Puzzle in Japan: Despite Lowering Rates
To Rock-Bottom, Banks Lack Borrowers

By PHRED DVORAK
Staff Reporter of THE WALL STREET JOURNAL

HIROSHIMA, Japan -- Why does Japan's economy, despite phenomenally low interest rates, keep wasting away? The answer begins in a vegetable garden near here.

Yuji Kawamoto spends Sundays tending his leeks and carrots. He used to sprinkle them using only tap water, but now he saves money by using bath water, rain water and water hauled from a nearby stream in plastic buckets slung on a pole. His wife, Kaoru, has shaved expenses by tossing out the television set and cutting off the electrical power to their son's room.

Mr. Kawamoto, who owns his spacious house and has a safe civil-service job, is no victim of recession. And that is what makes him a player in a central banker's worst nightmare.

Economists are calling it a "liquidity trap," a phenomenon postulated by John Maynard Keynes to describe what happens when demand for credit remains weak no matter how low interest rates go. Faced with an economy seriously ailing since 1990 and resistant to every treatment, Japan's central bankers have been doggedly applying the classic remedy of cutting interest rates. This is supposed to persuade everyone from the CEOs to the Kawamotos to grab and spend these cheap funds and galvanize the economy.

A Deep Pessimism

But after more than a decade of economic slump, the populace has sunk into a deep pessimism that threatens to become self-perpetuating. The fear that profit and income will only decline over the long term has persuaded corporate executives and families alike that their sole recourse is to cut spending. Slack demand has led to falling prices for goods and land. Falling prices have bred deeper cost cuts by businessmen and more heroic efforts to save by individuals. Companies are paring down old debt rather than borrowing anew for capital investment.

The devastated banking sector gets a double-whammy, since banks aren't making money from the interest on loans and they are spending money to pay interest on savings accounts. The central bankers, who have cut interest rates to virtually zero and can't go any lower, have blunted their primary tool for stimulating business.

'You Just Feel Like Saving'

"Theoretically, if interest rates are lower, you should use more money," says Mr. Kawamoto, in his baggy gardening trousers. "But actually you end up not using it because things just aren't looking that bright." Adds Mrs. Kawamoto: "You just feel like saving."

How to rescue Japan from this liquidity trap has sparked one of the great economic debates of the age, one that has taken on greater urgency since the Sept. 11 terrorist attacks increased concerns about a world-wide downturn. Japan's nominal economic output -- that is, unadjusted for deflation -- plunged at an annual pace of 10% in the April-June quarter, and many economists say the country is entering a contraction even worse than the one suffered in 1998, amid a near-panic in the banking system.

Now, with the U.S. economy slow to respond to aggressive rate cuts by the Federal Reserve, analysts such as Andrew Smithers, head of British economic-research firm Smithers & Co., have begun to wonder whether a global trap is emerging. "The U.S. and continental Europe are teetering on the brink," says Mr. Smithers. "And if they were to fall into it, you would have a world liquidity trap."

Acute Symptoms

The liquidity trap, so named because people stuck in it would rather hold cash -- be liquid -- than hold debt, was first formulated by Mr. Keynes amid the global Depression of the 1930s. For decades, the trap was just an ivory-tower concept. Now, Japan shows acute symptoms: The Bank of Japan is holding the key overnight call rate -- what banks charge each other to borrow money overnight -- to around 0.001%, but economic output and prices are still dropping.

Monetary policy is supposed to work through banks: The Federal Reserve, for instance, will cut the interest rates at which commercial banks borrow. That, in turn, tends to lower the rates charged businesses and consumers, who invest in factories or spend on cars. In Japan, that chain has broken down, in strange and alarming ways.

Japanese banks are facing customer flight -- not by depositors but by healthy borrowers, who are paying down old debt or balking at new loans. Outstanding bank loans have fallen in Japan from year-earlier levels for 45 straight months, sucking about $741 billion in credit out of the system -- more than Canada's annual economic output. Some of the most eager borrowers of Japan's low-interest money aren't Japanese at all, but foreigners -- such as the governments of Tunisia, Croatia and Argentina and many U.S. corporations and investment banks, all of which have sold large bond issues at low rates here.

Lacking borrowers, Japanese banks are stuffing cash into Japanese government bonds. They bought $198 billion in 2000 alone, nearly doubling their holdings. That's risky because bond prices might fall, costing banks more in lost portfolio value than they would gain with rising yields and putting the already-troubled banking system in further jeopardy. So, some banks are putting excess cash into savings deposits at rival banks -- who are rejecting the money.

In the perverse universe of deflation, where the prices of goods and services are declining, saving at near zero-percent interest makes sense. Since prices are falling at about 1.5% a year, the real value of money is actually rising. Bank deposits have risen about 2%, or $78 billion, during the past five years, even though banks are now paying only 0.02% on savings. At that rate, it would take 3,500 years for one's money to double in nominal value.

Need to Spark Inflation?

The solution to Japan's liquidity trap, according to a number of academic economists, is for the nation to spark inflation intentionally. If prices are rising at a decent clip -- say, at 5% a year -- and interest rates stay below that, companies and consumers might snap up loans because the real cost of borrowing would be negative. That might prod the Kawamotos to dip into their savings and buy a TV set.

Two weeks ago, Japanese Finance Minister Masajuro Shiokawa called for reflating prices back to their 1997 levels. But calls for reflation are meeting a stern response from the one man who can deliver it: central bank Gov. Masaru Hayami. He argues he has already gone into dangerous territory by slashing rates to zero and pumping up the money supply. Going further would risk sparking an inflation, he warned earlier this month, "whose fires will spread and could even ... burn furiously."

The fight has drawn front-page coverage by tabloids. Pro-reflation legislators are pushing for a law that would curb the Bank of Japan's power by forcing it to target a positive rate of inflation. One of the ringleaders, Yoichi Masuzoe, called Mr. Hayami a "dictator" and challenged him to debate monetary policy on TV. Mr. Hayami refused, and accused his detractors of "throwing rocks."

A look at the rusting industrial hub of Hiroshima shows why monetary policy is sparking such emotion in Japan -- and how an economy awash in money can wither away.

Just 9% of Hiroshima-area firms say they plan to borrow for investment, the Bank of Japan found in a recent survey. To understand why, consider Mazda Motor Corp. The company, which accounts for about half the falling industrial output in this city of one million, this year cut 2,210 jobs and closed half of its vast Ujina factory complex. The Ford Motor Co. affiliate's sales fell to 334,000 cars in Japan last year, about half its 1990 peak. That is gutting the profit needed to pay down Mazda's huge debts -- equal to three times shareholder equity -- to a target of half of equity, in line with standard U.S. levels. For now, though, that crushing debt, coupled with falling demand, means Mazda will keep borrowing to a minimum, officials say.

A few miles from Ujina, Masato Uno, president of car-door supplier Hirotec Corp., says Mazda wants him to cut prices. That will sharpen the pain of his shrinking sales volume, already half of 1992 levels. Banks are still urging Mr. Uno to borrow fresh money, though he considers it foolhardy to invest in Japan.

But he is taking advantage of the cheap credit -- by investing it overseas, to start metal-stamping ventures in Thailand and Mexico. Last year, Mr. Uno borrowed at a bit more than 2% to invest 350 million yen (about $2.9 million) in Ingemat SA, a Spanish maker of car-assembly equipment. His accounting manager, Kenso Iwami, says banks are begging Hirotec to borrow more: "They say they'll lend cheaper than other places," Mr. Iwami says. "They want to steal market share from each other, you see."

Financing Stagnation

Back home in Hiroshima, plentiful credit is financing stagnation, as banks use cheap rates to keep ailing companies on life support. The shelves of a discount auto-parts chain, Monte-Carlo Co., are piled with unsold shock absorbers and faux-leather steering wheels. Mazda workers, once the store's best customers, aren't splurging on their cars anymore.

Akira Okano, managing director, says car-navigation systems used to be a big money-maker for the $150 million-in-sales company, but now sell for an eighth of what they used to. Monte-Carlo has posted losses for two years and groans under a debt load of four times equity. But banks keep rolling over its 6.7 billion yen in loans, on which Monte-Carlo pays hardly any interest. "There are a lot of companies like us, ducking their heads and holding on while the wind rushes over," says Mr. Okano.

Lenders can afford to be so forgiving in part because they are swimming in cash. Setouchi Bank Ltd., a small lender based just outside Hiroshima that is one of Monte-Carlo's two main banks, has 700 billion yen in deposits, but just 600 billion yen in loans. Banks earn their money by lending, so such an imbalance can cut into revenue unless they have other profitable places to invest funds collected from depositors. In Japan, total bank loans fell below deposits in early 1999 -- and now exceed them by about $300 billion.

This liquidity surplus is driving Hidenori Nuibe crazy. As treasury chief at Setouchi, he is in charge of investing 130 billion yen of the bank's money but has run out of safely lucrative places to put it. So in June, Mr. Nuibe took a desperate step: He stuck the yen equivalent of $33 million into a plain-vanilla savings account at rival Hiroshima Bank Ltd., earning him interest of $17 a day. Hiroshima Bank, which won't comment, howled in protest, and Mr. Nuibe says he withdrew the money the next month.

So Mr. Nuibe is stuck putting the cash in overnight money markets. That's a money-losing proposition, since the bank pays more on deposit insurance alone than it makes from the 0.001% return, even before figuring in the salaries of Mr. Nuibe and his team. Each day Mr. Nuibe invests 30 billion yen -- more than the cost of a Boeing 747 -- in the overnight markets, and earns just 800 yen.

"We only get what a part-timer at McDonald's would make" an hour, quips the 12-year trading and investment veteran. "But it can't be helped."

Pipes Have Gotten Clogged

The dysfunction deepens in Tokyo, the center of the overnight-lending markets where Mr. Nuibe is losing his shirt. Those markets are the pipelines through which the Bank of Japan channels money to banks. Each day, the central bank injects far more money into the markets than banks need, in order to drive down the price of credit and, hopefully, spark some borrowing.

But the pipes have gotten clogged. Japan's six money-market brokers this year merged into just three, because demand for the cash that they trade is so weak. In May, the system went haywire: On 16 occasions, the central bank failed to find enough takers for its money, leaving it powerless to ease credit further. Atsushi Miyanoya, head of open-market operations, in July doubled, to 120, the number of banks that can bid for the BOJ's cheap funds. And he had the BOJ's computers reprogrammed so the bank can price the interest on its funds at even closer to zero -- a thousandth of a percentage point, down from a hundredth. The overnight rate immediately fell to 0.001%, its low-end limit.

"If we took the unit down one more time, would that really change anything?" laughs Mr. Miyanoya. "We're at the nano-technology level."

In fact, rates have fallen so low that credit is tightening, not easing, bankers say. That's because many companies now prefer to leave their cash idle rather than invest it in the money-markets at near-zero rates. So when demand for cash picks up for some reason, as it did earlier this month, there aren't enough fund-suppliers to satisfy it, causing interest rates to spike. "It's a truly weird situation," says Takeshi Ogura, a money-market dealer at Sanwa Bank Ltd.

Even so, critics say there's plenty more the BOJ can do. Many politicians and economists are calling on the bank to purchase huge amounts of dollars, thereby cheapening the yen and ramping up the money supply, both of which would help push up prices. Others suggest that the bank buy bad loans, property, stocks -- anything to create inflation, so that consumers will decide that they had better start spending again before their money loses value.

"Outside Japan, monetarists agree there's no technical problem creating or controlling inflation," Ben S. Bernanke, chairman of the economics department at Princeton University, told a gathering of economists in Tokyo recently.

Meanwhile, outwardly prosperous families like the Kawamotos are clamping down even harder on expenses. Mr. Kawamoto, a 49-year-old city-planning official, makes about 6.1 million yen a year, a bit above average for his age group, and puts about a third into term savings accounts at the post office.

Mrs. Kawamoto polices expenses, using a popular technique that women's magazines have dubbed "the bag method." On her husband's payday, the 47-year-old withdraws all the cash she needs for that month, and divides it out into 11 clear plastic bags, according to her prearranged budget. She buys groceries with money from the "food" bag and shoes with money from the "clothing" bag. Every morning, she checks electricity and gas-meter readings and marks them on a wall calendar. When she noticed water bills were high, she screwed down the main water tap. This year, she threw out the old television set, and hasn't replaced it.

The Kawamotos have worked out a lifelong-savings plan, plotting out income and expenses through 2023, but it doesn't look pretty. They will soon have two children in college, but Mr. Kawamoto's income isn't rising as expected, as the strapped local government tightens spending. That will leave them 5.5 million yen shy of the 30 million yen nest egg they hoped to have by 2012, when Mr. Kawamoto wants to retire, buy a little house in the country and try his hand at farming. Already, the Kawamotos have amended their savings plan, by expunging all the expenditures in the "pleasure" category until 2006.

And so it is that in Japan, a land once notorious for its $100 melons and $6 cups of coffee, some people pine for the old days of rising prices. Mr. Kawamoto, gazing out at his garden, notes how his property's value has fallen back to nearly what he paid for it in 1975. "It's easier to use money when prices are high, because whatever assets you have, they're going up," he says.

Write to Phred Dvorak at phred.dvorak@wsj.com