Japan's negative risk premium in interest rates: The liquidity trap and the fall in bank lending

Since the asset price bubble burst in the early 1990s, Japan's economy has been virtually stagnant and its banking sector has been troubled. Since the late 1990s, the macroeconomic performance has deteriorated and the banking sector troubles have worsened. The government has resorted to expansionary monetary policy and has tried expansionary fiscal policy. However, these standard stabilisation tools have failed to stimulate the economy. Most existing analyses have emphasised the need for broad-based structural reforms to clean up the banking sector and to liberalise various sectors of the economy. Others have emphasised the need for an even more expansionary monetary policy to halt deflation. We believe that this emphasis on structural reform and further monetary (or fiscal) 'expansion' is misplaced. In this paper, we argue that long- and short-term nominal interest rates in Japan have been compressed to historically low levels - the so-called liquidity trap - because of pressure coming through the foreign exchanges. This pressure has several facets. The first facet is the declining nominal interest rate on dollar assets from inflation stabilisation in the United States in the 1990s. The second is a negative risk premium in Japanese interest rates that has kept yields on yen assets well below those on dollar assets. The third facet is a residual fear, now possibly quite small, that the yen will resume appreciating secularly. This paper focuses on the domestic financial consequences of the negative risk premium arising from the cumulative effect of more than 20 years of Japanese current-account surpluses.