May 1, 2001

Japan’s Banking Crisis and Low-Interest
Rate Trap
byRonald I. McKinnon
Stanford University

Since the end of the so-called bubble economy in 1991, Japan’s economic slump
has been dismayingly persistent. I shall argue that perverse exchange rate expectations are
an important part of the problem. Otherwise, two related financial mysteries associated withthe slump seem to defy explanation.
The first mystery is the banking system’s ongoing bad loan problem. Despite
repeated government attempts to recapitalize the banks and help clean up their balance
sheets, new bad loans keep appearing. Officials at the Financial Services Agency (FSA)
estimate existing bad loans to be about Yen 47,000 billion, whereas the Democratic Party ofJapan (DPJ) believes that the true figure is closer to an incredible Yen 150,000 billion. This
would be about 30 percent of GNP, which is extraordinarily high by international standards.
And, even though the overall money supply continues to grow, new bank lending—good orbad—continues to decline.
The second mystery is the low level of nominal interest rates on yen assets incomparison to those on dollar assets. The current three-month money market rate in is 0.03
percent in Japan, and 4.6 percent in the United States. On ten-year government bonds, therate is about 1.3 percent in Japan, and 5.3 percent in the United States. Because theseinterest differentials of about 4 percentage points have persisted since 1978, why don’t
Japanese business firms and households demand dollar assets with much higher yields atevery term to maturity? The pressure from such arbitrage should force Japanese nominalinterest rates upward toward international levels.
Instead, this interest rate differential has been sustained because market participants
implicitly believe that the dollar value of the yen is likely to be much higher in the future.
Today, for example, a holder of a 10-year JGB would accept the very low yield of 1.3 percent
only if he or she expected the yen to be much higher 10 years from now than it is today. And,from August 1971 at 360 yen per dollar through to a peak in April 1995 of 80 yen per dollar,
the yen did rise enormously—with serious deflationary consequences for Japan’s economy.
Although the yen has come down to about 122 per dollar, market expectations thatthe yen will rise, if only erratically, remain surprisingly strong—as revealed by the persistenceof the interest differential. In our book, Dollar and Yen: Resolving Economic Conflict Between
the United States and Japan (Nikkei, 1998), Kenichi Ohno and I hypothesized that recurrent
American mercantile pressure since 1971 to get the yen up, in order to reduce Japanesetrade surpluses, created the expectation that the yen would naturally move higher. Since
1995, when Secretary of the Treasury Robert Rubin announced a strong dollar policy, thisovert pressure from the Americans has been muted. However, with the current downturn in
the American economy leading to rising unemployment, this pressure could well return.

American nominal interest rates have themselves fallen from the very high levels of
the 1970s and 1980s to the moderate levels we see today. Combined with the expectation ofan ever-higher yen and ongoing deflation in Japan, this pushes yen interest rates toward
zero. In this externally imposed low-interest liquidity trap, the Bank of Japan is powerless tostimulate the Japanese economy. First, no matter how much base money it creates, yeninterest rates cannot be driven below zero. Second, at 122 yen per dollar, Japan’s currency
today is very close to purchasing power parity with the dollar. (Indeed, the yen is slightly
undervalued by The Economist’s (April 21) Big Mac hamburger standard!) Thus, if Japan
tried to use a much weaker yen to export its way out of its current difficulties, American
mercantile pressure—and pressure from other important trading partners such as China andKorea—would return with a vengeance.
This unnatural compression of nominal interest rates toward zero also worsens thebanking crisis. Apart from past and existing bad loans, Japanese banks cannot make newloans to high-quality borrowers on a sufficiently profitable basis to restore their balance
sheets. Today, the prime loan rate in Tokyo and Osaka is just 1.4 percent—a spread of 1.3
percentage points over the banks’ virtually zero-interest cost of funds in the interbank market.
In comparison, in the United States, the prime loan rate remains at 7.5 percent—a spread of
3 percentage points over American banks’ cost of funds in the money market of about 4.5percent. By this particular measure, American banks enjoy gross profit margins more than
twice those of their Japanese counterparts.
Another measure of bank profitability on new lending would be the spread between
interest on checking accounts, usually zero in both countries, and their prime loan rates. AnAmerican bank can attract checking accounts, which are costly to maintain, at zero interestand lend the proceeds to prime quality borrowers at 7.5 percent. A Japanese bank would
only get 1.4 percent. No wonder Japanese banks remain reluctant to lend, and cannot
generate a flow of profits to restore their capital positions depleted by the large losses onpast loans. As long as market interest rates remain compressed toward zero, just cleaning
up bank balance sheets, i.e., taking away old bad loans and recapitalizing, will fail tostimulate new bank lending.
Consequently, escaping from the low-interest liquidity trap is necessary for two
reasons: to restore the power of the Bank of Japan to macro manage the economy, and towiden bank profit margins sufficiently to stimulate new lending and rebuild bank capital.
The expectation of a higher future value of the yen and associated deflation can bechanged by government policy. However, a credible signal from both the American andJapanese governments that the future dollar value of the yen will not differ substantially fromwhat it is today is necessary. From 1971 to 1995 there was substantial implicit and explicit
political pressure from the United States, backed up by threats of trade sanctions, to get theyen up. While this higher-yen policy failed to reduce Japan’s trade surpluses, it imparted
deflationary momentum, ending up with the low interest rate trap, to Japan’s economy.
Surprisingly, this deflation has now taken on a life of its own and has lasted into 2001 eventhough the yen is not now overvalued. The problem is the long-term expectation of an everhigher yen. Today’s exchange rate of 122 yen to the dollar seems correctly valued at close topurchasing power parity.
To quash the expectation of an ever-higher yen and future deflation, Ohno and I
proposed a bilateral trade and exchange rate pact between the United States and Japan.
The trade pact would restrain mercantile pressure from the United States for a higher yen,
but also require Japan to continue with its economic liberalization. Then an agreement tostabilize the yen to anchor expectations against future deflation becomes feasible. The newparity rate, say 122 yen per dollar, would be a long term benchmark towards which the twogovernments would occasionally intervene to nudge the market rate. (No hard short-term fix
is necessary.) Then, as deflationary expectations decline, Japanese nominal interest rates,and bank profit margins, will increase to “normal” international levels.
[This essay was translated into Japanese and published in Japan Economic Journal, May 11,2001]