Japan’s low-leverage economy should withstand rate hikes

The rate hikes we expect over the next few months are unlikely to derail Japan’s economy from its modest but steady growth path. Most firms and households will be able to withstand a rise in interest rate costs thanks to their healthy balance sheets.

Most companies will likely maintain a reasonable spread between return on assets and interest rate costs thanks to their low leverage and rising profitability. However, an analysis of small firms shows that a 1ppt rise in effective interest rates could increase the share of loss-making small firms from 27% to 31%.

On aggregate, the Japanese are net savers and rate hikes will have a net positive impact by raising deposit rates. However, people in their 30s and 40s tend to be net debtors due to large, overwhelmingly floating-rate mortgages, making them vulnerable. Although higher rates will weaken already stagnant residential investment, their impact on overall economic growth should be limited.

The economy’s overall resilience to higher interest rates may allow the Bank of Japan to hike its policy rate beyond 1.75% to prevent further weakening of the yen and/or the de-anchoring of inflation expectations driven by prolonged cost-push inflation. However, the potential damage to vulnerable small firms and stretched household finances could make the government more cautious, exerting pressure on the bank.