Japan Reverts to Zero Interest to Stem Slide

In a bid to prop up its weak economy and stem a stock market slide, Japan’s central bank Monday effectively returned to its policy of free money--zero interest rates--after a seven-month hiatus.

The Bank of Japan also reversed policy after months of domestic and foreign criticism by conceding that deflation was a problem and by changing the way it approaches monetary targets.

Rather than set a specific interest rate at which banks can borrow, as does the U.S. Federal Reserve, Japan’s central bank will now flood markets with money to drive down interest rates to close to zero from 0.15% last week. Rates were as high as 0.5% as recently as February, when the bank started cutting rates.

The bank also pledged to keep rates near zero until some sign of inflation appears, which could take two to three years in an economy in which prices just keep falling.

“It’s a 180-degree change,” said Seiji Shiraichi, analyst with Daiwa Research Institute. “They’ve essentially exhausted all their other options.”

One problem with Japan’s zero-rate policy is that even at low rates, debt-laden companies still aren’t in a mood to borrow because they don’t see many investments that offer much hope of bringing a return. Economists use the analogy of trying to push on a string.

Furthermore, because deflation in Japan is at 1% or 2% a year, even zero-interest rates essentially carry a spread of 1 or 2 percentage points.

Markets are closed today for a national holiday, although few expect a sharp immediate rally because the change was hinted at in advance.

Economists say that by pledging to stick to an effective zero-rate policy until conditions change, the Bank of Japan provides what relief it can to troubled economic players while introducing a measure of predictability to debt markets.

And by lowering rates and effectively printing more money, the bank does almost everything Japanese lawmakers asked of it.

Few expect monetary policy alone to pull Japan out of its dire straits. But its easier stance puts the onus on Japanese politicians to take tough steps they’ve long delayed: writing off bad loans, restructuring the government, introducing more competition, deregulating, letting insolvent companies fail and cutting workers loose to find more productive jobs.

“What the BOJ is saying is, ‘We’ve done everything. The only thing left is structural reform. Now it’s entirely up to you, mate,’ ” said Garry Evans, strategist with HSBC Securities.

But the bank’s newly cooperative stance also risks undermining its independence. Bowing to political pressure could hurt its ability to take necessary but unpopular steps in the future.

The bank also faced pressure from Washington to act more forcefully, especially with the Federal Reserve expected to cut rates by a half-point or more today. “If the BOJ didn’t move, the criticism would be very huge,” said Tetsuro Sugiura, chief economist with Fuji Research Institute.

Washington also may be concerned that further deterioration in Japan’s economy could prompt Japanese investors to sell U.S. Treasury bills and bonds in desperation.

Bilateral coordination was a key topic during Prime Minister Yoshiro Mori’s summit with President Bush this week in Washington. “I think the U.S. influence is rather big,” said Hiroshi Sakurai, analyst with Mizuho Investors Securities.

The Bank of Japan also vowed Monday to increase its buying of long-term Japanese government bonds within certain limits and to boost the size of the current accounts that banks keep with the central bank by about $8.1 billion--not a huge jump. Both moves are intended to increase the supply of money as part of the new policy known in monetary-speak as “quantitative easing.”

The hope is that these moves will halt Japan’s downward momentum even if they’re not enough to spark a rally. In general, analysts rated the moves as sound but late. “The question is, why didn’t they do this three months ago--or before?” said Richard Jerram, economist with ING Baring Securities Japan Ltd.

In the winners-and-losers column, meanwhile, several troubled players should benefit from Monday’s changes.

“Moving interest rates from 0.25% to zero has a very major impact on banks and distressed companies,” said Craig Chudler, strategist with Nikko Salomon Smith Barney. “It can be the sliver between staying in business and going bankrupt.”

Already troubled life insurers, obligated to pay policyholders high interest rates, will suffer. And Japanese consumers also could be hurt, particularly pensioners living on fixed incomes, who will see Japan’s already minuscule interest rates become almost invisible.

That said, bank interest rates yield only about 10 cents annually for every $100 on deposit, so a further decline is not that dramatic. “It can’t get that much lower than it is already,” said Ikumi Terunuma, a 55-year-old company manager in Tokyo.

By sending money washing through the economy, planners hope some measure of confidence can eventually be restored, sparking a stock market rally and boosting consumer confidence.

If Terunuma is any judge, however, that could be a ways off. He has seen his salary cut by 10% over the last decade, fears pension coffers could be depleted when he retires and sees no good reason to convert his savings to higher-risk, higher-return investments such as stocks.

“The government has to make us believe in the future,” he said. “And that’s a real credibility problem. No one has even taken responsibility for all their past failures.”

Makiko Inoue in The Times’ Tokyo Bureau contributed to this report.