Shirakawa May Signal Bank of Japan Loath to Revive Zero Rates

By Mayumi Otsuma

Nov. 21 (Bloomberg) -- Bank of Japan Governor Masaaki Shirakawa will probably signal today that he's reluctant to return interest rates to zero because the policy may discourage lending rather than promote it.

Since reducing the benchmark overnight lending rate to 0.3 percent from 0.5 percent on Oct. 31, Shirakawa has warned three times that further cuts could freeze up the money market by making it unprofitable for banks to lend to each other. That would stifle the flow of money through the economy, which fell into a recession last quarter.

Pushing borrowing costs lower ``would evaporate returns to almost nothing and devastate incentives for traders to make transactions, rendering the money market defunct,'' said Shinsuke Kanabu, research director of Central Tanshi Co., a Tokyo-based money-market brokerage. ``The governor experienced the problem in the past and probably has a strong desire to avoid the policy.''

The central bank held the key rate at zero from 2001 to 2006 and flooded the banking system with extra cash to encourage lending, spur growth and overcome deflation. Shirakawa, who helped implement the policy as a BOJ official, said in May that it had ``only a limited impact'' in propping up economic growth.

Abundant funds pumped into the market failed to persuade commercial banks to lend to businesses and consumers. Instead, cash sat in lenders' accounts at the central bank, causing their reserves to swell almost nine times to 35 trillion yen ($368 billion) by early 2004. Meanwhile, daily call market trading volume dwindled to around 5 trillion yen from 20 trillion yen.

`Very Reluctant'

``Shirakawa is very reluctant to cut rates to zero,'' said Peter Wilson, a strategist at Mitsubishi UFJ Financial Group Inc. in London. ``The Bank of Japan has always stressed the negative side effects of a dysfunctional money-market mechanism.''

The central bank will keep the key rate at 0.3 percent at today's policy board meeting, according to all 35 economists surveyed by Bloomberg News. The announcement is expected by early afternoon in Tokyo, and Shirakawa will speak at a press conference at 3:30 p.m.

Shirakawa said this month that lowering borrowing costs too much may have ``possible adverse effects that might hamper proper functioning of the market mechanism.''

Rates that are too low will sap interest income to ``a level insufficient to cover various transaction fees, which in turn may reduce the volume of transactions in the market and bring about a reduction in market liquidity,'' the governor said in a speech on Nov. 6. ``Financial institutions cannot take risks when there are concerns over funding in the market.''

Seizing Up

Japan's financial markets are already showing signs of seizing up since the global credit crisis intensified two months ago.

The three-month Tokyo Interbank Offering Rate, an indicator of commercial banks' fund-raising costs, rose to 0.833 yesterday, 533 basis points higher than the key rate, compared with a 389 basis-point spread before the Oct. 31 reduction.

The nation's corporate bond market has closed to all but the top-ranked companies such as Tokyo Electric Power Co. The balance of commercial paper, used by businesses for short-term funding, underwritten by banks has fallen to the lowest since March 2002.

``The money market plays the role of a heart, pumping out money, or blood, all through the economy,'' said Central Tanshi's Kanabu. ``It's crucial to ensure that financial institutions can borrow from the market whenever necessary so that cash can be provided promptly to those who need it.''

Fed Nears Zero

Even as the Bank of Japan shows reluctance to return to zero rates, the U.S. Federal Reserve may be headed there for the first time. The Fed will lower borrowing costs to zero from the current 1 percent by January, JPMorgan Chase & Co. economist Michael Feroli wrote this week.

Some investors and economists say the Bank of Japan will have no choice but to cut rates again to limit damage from the recession. The world's second-largest economy shrank an annualized 0.4 percent last quarter as the global downturn weakened exports and prompted companies to slash spending.

There is a 26 percent chance of a cut by March, according to calculations made by JPMorgan yesterday based on interest-rate swaps trading. Nine of 28 economists who made predictions through March forecast a reduction by then.

``Japan's financial system might be rocked by some external shock, and if that happens, the BOJ won't be able to dismiss zero rates just by citing the market-mechanism problem,'' said Masaaki Kanno, chief economist at JPMorgan in Tokyo, who predicts a cut to 0.1 percent in the first quarter of 2009.

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