Policy interest rates in Japan will rise from 2024. That shouldn't leave the nation too afraid. Japan shows resilience to assumed rising yen rates.

We anticipate a gradual increase in Japan's policy interest rates. They will be up approximately 0.1% in 2024 and about another 0.1% in 2025 from the current level of -0.1%. We also believe that there won't be an accompanying sharp deceleration in economic growth, which is affected by changes in monetary policy.

Therefore, from a macro perspective, we do not expect a significant deterioration in the performance of corporate sectors even if there may be pain for some individual companies. We estimate higher interest expenses due to rising yen interest rates will shave about 2% off operating profit.

A rise in yen rates will have positive and negative effects for banking; the sector is likely to enjoy a net benefit from it. The positive impact of improved yields on lending should outweigh negative effects such as increasing unrealized losses on bond holdings. Our conservative estimate is that operating profit at Japan's three major banking groups should rise about 3%. The increase would likely be higher after factoring in effects such as improved yields for newly held bonds. The three groups are Mitsubishi UFJ Financial Group Inc., Mizuho Financial Group Inc., and Sumitomo Mitsui Financial Group Inc.

Base-Case Scenario: A Moderate Path For Japan

The rise in policy rates we expect for Japan will be moderate compared with rates as of the end of March 2023, and we do not expect such a change in policy rates to act as a sharp brake on economic growth. Our assumptions of key macroeconomic conditions for Japan are in the table below.

Table 1

Corporates: Higher Cost For Debt Will Reduce Profit

Our simulation indicates that the decrease in corporate sector operating profit due to an increase in interest expenses would be 2%. For the simulation, we assume the rate rise occurs on the first day of the fiscal year and lasts for 12 months. However, we note that when rates rise, businesses tend to pass on some of their increased costs (including interest expenses) in sales prices. Therefore, the actual negative impact on earnings is likely to be lower than 2%, in our view.

We calculated the impact of increasing interest expenses on operating profits in the corporate sector without adjusting variables other than interest rates. We assume a rise in fixed long-term borrowing rates of +0.4 percentage point (ppt) and +0.2 ppt for floating short-term borrowing. The composition ratio of fixed long- and floating short-term borrowings is set at 25% and 75%, respectively. We use the same assumptions for banks later in this report.

We considered the following when calculating the change in fixed long-term rates:

• The change in yields of three-year Japanese government bonds (JGBs) between March and September 2023. This was approximately +0.15 ppt. We used three-year JGBs because this corresponds to the duration of the average fixed long-term loan.
• Our assumption of a rise of approximately 0.2% in Japan's policy rate by 2025.
• For floating short-term interest rates, we only incorporate the assumed policy rate change of 0.2% by 2025 as we saw little change in banks' short-term lending rates between March and September 2023.

We retrieved data on corporate balance sheets and income statements for April 2022 to March 2023 from a Ministry of Finance quarterly corporate statistics survey. The retrieved data covers all industries other than finance and insurance. We calculated how an increase in interest expenses due to an assumed rise in yen borrowing rates would impact corporates based on operating profit over the last year. We used the total balance of corporate bonds and borrowings for our calculations. This is because disclosed data on corporate bonds and borrowings does not provide a breakdown between yen- and foreign currency-denominated debt.

Banks: A Little Goes A Long Way

For the Japanese banking industry, a slight increase in lending rates can have a significant impact on interest income. The sector has been in a low-interest rate environment for many years. Assuming floating short-term lending rates increase by 0.2% and fixed long-term rates increase by 0.4%, the aggregated annual interest income of the three major banking groups would increase by 35% relative to fiscal 2022 (ended March 31, 2023). This increase in interest income would be equivalent to 12% of fiscal 2022's operating profit at the banking groups.

For our calculations, we use the assumptions outlined in table 2, as well as the base-case scenario in table 1. We also consider changes in short-term market interest rates and yields on JGBs from April to September 2023.

Table 2

As well as lifting interest income, higher rates are expected to negatively impact banks, in our view. We estimate unrealized losses on yen-denominated bond holdings would be -9% relative to operating profits in fiscal 2022. We calculate this figure by aligning holdings with the assumed 0.4% increase in fixed long-term lending rates and dividing it by an assumed 1.5-year duration.

Credit costs could also increase if interest rates rise significantly. However, we consider this to be unlikely and of limited impact. This is because borrowers' creditworthiness would need to be severely weakened for such costs to increase. For example, borrowers facing such risk would not be able to cover a surge in interest payment costs with the annual profits they generate. We do not expect to see this type of deterioration in creditworthiness at the major banks, given the limited increase in interest rates under our base-case assumptions.

A slightly higher credit cost ratio (credit costs/loan exposures) relative to the level in 2022 is likely in 2023, though. Repayments related to so called zero-zero loans start this year. These government-provided loans, handed out as a kind of subsidy during COVID-19, were interest-free and generally did not require repayment for the first three years after their provision. We believe the industrywide credit cost ratio in fiscal 2023 will remain at about 0.2%, about the same level as fiscal 2022. One-off special factors involving the bankruptcy of a few large borrowers pushed up the ratio in fiscal 2022.

After weighing the positives and negative, we assume an increase in yen-denominated interest rates would have a net positive impact of approximately 3% on operating profit at the three major banks. However, our calculations do not incorporate the following three positive factors related to revenues, making our estimate conservative:

• We do not consider the effect of hedging positions in bond holdings,
• We do not account for the increase in bond interest income likely as existing bonds mature and are replaced by bonds with higher yields, and
• We do not factor in potential improvement in banks' bond portfolios through consideration of unrealized gains and losses, including on equity holdings. Currently, their entire portfolios of available-for-sale securities are in a net profit position, thanks to an appreciation of equity holdings.

Other Considerations: Investment-Oriented Institutions At Risk

For three financial institutions--Japan Post Bank Co. Ltd., Norinchukin Bank, and Shinkin Central Bank--there will likely be short-term pain if rates rise. This is because these outliers focus on securities investments rather than lending. They are likely to see a large increase in unrealized losses because of higher interest rates. However, they should see bond interest income increase eventually. We factor the above into our current rating assessments of the three institutions and have revised their risk positions down to moderate as a result.

We also note that divergence from our base-case scenario could have severe consequences. If Japan's inflation rate deviated significantly from our macroeconomic assumptions, driven by cost-push rather than demand-pull inflation, and the rate was to hit a very high level of about 10%, about the peak shown in Europe or the U.S. in recent years, Japan's economic growth would be highly likely to slow significantly. Weakening consumer spending and deteriorating corporate performance would drive this slowdown. In this scenario, a downturn could hurt the corporate sector's ordinary profit and increase credit costs for the banking sector.

We have observed a large change in yields on U.S. Treasury bonds in the last six months and note that a rise of about 1 ppt in rates on 10-year U.S. Treasury bonds in April-September 2023 could cause unrealized losses for banks. However, securities holdings on the balance sheets of the three major banking groups in fiscal 2022 (ended March 2023) had a revaluation surplus of ¥2.7 trillion after tax effects. This indicates they have a substantial buffer against unrealized losses on their holdings. This surplus is about 1.6 times the negative impact of higher rates on bonds, calculated by combining 1) an increase in unrealized losses due to a 1.0 ppt rise in yields on bonds denominated in currencies other than yen (after tax effects: based on our estimations), and 2) an increase in unrealized losses based on the aforementioned scenario of rising yen bond yields (after tax effects). Furthermore, due to the robust performance of Japanese stocks, unrealized profits on major bank's equities holdings have increased since March 2023. In addition, major banks have been working on reducing their holdings of bonds denominated in currencies other than yen and on shortening their durations. Therefore, we believe the major banking groups have some resilience to higher U.S. interest rates.

Related Research

• Banking Industry Country Risk Assessment: Japan, June 15, 2023
• Global Debt Leverage: Japan Corporate Can Tolerate Higher Rates And Inflation, April 11, 2023
• Japan’s Credit Risks Could Rise With Costlier Financing If Growth Falters, Feb. 23, 2023
• Japan Banking Outlook 2023: The Impact Of Raising Interest Rates, Jan. 17, 2023