Economic Impact of Interest Rates and the Japanese Economy

Economic Impact of Interest Rates
There is a tendency to forget that for every borrower there is a lender and that interest rates work both ways. Less interest paid by borrowers means less interest received by lenders. When interest rates rise or fall, total disposable income doesn’t change; it simply redistributes.

Effect of rising interest rates on consumers
1. Consumer demand declines because the forced reduction in consumption by the greater number of borrowers is greater than the increased consumption of the lesser number of lenders.
2. Reduced demand is said to dampen inflationary impact of rising prices.
3. Budget-strapped families are forced to work extra hours or family member to seek part-time work.
4. The subsequent increase in availability of labour reduces pressure on wage demands.


Effect of interest rates rise on highly leveraged businesses
1. Profitability of highly leveraged businesses is reduced by their high cost of debt. Main impact on profitability is felt by exporters.
2. More foreign capital inflows are attracted by the higher interest rates which increases the exchange rate, consequently reducing the value of exports in the domestic currency.
3. Lower export output means reduced demand for labour and consequent further restraint on wage increases.
4. Higher exchange rate also means that the lower cost of imports will reduce prices
5. Reduced labour demand in industries competing with imported goods stabilizes costs by again increasing the availability of labour.


Effect of falling interest rates
1. Debtors are rewarded and more inclined to be financially irresponsible.
2. Those who have been prudent in accumulating savings in interest-bearing securities are penalized and less inclined to be prudent in the future. (Given the impact of a 40 percent tax rate and 3 percent inflation on an interest rate of 5 percent, the zero return (5 percent x 60 percent – 3 percent) provides zero incentive for prudence.)
3. Although serving short-term political objectives and rescuing overleveraged debtors, the longer-term effects of artificially low interest rates have proven to be undesirable.

Low Interest rates and The Japanese Economy
Any doubt about the effectiveness of low interest rates to stimulate the real economy should have been dispelled by the well-publicised Japanese experience. In spite of having interest rates close to zero and the government running a huge annual deficit, thus leaving more disposable income in the hands of the consumers, Japan has suffered a lingering recession since 1990.


The Nikkei 225 index’s loss of one-third of its value in the past 20 years can only be attributed to the low profitability of Japan’s corporations. Even with the leverage of close to zero interest rates, the ROE of Japan’s large nonfinancial firms fell from 8.2 percent in 1988 to an average of 3.1 percent between 1992 and 1999. It has since recovered to roughly 10 percent in 2007, but still lags a long way behind higher-interest-rate countries.


The real determinant of economic viability, ROFE (Returns on Funds Employed), would obviously be considerably lower than the quoted ROEs. When debt servicing is of no concern, inefficiencies creep into the business and the economic viability of capex becomes less important.
The prices of those wonderful products we buy from Japan are subsidized by shareholders of Japanese corporations. Little wonder that Buffett, when asked about investing in Japan in 2007, wryly commented that the profitability of Japanese companies was too low for Berkshire’s liking.


Although Japanese corporate profitability is improving, by Western standards most of its major corporations have not been economically viable in the past, and if required to pay equitable rates of interest, would be in serious financial difficulty.


The high Nikkei index PE ratio in 2007 of 18 (price-to-book value of 1.9) on average ROEs of 10 percent is influenced by the meager average dividend yield of 1.1 percent still being better than leaving money in the bank.


With so little incentive to invest and debt so cheap, it is not surprising that in 2005 Japan was the world’s largest consumer of luxury goods, accounting for 41 percent. Rather than working in favour of Japanese investors, low interest rates over the past 20 years have decimated their funds. Although low domestic rates persist, demand for Japanese stocks will remain high and they will therefore continue to be grossly overpriced.

The reason Japan keeps rates so low is to encourage an outflow of capital to dampen the yen exchange rate to help its exporters. In other words, domestic employment is the prime motivation. If Japan’s trade surplus were repatriated, rather than being left abroad, the US dollar would crumble and the yen appreciate to a level that would make life even tougher, perhaps impossible, for many Japanese exporters.

Here is a simple question to see whether you have been following the argument.
Given a Nikkei index figure of 16,500 and the abovementioned ROE (10 percent) and price to book value (1.9), what would the Nikkei index need to be to achieve a 10 percent return from an index fund that replicated it? Answer: 8684

When ROE and RR (Rate of Return) are equal, value is equal to book value. Therefore, 16,500 / 1.9 (price to book value) = 8684.

These are the sorts of things to consider when thinking about investing in international funds.


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