IMF Warns Japan on Financial Stability Amid Rising Interest Rates

By Leika Kihara

TOKYO (Reuters) – Japan needs to watch for potential spillover effects from increased volatility in foreign markets that could impact liquidity for its financial institutions, the International Monetary Fund (IMF) cautioned on Friday.

The IMF emphasized that Japan should stay alert to the consequences of the Bank of Japan’s (BOJ) interest rate hikes, particularly concerning rising government debt-servicing costs and possible increases in corporate bankruptcies.

> “As interest rates rise, the cost of servicing the large public debt is expected to double by 2030, requiring a robust debt management strategy,” the IMF stated following consultations with Japanese policymakers.

With growing gross financing needs and a decreasing BOJ balance sheet, the government will have to attract additional demand from foreign investors and domestic institutions for bond issuance, according to the IMF.

The yen has experienced significant fluctuations against the dollar, influenced mainly by the Japan-U.S. interest rate differential, compounded by the dynamics of yen carry traders.

The IMF noted that rising foreign volatility could impact domestic liquidity, potentially leading to broader effects.

To manage these risks, the central bank should monitor liquidity conditions and funding rates closely, with special attention to the uneven distribution of liquidity among banks.

The IMF praised Japan’s commitment to a flexible exchange rate regime, stating that it helps the country absorb external shocks and supports monetary policy aimed at price stability.

The BOJ concluded its extensive stimulus program last year and increased short-term interest rates to 0.5% from 0.25% in January, reflecting a belief that Japan is on a sustainable path towards its 2% inflation target.

After three decades of very low inflation, signs indicate that Japan’s economy is capable of achieving a “new equilibrium,” with inflation surpassing the 2% target over two years and a tight labor market propelling wage growth, according to the IMF.

The IMF advocated for a gradual rise in the BOJ’s policy rates, suggesting that ultra-low rates may have prolonged the existence of low-productivity firms and postponed necessary economic restructuring.

However, the IMF warned that swift interest rate hikes combined with a rise in bankruptcies among smaller firms could threaten the stability of the banking sector.

> “While gradually increasing interest rates have boosted bank profitability, unexpectedly rapid interest rate rises or sudden shifts in global financial circumstances could heighten market volatility,” the IMF declared.

Furthermore, a quicker-than-expected tightening of monetary policy could disrupt the Japanese government bond market, increasing interest rate risks for banks significantly exposed to it.