South-Western College Publishing - Economics  
Japan Doubles Short-Term Interest Rates
Topic International Trade
Key Words Japanese Yen and Carry Trade
News Story The Japanese economy has long been characterized with rock-bottom interest rates. Until recently the short-term interest rate was 0.25 percent. In a recent action by the Japanese central bank the short-term borrowing rate was increase to twice that amount at 0.5 percent.

The result of Japan's historically low interest rates is a huge flow of cheap yen out of Japan and into other global markets offering a better return on investment. Economists refer to this flow as the yen carry trade. The flow does not originate only from Japanese citizens; it also results from foreign investors borrowing cheaply in Japan to invest in real estate and other markets abroad.

This phenomenon has led some to call the carry trade a bubble, financed by cheap Japanese credit, that is just waiting to burst. For now though, most economist say that the increased rate by the Bank of Japan is a baby step toward closing the gap with Europe and the U.S, where the benchmark rate is 5.25 percent.

"This isn't much different from 0.25 percent," the bank's previous benchmark rate, said Masaaki Kanno, an economist for JPMorgan Securities. "The Bank of Japan must raise rates much higher to trigger and unwinding of the carry trade."

No one knows for sure just how large the carry trade is, but Mr. Kanno estimates that about 7 trillion yen, or about $58.39 billion, flowed overseas in 2006 alone. However, the Bank of Japan is not likely to burst the bubble soon because they would have to raise the rate so high that it would not be profitable for the yen to flow to other markets. Current estimates suggest that would require ratcheting the interest rate to near 2 percent.

A tighter monetary policy would require signs of increasing inflation which are not present in the Japanese economy. Also, the Japanese growth rate is slow already and would be hampered more by an increase in rates.

"It would be difficult for the Bank of Japan to justify any follow-up rate hikes," said Hiromichi Shirakawa, a Tokyo-based economist for Credit Suisse Securities. "I think their hands are tied in this regard until at least the end of this year."

Discussion Questions:
1. Use any source available to define and discuss the "yen carry trade" referred to in the article.
2. Discuss the notion of tight money policy as it applies to the article.
Multiple Choice/True False Questions:
1. The flow of yen from Japan to other markets is referred to as:
  1. anti trade.
  2. carry trade.
  3. benchmark trade.
  4. none of the above.
2. Because of a fast growing economy and new signs of inflation, the Bank of Japan is likely to increase benchmark interest rates in the near future.
  1. True
  2. False
Source Martin Fackler, "Bank of Japan Raises Short-Term Interest Rates," The New York Times Online, February 22, 2007.
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