12:3 13:1 13:3 14:1 14:3 15:1 15:315:4
1.0
15/01

Source: Japan Exchange Group, JSDA, QUICK, Bloomberg

3. Impact on the Management of Financial Institutions
Following the BOJ’s announcement of the NIRP, its effects have been observed in financial
institutions (Fig.3-1): major banks cut the interest rate on ordinary deposits to 0.001%, while they also
started to cut corporate loan rates and mortgage rates. In addition, investment companies stopped
selling Money Management Funds (MMFs), in which client funds are managed by investing inshort-term JGBs or Commercial Papers (CPs), as negative interest rates make it difficult to secure
investment returns. Not only MMFs but also Money Reserve Funds (MRFs), a settlement account ofinvestment companies through which individual investors trade investment trusts and stocks, have an
increasing risk of a loss of principal. MRFs have a balance of just over 1 billion yen —7 times that of
MMFs—which has a considerable impact. On the other hand, some life insurance companies stopped
selling single-premium whole-life policies, in which the premium is paid in a lump sum at the start ofthe contract, or increased the insurance premium. Since each life insurance company guarantees acertain yield (assumed interest rate) to contractors, when the investment environment worsens due tonegative interest rates, it increases the risk of having ultra-long-term debt.

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13 April 2016

Fig.3-1 Banks’ Response to NIRPBOJ decision to implement NIRP

2016/1/29
2016/2/1【Deposit】

2016/2/3【Housing loan】【Investment】【Investment】

2016/2/8【Deposit】【Investment】【Investment】

2016/2/9【Lending】

2016/2/15【Deposit】

2016/2/16【Deposit】【Housing loan】

・Resona Bank lowers fixed-deposit rate (ex. 5Y: 0.05% to 0.025%)
・Bank of Yokohama and Hachijuni Bank lower fixed-deposit rate for 1Y or less to 0.02%
・Sony Bank lowers ordinary deposit rate from 0.02% to 0.001%
・Shinsei Bank drops rate to record low (10Y fixed reduced by 0.1% to 1.15%/year)
・4 firms incl. MUFJ Kokusai AM halt subscriptions to MMFs and other funds
・MOF announces halt to subscriptions of new retail 10Y floating-rate JGBs, the 1st for 10Y JGBs
・3 megabanks (MUFJ, SMBC, Mizuho) also lower rates on some fixed deposits, MUFJ lowers from 0.025%
to 0.01% across the board.
・Nikko AM announces redemption of MMF and other funds ahead of schedule
The Investment Trusts Association of Japan requests BOJ to exempt MRF from negative rates
・Mizuho Bank announces lowering of L-T prime rate, on which the lending rate is based, from 1.1%/yr torecord 1.0/yr
・Sumitomo Mitsui Trust Bank lowers 2-8Y fixed deposit rate, 5 major banks reduce deposit rates (SMTB sets
rate for 2-4Y, JPY 3 mln or more at 0.025%/yr)

NIRP Starts
・SMBC lowers ordinary deposit rate from 0.02% to 0.001% (other megabanks and Resona as well)
・SMBC lowers prime rate by 0.15% to 0.9% (Mizuho reduces to same level, MUFJ to 0.8%)

Uncollateralized Overnight Call Rate Negative for 1st Time in 10 Yrs
2016/2/17【Insurance】

2016/2/22【Deposit】

2016/2/23【Insurance】

2016/2/25

・Dai-ichi Life and Fukoku Mutual Life Insurance temporarily halts sales of some single-premium whole life
products (Dai-ichi from 16th, Fukoku from end-Feb)
・Japan Post Bank announces lowering of ordinary savings rate from 0.02% to 0.001%
・Meiji Yasuda Life announces lowering of projected rate on single-premium whole life insurance from 0.85%
to 0.75% (from March contracts)

Newly-Issued 40Y JGB Yield Breaks Below 1% for 1st Time
【Housing loan】

・SMTB lowers 10Y fixed to record 0.5%, applicable from Mar

Source: News reports, MOF, corporate websites

Impact on Banks - Continuously Declining Profit Margin in the Midst of Monetary Easing
During periods of monetary easing, banks’ loan margins generally shrink. Provided that the loan
rate is reduced by a wider range than that of the deposit interest rate, which was already cut to nearly
0% at the time of the introduction of the NIRP, a further reduction in the profit margin is inevitable. In
European countries, where NIRPs have been introduced, banks have reduced deposit interest rates andloan rates. On February 19, the Financial Law Board, for which the BOJ serves as the administrative
office, articulated its view on legal interpretations for negative interest rates and deposit and loaninterest rates. The committee’s opinions include “banks are not allowed to take interest from
depositors by applying negative interest rates to deposits,” and “lenders, including banks, are notrequired to pay borrowers even at the time of the application of negative interest rates,” while it insiststhat “there is room to receive compensation for services in accordance with the deposit agreement.”
This means that in the future, it is likely that banks will charge an additional fee or raise the existingfee instead of applying negative interest rates.
Banks have managed funds in a harsh environment since before the introduction of NIRP. In
September 2015, the loan-deposit interest margin of banks nationwide was 0.29%, the lowest level
since 1998 when a string of bankruptcies of financial institutions occurred (Fig.3-2). The deposit andbond yield, which is equivalent to the funding cost, has been kept at zero percent since the end of the
1990s when the short-term interest rate was cut to the floor rate of the zero interest rate policy. On theother hand, the investment yield of loans has been declining following the introduction of the BOJ’s

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Comprehensive Monetary Easing in October 2010 and QQE in April 2013.
Fig.3-2 Bank Deposit/Lending Interest Rate Spread Shrinking Nationwide
1.0

(%)

(%)
Interest rate spread (after deducting the operating cost)lending rate (RHS)
deposit rate (RHS)

0.8

2.5
2.0

0.6

1.5

0.4

1.0

0.2

0.5

0.0

0.0
10:1

10:2

11:1

11:2

12:1

12:2

13:1

13:2

14:1

14:2

15:1
(biannually)

Source: Japanese Bankers Association

The introduction of the NIRP is associated with an increased likelihood that banks will be forced tofurther shrink their profit margin. However, we should take a comprehensive view of the impact of the
NIRP on the revenues of financial institutions for the following possible reasons:(1) Banks have the choice to charge a fee instead of imposing negative rates on deposits and loans(2) Banks can continue to receive an interest rate of +0.1% for most of their current accounts at BOJ(3) The effects of being charged a negative interest rate may be offset to some extent, since banks
can sell JGBs to the BOJ at a higher price in the future(4) The interest rate cut produces unrealized capital gains from JGBs on banks’ financial statements.
The influences of the interest rate cut on the actual economy include reduced mortgage rates andstimulated investment in housing, which can spur consumption through an asset effect after a rise inproperty prices. Bank loans have increased mainly by virtue of the increase in housing loans, while
indications of increases have recently been seen in corporate loans for business investments (Fig.3-3-1,
3-3-2).
Fig.3-3-1 Corporate Lending
470

(%)

(Trillion yen)
Avg Outstanding Amount of Loans

6.0

YoY (RHS)

450

4.0

430

2.0

410

0.0

390

-2.0

370

-4.0

(Monthly)350
15/12
00/01 01/01 02/01 03/01 04/01 05/01 06/01 07/01 08/01 09/01 10/01 11/01 12/01 13/01 14/01 15/01-6.0

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Fig.3-3-2 Growth Primarily in Individual Loans (Housing) but Signs Capital Funding also Rising
130(Trillion yen)100

Housing Loans

120(Trillion yen)
Loans for Business Investments

90

110

80

100
70

90

60

80

50

70
(Quarterly)
60

00:1 02:1 04:1 06:1 08:1 10:1 12:1 14:115:4(Quarterly)

40
00:1

02:1

04:1

06:1

08:1

10:1

12:1

15:4
14:1 15/03

Source: BOJ

Meanwhile, corporate on-hand liquidity has reached record levels (Fig.3-4), which some view as anindication that loan demands are somewhat weak. However, if corporate business investment
continues to increase, together with individuals’ increased hosing loans demands, it may boost
economic activity.
Fig.3-4 Corporate On-Hand Liquidity at Record Levels
20
18
16
14
12
10
8
6
4
2
0

(Trillion yen)

【Cash flow】(Quarterly)
90:1

95:1

00:1

05:1
All industries

10:1

20
18
16
14
12
10
8
6
4
2
0

(Trillion yen)

15:4
15:1
90:1
Manufacturing【Business Investment】(Quarterly)
95:1

00:1
05:1
Non-manufacturing

10:1

15:4
15:1

Source: MOF

Based on the comprehensive list of multipliers of “The ESRI Short-Run Macroeconometric Modelof the Japanese Economy (2015 version)” published by the Cabinet Office in January 2015, theestimated economic effects of a 0.2% point cut in the short-term interest rate revealed an increase net
private-sector capital spending by 0.6%, and corporate business income by 1.7% in one year (Fig.3-5).
As pointed out by Kazumasa Iwata, President of JCER, it is likely that “personal consumption will
also be stimulated by the asset effect along with the rise in stock prices, if the investors’ money flows
into stocks or external bonds instead of JGBs.”

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Fig.3-5 Effect of Lowering Short Rate by 0.2%(%)
Real private
business
investment

CorporateincomeAfter 1y

0.6

1.7

0.5

After 2y

0.6

1.9

0.4

After 3y

0.8

1.7

0.4

TOPIX

Source: Cabinet Office “The ESRI Short-Run Macroeconometric Model of theJapanese Economy (2015 version)” (Jan 2015)

4. Associated Costs of NIRP
Under the “QQE with a Negative Interest Rate” scheme, the BOJ will apply an interest rate of-0.1% to the policy-rate balances in current accounts, while maintaining its large-scale asset purchasessuch that the monetary base will increase by 80 trillion yen annually. Therefore, when financial
institutions sell JGBs to the Bank, the Bank will levy 0.1% interest on the excess reserve held byfinancial institutions. Governor Kuroda stated in a speech at the Kisaragi-kai Meeting in Tokyo on
February 3, 2015 that “the costs of holding the current balance with a negative interest rate will becompensated by higher sales prices […] of the assets sold to the Bank”, therefore, “a NIRP will notnecessarily make the Bank's purchases difficult.” The BOJ is supposed to buy JGBs at higher prices tocompensate for the cost on the financial institutions owing to the negative interest rates. In fact, theBOJ can buy JGBs, however expensive they might be, in contrast with the ECB, which has set an
upper limit on the purchase price.
JGB Purchases cost BOJ 8 trillion yen
The BOJ has not clearly stated whether it will sell the already purchased long-term JGBs in themarket in the future. Governor Kuroda only expressed his view at the Lower House Budget
Committee meeting on February 15, 2016 that “we intend to hold sufficient discussions on how todeal with the long-term JGBs held by the BOJ at the time of exit, including the issue of the balance
sheet.” As discussed in Iwata & Fueda-Samikawa(2013), under the current accounting rules, the BOJ
is regarded as holding the long-term JGBs to maturity. The reason is because the evaluation method of
long-term JGBs changed in 2004, and the conventional “lower-of-cost-or-market method” wasreplaced by the “amortized cost method”. If, for example, a long-term JGB with five years remaining
to maturity is purchased in the market at 110 yen, its principal (nominal value) of 100 yen is reflectedin the balance sheet, while the remaining 10 yen will be amortized equally by 2 yen each year during
the next five years to maturity (deducted from the interest on JGBs in the income statement). With theamortized cost method, since the bond holder will receive only 100 yen five years later, even if a JGB
is purchased at the cost of 110 yen and held to maturity, it is better to equalize the loss on bondredemption of 10 yen throughout the remaining period than to pay the full amount at the time of
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maturity.
The annual loss (amortization expense) increases (1) as the remaining term of the purchased
long-term JGB becomes shorter, (2) as the excess of the purchase price above the face value becomeslarger, and (3) as a greater amount of JGBs are purchased at a price higher the face value. In the casewhere the BOJ buys JGBs equivalent to 120 trillion yen per year with additional costs of 3%(including amortization), a loss of 3.6 trillion yen must be amortized by maturity. If the JGB
purchased at that time had a remaining term of three years, the annual burden would be equivalent to
1.2 trillion yen.
How much loss has been sustained from the BOJ’s JGB purchases under QQE? Using BOJ data, we
calculate the difference between the acquisition costs and the face values of purchased JGBs (loss onredemption), to review the “invisible loss” already incurred. The purchase price of long-term JGBs
was used as the acquisition cost based on “Sources of Changes in Current Account Balances at the
Bank of Japan and Market Operations”. The face value was calculated by deducting the amount of
JGBs held in the previous month from that in the current month, based on monthly data on “JGBs heldby the Bank of Japan”. Note that the gross purchase price was adjusted for by the amount that was
deducted from the balance due to redemption or retirement by purchase. The amount obtained bydeducting the acquisition cost from the face value of JGBs was considered as the loss on redemption.
The calculated results are shown in Fig.4-1. The accumulated loss on redemption from the
beginning of QQE in April 2013 to the end of January 2016—just before the introduction of the NIRP
—was approximately 8 trillion yen. The average maturity of the JGBs purchased during this period
was approximately eight years, which means, that around 1 trillion yen was deducted from the JGBs’interest on the income statement each year. Provided that the BOJ continues to buy long-term JGBs at
higher prices under the NIRP, the annual burden of redemption will increase. Iwata (2014) points outthat “an increase in the interest rate on excess reserves at the exit from QQE will incur heavy losses on
the BOJ,” however, the BOJ has already suffered a loss owing to the JGBs being purchased at overly
high prices.
Fig.4-1 BOJ Necessary Amortization for JGB Purchases on the Increase
5.0(Trillion yen)(%)
Necessary amortization

1.5

Yield on JGBs held by BOJ (RHS)

4.0

1.2

3.0

0.9

2.0

0.6

1.0

0.3
0.0

0.0
07

08

09

10

11

12

13

14

15 (FY)

Source: BOJ, MOF

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BOJ Governor Kuroda said that the financial assets held by the BOJ, “by and large, produce
unrealized capital gains,” but as far as the long-term JGBs are concerned, the change in the current
prices does not have any impact on neither the income statement nor the balance sheet of the BOJ,
since the Bank intends to hold them to maturity. In addition, the investment yield of the JGBs held by
the BOJ in FY2014 was 0.556%, which was cut by 0.16% points during the two years from FY2012,
when QQE was launched. With a surge in the amount held, the income gain from the JGBs increased
to 1.7-fold, from 600.5 billion yen in FY 2012 to 1.03 trillion yen in FY2014, however there is no
guarantee that it will continue to increase in the future as well.
The Government Sector can borrow Money at Negative Interest Rates
The long-term interest rate, which has continued to decline since the introduction of QQE, has
shown further decreases following the additional easing in October 2014 and the introduction of NIRP.
On February 9, 2016, the yield of newly issued 10-year bonds became negative for the first time inhistory (Fig.4-2).
Fig.4-2 JGB Yield turns Negative even for 10Y Bonds
1.0

(%)

0.3

0.8

(%)

0.2

0.6

0.1

0.4

0.0

0.2

-0.1

0.0

-0.2

-0.2
-0.4
13/01

(Daily)
13/07

14/01
1-Year

14/07
2-Year

15/01

15/07
5-Year

-0.3

16/02
16/01
7-Year

16/01
10-Year16/02 16/02(Daily)Source: Bloomberg

It is reported that the central government, which suffers from a lack of funds (excessive investment),
benefits from the interest rate cut, since it can raise funds at lower interest rates. Following the declineof the market interest rate, the average closing bid yield of JGBs has also been declining (the averagecontract price has been increasing). Some of the JGBs have negative interest rates at the time ofissuance and the government (the borrower), which must normally pay the interest rate, conversely
receives an income gain. Since interest rates turned negative from October 2014 onward, thegovernment has allegedly received income gains of approximately 71.7 billion yen in total by March 3,
2016: about 35.6 billion yen from T-Bills (3 months, 6 months, and 1 year), 12.5 billion yen from
2-year bonds, 16,700 million yen from 5-year bonds, and 20.6 billion yen from 10-year bonds.

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Issuance of JGBs under Negative Interest Rates from Integrated Government Perspective
While the government receives benefits from negative interest rates, the BOJ bears the “invisibleloss” caused by the purchase of JGBs. In the event that the BOJ sustains an excessive loss and its
financial conditions worsen, the government may have to cover for the loss. In order to explain thenotion of loss caused by negative interest rates from the perspective of the integrated government, a
discount bond without receipts and payments of interest rates is taken as an example. In Fig.4-3 below,
we present a case where a private financial institution wins a bid to buy a discount bond with a facevalue of 100 yen issued by the government for 101 yen, and the BOJ buys it for 102 yen from theprivate financial institution.
Fig.4-3 BOJ Trade from Integrated Government Perspective
Integrated
government
Government(1)Bid at 101yen
Financial institutions(3)100yen redeemed
BOJ(2)Buy at 102yen

In this case, purchase price (2) at which the BOJ bought the bond from the private financial
institution in the outright purchase is higher than purchase price (1) at which the private financial
institution bought from the government (in the price competitive bid). The government realizes a
profit of 1 yen by selling the discount bond of 100 yen to the private financial institution for 101 yen,while the BOJ buys it for 102 yen from the private financial institution: this means that the BOJ
suffers a loss of 2 yen, which is equivalent to the difference in the principal (amount of redemption).
From the perspective of the government and BOJ’s integrated government, the total loss caused bynegative interest rates is 1 yen, equivalent to the difference between the loss to the BOJ (2 yen) andthe profit of the government (1 yen).
It should be noted that, when focusing only on the government, funds can be raised at a lower
interest rate, therefore there arises a risk of increasing requests to expand expenditure—including the
fiscal stimulus extra issuance of JGBs—or of relegating financial reconstruction. It is potentiallyregarded as a relaxation of financial discipline. Etsuro Honda, special adviser to the Cabinet, suggeststhat economic measures worth around 5 trillion yen should be formulated by utilizing the excess ofinterest payment costs. Nonetheless, the fact remains that the potential loss to the BOJ and the cost to
the integrated government shown in Fig.4-1 will become a burden on future generations. The burden

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13 April 2016

on the BOJ caused by the purchase of JGBs is less noticeable than the advantage brought about to thegovernment by the interest rate cut, so further thorough discussion is expected.
Can the BOJ maintain Financial Soundness?
The BOJ is required to save an amount equivalent to 5% of the profit (surplus) in each period as
legal reserve (Bank of Japan Act, Article 53, Clause 1). This ratio was raised to 20% in FY2013 and
25% in FY2014. The BOJ is presently accumulating a substantial amount of reserves in preparation
for the future worsening of financial conditions (Fig.4-4).
Fig.4-4 Increasing Treasury Payments

Source: BOJ

It was not permitted to reduce legal reserves except when the financial results fell into the red, so
the BOJ revised the provision system at the time of the final accounts of FY2015. Consequently,
approximately 50% of the difference between the interest rate paid on current accounts with excess
reserve balances and the interest income from the held JGBs may be transferred to the provisions forpossible losses on bond transactions. In addition, the provisions may be reduced as needed even if thefinancial results do not fall into the red. This is a measure for dealing with the future change in interest
income from JGBs and interest payment costs for excess reserve balances.
At the press conference on November 19, 2015, Governor Kuroda explained the provisions asfollows: “a substantial increase in the purchase of long-term JGBs will increase interest income
significantly, and in turn, increase profits. If the interest rate rises sometime in the future, on the other
hand, profits may swing downward according to various possible specific policy instruments,
including the hike of the interest rate on the current accounts of the BOJ and fund absorption
operations. Considering this situation, it is possible to develop a provision system to level thevolatility of profits.” From the government’s perspective as well, there is an advantage of contributing
to the stabilization of annual revenue in the long term, although the payment to the National Treasury
decreases temporarily.

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Concern that the Financial Conditions of the BOJ may worsen
Article 18 of the Accounting Rules of the Bank of Japan stipulates that the capital of the BOJ “shallbe managed with the aim of maintaining the capital adequacy ratio at around 10%, within the range of
8%~12%.” Although it has shown an improving trend since FY2012, it still remains at around 8%,
which is the lower limit (Fig.4-5).
Fig.4-5 BOJ Equity Ratio
8.4

(%)

8.2

Lower limit of equity ratio (8%)

8.0
7.8
7.6
7.4
7.2
(FY)
7.0
06

07

08

09

10

11

12

13

14

15 (1st half)

Source: BOJ

There is concern about the financial base of the BOJ. As of the end of September 2015, the legal
reserve was approximately 3.1 trillion yen and the provisions for possible losses on bonds transactions
were approximately 2.2 trillion yen. As mentioned above, under the circumstances where the interest
income from the JGB has stagnated and it is anticipated that the additional accumulation of reserve
funds and provisions will gradually become more difficult, the amortization burden of the potential
loss is more likely to be heavier. Out of the assets held other than the JGBs, the external bonds aremeasured at fair value, and the Exchange Traded Funds (ETFs), which are measured by the moving
average cost method, are supposed to be recorded as an impairment loss when the current prices drop
significantly. This may suddenly apply pressure to the profits of the BOJ depending on the trend of thestock prices and the exchange rate.
The insolvency of the central bank can cause the following problems: high inflation, a drop in thecurrency value caused by the loss of confidence of the central bank, and a functional decline of thepayment system (Ueda, 2003). In fact, it is reported that a number of countries have suffered fromhigh rates of inflation after the central bank was caught in a situation where it is difficult to pursue thegoal of stabilizing prices.
On the other hand, some insist that even if the central bank becomes temporarily caught in
insolvency, it does not matter as long as the loss is compensated by the government. Taking this into
consideration, the article on loss compensation, which was stipulated in the former act, was deleted at

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13 April 2016

the time of the revision of the Bank of Japan Act in 1998, and presently it is required to deal with theloss at the BOJ’s discretion. From the standpoint of the law, therefore, the loss cannot be compensatedby the government. In the Monetary Policy Meeting of April 2013, where QQE was introduced, one of
the committee members mentioned that “regulations on loss compensation are worthy of a discussion
with the government,” however it was not discussed in the end.
Even if the loss can be compensated by the government, there may be a risk that the independenceof the central bank or that of the monetary policy is lost as the financial authorities increasingly
perform intervention in the central bank. The potential loss to the BOJ has continued to increase since
the launch of QQE. Depending on the scale of the loss, it would be required to immediately review theloss to the BOJ, for which taxpayers’ money is potentially expected to be spent in the future, byconsidering the issue of the independence of the central bank and the adverse effects brought about by
insolvency.
5. Room to further cut Negative Interest Rates indicated by the Natural Interest Rate
In order to bring the effect of monetary easing to the economy, real interest rates must be reduced toa level below the natural interest rate. The natural interest rate, which is independent from the prices
and plays the role of achieving a balance between saving and investment, “is used as a guide to makea political decision about the level to which the real interest rate should be reduced, and can beconsidered as a guidepost when setting the policy rate. Under conditions where the real interest rate ishigher than the natural interest rate, deflationary pressure is exerted on the economy.
The secular stagnation theory can be interpreted very differently depending on whether the cause ofstagnation is attributed to the supply side—declining population as well as low birth rate andlongevity—or the demand side —a lack of investment for excessive savings. Gordon (2012), whoplace emphasis on the supply side, underlines the importance of deregulation and education reform byfocusing on the structural factors such as productivity and the labor force. Contrastingly, Summers(2014, 2015), who place emphasis on the demand side, insists that monetary easing and fiscal stimulus
are effective for overcoming secular stagnation. Fig.5-1 summarizes recent in-depth discussions.

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Fig.5-1 Recent Discussions on Secular Stagnation
Pointed out that the debate over secular stagnation was too pessimistic. Slow economic recovery in the US currently isa result of a worsening of the balance sheet and fiscal restructuring but being confused as chronic recession. Argues
equilibrium real interest rate is between 1 and 2 percent.
Presents new theoretical model supporting secular stagnation theory. Falling prices of investment goods are constraining
Thwaites (2015)
corporate investment activities, while also pushing down interest rates. Shows result that in equilibrium, even if prices ofinvestment goods stop falling, the equilibrium real interest rate will remain at a low level.
Using data until 4Q 2014, calculated the natural interest rate in the US. His result showed it has been in negative territory
Williams (2015)
since mid-2012.
Cited historical effects and a decline in the potential growth rate as reasons for the economic growth rate slumping aftera recession. While stressing the need for active monetary policy in tandem with production trends in the case of
Blanchard et al. (2015)
historical effects, he also pointed out that monetary policy should not follow production trends in the case of a decline
in the potential growth rate.
Raised 4 points in a speech on secular stagnation at the Chilean central bank.
1. Low inflation can be a more serious problem than inflation.
Summers (2015)
2. The natural interest rate can remain at a low level for a long time.
3. Central banks around the world can’t stabilize national economies.
4. A contingency plan is required to address secular stagnation.
Explained the declining long-term real interest rates in both developed and emerging economies by two factors - slowing
Rachel and Smith (2015) growth and shifts in savings/investment levels. Shows result that the slowdown in the global economy will continue, witha medium to long term global neutral rate settling at 1% or slightly lower.
Hamilton et al. (2015)

What is important in figuring out the causes of the long-term stagnation is to determine the naturalinterest rate. Outlined below is a discussion on whether it is possible to determine the natural interest
rate—the level at which the interest rate should ideally be—and expand the NIRP. The natural interest
rate of Japan fell into negative territory in the late 1990s. Subsequently, it showed a decreasing
tendency, while the market-determined real interest rate remained at around zero. As a result, it was
revealed that “a situation as if under a monetary tightening policy” had continued where the realinterest rate is above the natural interest rate. After the introduction of QQE in April 2013, the realinterest rate fell into negative territory and the financial conditions eased, however the real interest
rate reversed its downward trend in 2014 and became “a situation as if under a monetary tightening
policy” again in 2015. The natural interest rate is now thought to be around -1.0%, and a further
reduction of the policy rate is necessary in order to benefit from the monetary easing.

Estimation of the natural interest rate
In the estimation of the situation of Japan, the same variables were used as Iwata et al. (2015),
except the inflation rate and the expected inflation rate. With regard to the inflation rate and the
expected inflation rate, the annualized period-over-period core CPI was used instead of theyear-over-year core CPI. The estimate was conducted from the second quarter in 1972 to the third
quarter in 2015.

【Japan】
The estimated natural rate of interest for Japan is shown in Fig.5-2. It declined sharply from the late1980s onward, and has remained in negative territory since 1997. In the third quarter of 2015, it ishttp://www.jcer.or.jp/

Japan Center for Economic Research
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13 April 2016

estimated as -0.7%. In relation to the market real interest rate, Japan’s natural rate has long been
below the real interest rate, which shows the BOJ’s monetary policy was deflationary.
Fig.5-2 Japan Natural Rate of Interest
(%)

6.0
5.0

Real Interest Rate

4.0

Natural Rate of Interest

3.0
2.0
1.0
0.0
-1.0
-2.0

（Quarterly）

-3.0
85:1

90:1

95:1

00:1

05:1

15:3
15:1

10:1

【US】
Fig.5-3 presents different estimations of the US natural rate of interest for US, one estimated by the
JCER Financial Research Team and the other by the Federal Reserve Bank of San Francisco. The
fluctuation of the former is bigger than that of the latter. The figure also indicates the US market realinterest rate. The natural rate of interest estimated by Bank of San Francisco became negative in
mid-2012, whilst we estimate that it was in mid-2008 when the global financial crisis took place.
Fig.5-3 US Natural Rate of Interest
(%)

6.0
5.0
4.0
3.0
2.0
1.0
0.0

Natural Rate of Interest（JCER Financial Research Team）-1.0

Natural Rate of Interest（Federal Reserve Bank of San Francisco）-2.0

Real Interest Rate

-3.0
85:1

90:1

（Quarterly）
95:1

00:1

05:1

10:1

15:3
15:1

【UK】
Fig.5-4 shows the estimation result of the UK natural rate. Prior to the 2008 financial crisis, the rate
has been positive most of the time, with the exception of the late-1980s and the mid-2000s.
Nonetheless, it has turned negative since the global crisis, which is a similar result to our estimations

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for Japan and the US.
Fig.5-4 UK Natural Rate of Interest
10

(%)

8
6
4
2
0
-2

Natural Rate of Interest-4

Real Interest Rate

-6

（Quarterly）

-8
85:1

90:1

95:1

00:1

05:1

10:1

15:3
15:1

As pointed out in Iwata et al. (2015), the results obtained from the Kalman filter quickly become
unstable because of the major impact of the kinds of parameters to be estimated, the initial values ofstate variables as well as variance matrices and covariance matrices, and the period of estimation. In
this analysis, as well, there were cases where useful results were not obtained just because the initialvalues or the period of estimation were changed, so the estimation results should be interpreted byallowing for some wiggle room. But then again, an interesting point is that the natural interest rates of
the U.S. and the U.K. both decreased after the failure of Lehman Brothers, as did that of Japan, andthey all fell into negative territory. This is thought to support the secular stagnation theory indeveloped countries. In the U.S. and the U.K., the real interest rates fell to a level below the naturalinterest rates as a consequence of the monetary policy after the failure of Lehman Brothers and thefinancial conditions were eased, which is quite different from the situation in Japan.

Japan needs further Monetary Easing
Fig.5-5 shows the range (the band between the maximum and minimum values) of the naturalinterest rate of Japan estimated using different methods, including the DSGE model. The naturalinterest rate of Japan has remained in negative territory since it fell below zero in the mid-1990s.
During this period, the real interest rate remained higher than the natural interest rate, which shows apossibility that further monetary easing could have overcome deflation. The market-determined realinterest rate, which declined at the time of the introduction of QQE, remained below the naturalinterest rate for a while, however it then started to increase and has recently been above the naturalinterest rate, which places deflationary pressure on the economy. The price of crude oil has beenfalling, and there is now greater uncertainty in the economies of resource-rich countries andhttp://www.jcer.or.jp/

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developing countries, and what is worse, the expected inflation rate has declined. Nonetheless, there ispotential that the effect of monetary easing can be produced again, provided that the zero restriction of
the nominal interest rate can be removed by the introduction of the Quantitative and Qualitative
Monetary Easing Policy with negative interest rates, and the real interest rate can be reduced in the
future. Along with this, a policy for increasing the natural interest rate is also required.
Fig.5-5 Japan’s Natural Rate of Interest and Real Interest Rate
6.0(%)
Natural Rate of Interest（Bandwidth of Two Estimates）

5.0

Real Interest Rate

4.0
3.0
2.0
1.0
0.0
-1.0
-2.0

（Quarterly）

-3.0
85:1

90:1

95:1

00:1

05:1

10:1

15:3
15:1

6. Cashless society ― New Technological Innovation and Enhancement of Growth Potential
To what Level will the Interest Rate go down without the Zero Restriction on the Interest Rate?
Since the late 1990s, Japan has been under the constraint of ZLB, i.e. the floor of the short nominalinterest rate set at zero percent. Although Japan’s natural rate of interest was negative and lower thanthe market real interest rate, and economic conditions required the BOJ to ease further, there wasalmost no room left for the Bank to lower its policy rate because of this ZLB. When short-term
interest rates almost hit zero, the Bank needed to introduce measures that would influence the entire
yield curve in place of the traditional operation of controlling short-term interest rates.
In April 1999, the BOJ introduced qualitative forward guidance by indicating the future expected
path of the policy rate, stating that it would continue with the zero interest rate policy (ZIRP) until
deflationary concern is dispelled. Instead of cutting the policy rate, it made a commitment to the future
course of monetary policy. If market participants believe that a central bank's commitment tomonetary easing will continue in the long term, and that the policy rate will stay low for an extended
period, this will exert downward pressure on long-term interest rates.
In March 2001, the BOJ commenced Quantitative Easing (QE), in which the operating target was
the outstanding balance of current accounts, and committed to continuing the policy until the annual
rate of change in the consumer price index (CPI, excluding fresh food) registered zero percent orabove in a stable manner.

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Then, in October 2010, the BOJ introduced Comprehensive Monetary Easing (CME) under which it
started to purchase a comprehensive range of assets – not only JGBs, but also credit products such as
CP and corporate bonds, ETFs and Japan Real Estate Investment Trusts (J-REITs). The aim was todirectly lower part of the yield curve up to three years and at reducing various risk premiums.
The QQE program implemented in April 2013 included the strong and clear commitment to achieve
the 2% price stability target within a time horizon of about two years, and directly worked on private
entities' inflation expectations. The Bank aimed to double the monetary base in two years andpurchase massive amounts of JGBs, including those with longer remaining maturities.
The ZLB on nominal rates is regarded as being driven by the presence of physical currency. Whenthe policy rate is turned negative, or when bank deposit rates and bond yields go below zero percent,people may seek to hoard cash, as banknotes guarantee a zero nominal rate of return. There is no
incentive to invest in financial assets when negative interest rates are applied. By how much can the
BOJ cut its policy rate? How low would Japan’s policy rate be dragged down without causing flight tocash? Using shadow-rate dynamic term structure model (DTSMs) which account for the ZLB
proposed by Bauer and Rudebusch (2016), Japan’s future short-term nominal rates is estimated below.
In Gaussian affine DTSMs which ignore the ZLB, short-term interest rateis specified as follows;=(1)

where δ and δ are parameters and+denotes risk factors.

Shadow-rate DTSMs are similar to Gaussian affine DTSMs, but have a fundamental advantage overaffine DTSMs in that they impose the non-negativity of nominal interest rates. A shadow-rate
specification is described as follows;
= max

,

where s is the affine Gaussian shadow-rate.
“yields-only” models, where

,

=

+

(2)

is set to 0 as Black(1995) defines. In addition toreflects only information in the yield curve, Bauer et.al (2016)

estimate “macro-finance” models where

also includes macroeconomic variables.

As in Gürkaynak, Sack and Wright(2007), Bauer and Rudebusch(2016) also used US T-bill rates
and smoothed zero-coupon Treasury yields with maturities of 0.25, 0.5, 1, 2, 3, 5, 7 and 10 years.
Their sample period is from January 1985 to December 2014. Bauer and Rudebusch(2016) firstestimate parameters only for the affine model, using the pre-ZLB sample ending in December 2008.
Then they use the same pre-ZLB estimated parameters in the affine model and the corresponding
shadow-rate model, and apply the models to the full sample period until December 2014. In moredetail, using
estimate∗

obtained in affine model for the pre-ZLB sample, Bauer and Rudebusch (2016)
specified in equation (1). They then obtain the shadow-rateby estimating, the shadow risk factors.
= max

,

,

=

+

∗

(3)

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In our analysis, we use Japanese zero-coupon yield curve data from January 2009 to estimateparameters and shadow risk factors. The lower bound for the short-term rate is not set to zero percent
but to 0.1%, the same level as the interest rate on excess reserves paid by BOJ until the start of the“Quantitative and Qualitative Monetary Easing with a Negative Interest Rate” policy in February 2016.
The uncollateralized overnight call rate in Japan had in fact been moving around 0.1% from January
2009 to January 2016. The maturities are 5, 6, 7, 8, 9, and 10 years, provided by JPMorgan Securities
Japan Co., Ltd. As interest rates with relatively longer maturities were in positive territory even during
a period of near-zero interest rates, we believed necessary information could be obtained from thedata.
The results are shown in Fig.6-1. The estimated shadow-rate DTSMs had been negative for theperiods 2001 through 2005, and from mid-2012 onward, slightly before the QQE was announced. In
2015, the shadow rate remained between -1.5 and -1.0%, when the short-term nominal rate hit the
ZLB and stayed there. Using the same data, we also estimated another shadow rate by Gaussian affine
DTSMs. Bauer et.al (2016) point out that “as nominal interest rates have fallen to near zero, the lackof an appropriate non-negativity restriction in conventional models has become a conspicuous
theoretical deficiency.” Having used zero-coupon yields with longer maturities from 5 to 10 years, theestimation results were in line with Ichiue and Ueno (2013) and Imakubo and Nakajima (2015).
Fig.6-1 Shadow Rate and Short-term Interest Rate
2.5

(%)

2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0

Shadow rate (Dynamic Term Structure Model)
Short-term interest rate (Dynamic Term Structure Model)
Short-term interest rate (Affine Term Structure Model)(Monthly)

01/01 02/01 03/01 04/01 05/01 06/01 07/01 08/01 09/01 10/01 11/01 12/01 13/01 14/01 15/0115/12
Source: Bauer and Rudebusch (2016)

QQE, which was launched in April 2013, aimed to explore an additional cut of the nominal interest
rate by focusing on the long-term zone as well as to reduce the real interest rate by increasing the
expected inflation rate. However, it must be admitted that it had only limited effects in terms ofovercoming deflation. Governor Kuroda stated, “When necessary, we intend to cut the interest rate,
which has already been set in negative territory.” Judging by reference to the European countries that

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have implemented a NIRP, it seems that the policy rate can be cut to around minus 1%. As the shadow
rate estimated above shows, what will happen in the future when the further reduction of the policy
rate (the interest rate on the policy rate balance of the BOJ’s current accounts) is required? One
possible answer is the shift to cash (banknotes), which is a safe asset with no interest. In January, theBOJ decided to impose a penalty on financial institutions’ withdrawal of banknotes from the BOJ’s
current accounts, however, in case households and businesses start to shift to cash on a full-scale basis,
meaning that the economy might fall into “a liquidity trap” (Fig.6-2).The shift of households andbusinesses to cash must be avoided in order to increase the effectiveness of the NIRP.
Fig.6-2 Risk of Falling into a “Liquidity Trap”
Interest rate

Interest rate

Liquidity trap0％
Liquidity demand0％-X％
Liquidity demand

At what level of negative interest rate can the shift to cash be avoided? Based on the social cost of
cash payment estimated by Schmiedel et al. (approximately 2%), Kazumasa Iwata mentioned that “thecost of cash possession is 2%, including the cost of keeping it in a safe” and offered the perspectivethat the lower limit of the negative interest rate should be around 2%. In fact, a large amount of cash isbulky and a huge space for storing it is needed. Besides, it costs a lot to secure safe storage (insurance
cost, etc.). Hideo Hayakawa stated that “Japan is relatively safe, and there remains a deep-rooted
custom of cash settlement, so it would be natural to think that deposits will easily flow out even undera relatively lower negative interest rate.
How to prevent the Shift to Cash ― Application of Negative Interest Rates to Banknotes
University of Tokyo Professor Kazuo Ueda pointed out that “the lower limit of the interest rate will
not be too low unless we decide to apply a negative interest rate to cash, which is powerful medication
with a risk of damaging the trust of the currency system” (Ueda [2016]). How can this “powerful
medication” be used? Since the beginning of the 20th century, economists have held repeateddiscussions on how to prevent people from storing their cash during a recession (Fig.6-3).

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Fig.6-3 Ways to Apply a Negative Rate on Cash
Proponent

Title

Silvio Gesell

GermanSocial Activist

Year

Robert Eisler

Austrian
History researcher

Marvin Goodfriend

Yale University
Professor, AEA
President
Richmond Fed VP

Mitsuhiro Fukao

Keio U Prof

Willem Buiter

Citigroup Chief
AnalystGregory Mankiew

Harvard Prof

Miles Kimball

Michigan Prof

Irving Fisher

ProposalNational-level implementation of free-money that can only retain value by attaching stamps
1916
equivalent to 0.1% (5.2% APR) of face value every week.
Adjust exchange rate of bank money (check-like instruments received when depositing
money in a bank, similar to digital currency today) and paper currency. Exchange rate of1932
bank money and paper currency can fluctuate, but is fixed between banks of different
countries.
1934

Implementation of stamp scrip that can be used in designated regions. Required to attach
2 cent stamp every week on backside of stamp currency with 1 dollar face value.

2000 Implementation of carry tax on required reserves and cash
Modern version of Gesell banknote stamp tax. Every year, change color and design of2001 BOJ banknotes and require older banknotes to be affixed with stamps. When BOJ
exchanges banknotes, it receives 2 percent of face value as handling fee.
3 ways to remove ZLB on nominal rate. 1. Eliminate currency 2. Tax currency 3.
2009
Implement exchange rate that reduces currency value.
Random elimination of paper currency. Every year, the Fed selects last digit of serial
2009 number and declares that those with that number will no longer be recognized as legal
currency.
Differentiate between digital currency and paper currency, and allowing exchange rate to2015
fluctuate, reduce value of paper currency.

Source: Goodfriend (2000), Iwamura (2008), Buiter (2009), Haldane (2015), Agarwal and Kimball (2015) and Fukao (2001)

The BOJ have also adopted a measure to prevent a shift to cash, “Adjustment concerning asignificant increase in financial institutions' cash holdings”, in the NIRP scheme announced on
January 29, 2016. The BOJ stated as follows: “In order to prevent a decrease in the effects of anegative interest rate due to financial institutions' cash holdings, if their cash holdings increasesignificantly from those during the benchmark reserve maintenance periods, the increased amount will
be deducted from the macro add-on balance. In cases where the increased amount is larger than themacro add-on balance, the amount in excess of the macro add-on balance will be further deductedfrom the basic balance.” In other words, the BOJ declared that a financial institution that has
significantly increased its cash holdings must increase the payment of negative interest rates, so a defacto “penalty” is imposed owing on cash holdings.

Cash revolution in Europe ― Movement to abolish cash in Northern Europe
In Europe, along with the introduction of negative interest rates, there has been growing momentum
in favor of reforming the monetary system, including cash (Fig.6-4). Rogoff (2014) states that theexistence of paper currency “[facilitates] tax evasion and illegal activity,” as paper currency allows
transactions to be anonymous.
Fig.6-4 Pros and Cons of Paper Currency
Pros and Cons of Paper currency【Pros】○makes transactions
anonymous○government/central bankobtain seigniorage【Cons】○sets an effective lower
bound to negative rates○used for illegal activity (taxevasion, money laundering etc)

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In Europe, like the spread of NIRP, there is growing movement toward a “cash revolution” toabolish paper currency (Fig.6-5). The movement can be seen particularly in Northern European
countries. For example, Denmark is preparing to launch a scheme in 2016, under which restaurants
and retailers can refuse cash payments. It is claimed that the reduction of cash management costs
contributes to economic growth. Danmarks Nationalbank is scheduled to start the process of ceasing
to print banknotes and mint coins by the end of 2016, which is expected to help reduce expenditure by
100 million kroner by 2020.
Fig.6-5 Recent Moves in Cash Reform
Year
2009
2014

2015

2016

Month

Event
Swedish central bank (Riksbank) becomes first in world after financial crisis to adopt a7
negative rate. Deposit rate lowered to -0.25%.
6
ECB decides to adopt a negative rate.
BOE Chief Economist Haldane suggests digital currency can ease constraints on ZLB.
9
French government prohibits cash payments of 1,000 euros or more.
10
Norway’s 2nd biggest bank, Nordea, announces it will halt cash handling over the counter.
BIS issues report on digital currency, saying central banks could consider using distributed
11
ledgers in their own payment systems.
1
BOJ decides to adopt a negative rate.
ECB considers scrapping high-denomination 500 euro notes to curtail use in money2
laundering and terrorist activities.
The Danish government prepares to launch scheme under which restaurants and retailers canscheduledrefuse cash payments.

Source: News reports, Central Bank websites

Cashless systems are also rapidly spreading in places other than Denmark. Among major countries,
the amount of cash in circulation in Sweden and Denmark is exceptionally small (Fig.6-6). In
Scandinavia, most bank branches have ceased point-of-sale cash handling. In October 2015, Nordea,
the second biggest bank in Norway, declared that it would cease cash delivery at the window. In thesecountries, settlement is carried out using debit cards or credit cards instead of cash.
Fig.6-6 Cashless Systems are spreading in Northern Europe【Cash in Circulation (% of Nominal GDP)】【Per Capita Cash in Circulation】(USD per capita)
22 (% of Nominal GDP)
10000
Denmark
SwedenDenmark
Sweden20
9000
Switzerland
Euro Area
Switzerland
Euro Area
18
8000
Japan
Japan
16
7000
14
6000
12
5000
10
4000
8
3000
6
2000
4
1000
2
(CY)
0
0
80
85
90
95
00
05
80
85
90
95
00
05
10
15

(CY)
10

15

Note: 2015 GDP/population figures for Denmark, Sweden and Switzerland are IMF estimates.
Source: Central Bank websites, IMF, Eurostat, OECD.Stat, Cabinet Office, MIC

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Cashless Economy and Technological Innovation ― Cash Revolution in Japan
In the growth strategy compiled in June 2014, the Japanese Government demonstrated a policy ofaccelerating the spread of cashless settlement with a view to the Tokyo Olympics in 2020. The key
pillar is the promotion of tourism and the expansion of card settlement, such as an increase in thenumber stores where credit cards issued abroad are accepted. Speaking of cashless systems, anothertopic—the development of IT technologies—is also emerging. As demonstrated in Fig.6-7, e-cash
payments are on the increase in Japan, however, it is lagging behind other developed economies interms of becoming a cashless society. However, there is growing interest in technological innovations
to reduce payment costs; recently, there were reports that the Bank of Tokyo-Mitsubishi UFJ isdeveloping its own virtual currency. If the BOJ’s NIRP affects the profits of Japanese banks, this may
encourage the development of blockchain technology and FinTech as in Europe.
Fig.6-7 Japan still has a long way off from becoming a Cashless Society
400【E-cash payments are on the increase in Japan…】(Million payments)
(Yen)

350
300

Total payments【...but cashless payments account for only 14% of all payments】
1200
1100

Value per payment (RHS)

1000

250

900

200

800

150

700

100

600

50
0
08/01

(Monthly)
10/01

12/01

14/12
14/01

500
400

Singapore
Netherlands
SwedenFranceU.K.
U.S.
GermanySouth Korea
BrazilJapan
China
Russia
India

(%)
0

10

20

30

40

50

60

70

Source: BOJ, MasterCard

In the future, the effects of economic revitalization may be enhanced by promoting electronic
settlement instead of printing new banknotes (physical paper money). This means that, if electronic
settlement becomes widespread, the restrictions of negative interest rates brought about by cash use
will be removed. One problem to be solved is to dispel people’s concerns over privacy, however theuse of the blockchain technology can realize anonymized settlement. For example, what if the BOJ
issued “new bills” in the form of electronic money encrypted with the blockchain, while it has theauthority to identify the person who paid by the anonymized money? The innovation could beincorporated into the system if the use of this authority is limited only to emergencies, such as tax
evasion investigations. The abolition of cash and electronic settlement are expected to help improve
the precision of macro-measurements of the amount of money in circulation. If it is possible to grasp
the amount of money in circulation, the circulation speed of money, and the rate of credit creation in areal time manner, there will be more room for adopting an agile monetary policy.

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