Bank of Japan May Pay Interest on Reserves, Morgan Stanley Says

By Mayumi Otsuma

Oct. 22 (Bloomberg) -- The Bank of Japan may announce next week that it will start paying interest on reserves lenders deposit at the central bank to counter the global financial turmoil, Morgan Stanley said.

``The BOJ is likely to team up with other central banks to expand liquidity provisions in the run-up to year-end when funding supply and demand tightens,'' Takehiro Sato, chief Japan economist at Morgan Stanley in Tokyo, wrote in a report published yesterday. ``This may mean more urgent consideration of interest payments on reserves'' and the bank may announce the plan as soon as Oct. 31, when it releases its economic outlook.

The step would discourage lenders from hoarding cash and help the central bank provide more funds without worrying about the overnight lending rate falling below its target of 0.5 percent. The Federal Reserve adopted the measure on Oct. 6, and BOJ Governor Masaaki Shirakawa last week said he ordered his staff to hammer out a similar plan as soon as possible.

``Paying interest would allow the Bank of Japan to flood the money market with liquidity without cutting its benchmark rate,'' said Naoki Iizuka, a senior economist at Mizuno Securities Co. in Tokyo. ``It shows the bank intends to counter the financial turmoil with liquidity rather than a rate cut.''

The Fed's reserve payments are about 10 basis points below the 1.5 percent benchmark rate, giving commercial banks an incentive to park excess cash at the central bank rather than invest it at lower rates in the market. The Bank of Japan would also set the rate on reserve payments below its benchmark target, economists said.

Bottom End

``The reserve deposit rate would set the low end for rates in the overnight lending market,'' Sato wrote. ``For the BOJ, this would be an effective way to control fluctuations in the overnight rate via a new fund absorption route.''

The measure, if implemented, would follow other actions by the central bank as part of global efforts to free up credit after the bankruptcy of Lehman Brothers Holdings Inc. last month made banks reluctant to lend for fear of not being repaid.

The bank today accepted bids for $50.2 billion in loans from 40 financial institutions after last week saying it will offer lenders as many dollars as they need. Also on Oct. 15 it expanded the range of collateral it accepts for lending.

Shirakawa this month said the most essential contribution central banks can make to weather the financial turmoil is to provide liquidity. The bank didn't participate in the joint rate cuts by central banks in North America and Europe on Oct. 8, saying Japan's borrowing costs are already ``very low.'' The policy board last week unanimously kept the overnight call rate unchanged at 0.5 percent, the lowest among major economies.

The interest payments might not have much effect in Japan because the financial system remains stable and lenders aren't hoarding much cash, said Hiromichi Shirakawa, chief economist at Credit Suisse Group in Tokyo and a former central bank official.

``Paying interest on reserves and encouraging banks to put up funds at the central bank is meaningful if there is a concern about a country's financial system, but that's not the case in Japan now,'' he said. Shirakawa isn't related to the central bank governor.

To contact the reporter on this story: Mayumi Otsuma in Tokyo at motsuma@bloomberg.net