Corporate debt rejection: the real reason global interest rates are so low

International Economy, The, Fall, 2004 by Richard C. Koo

Low long-term rates in so many parts of the world--in spite of higher oil prices, larger budget deficits, higher short-term interest rates in the United States, and pick-up in economic activity in Japan--have baffled both policymakers and market participants. Although some monetary officials are claiming that low long-term rates represent the triumph of their monetary policy in taming inflationary expectations, the real reasons for low rates may not be so pretty.

The champion of low long-term rates has, of course, been Japan, which has seen long bond rates lower then the lowest rate observed in the United States during the Great Depression for very many years. Furthermore, low rates are persisting despite a significant pickup in economic activity since the spring of 2003, and despite an ever-larger government budget deficit.

This seemingly contradictory development, however, can be explained by the fact that, in Japan, corporate demand for funds has actually turned negative since 1998. In other words, today's corporate sector in Japan is actually a net supplier of funds to both the banking system and capital markets to the tune of [yen] 30 trillion per year or 6 percent of GDP. They have become suppliers of funds because so many companies are paying down debt. They are paying down debt because the nationwide collapse in asset prices starting in the early 1990s left them with huge debt overhang.

Even though their balance sheets may be under water, in most cases, their main line of business is still sound with healthy cash flow. The fact that Japan has maintained the largest trade surplus in the world throughout this period suggests that Japanese companies are still highly competitive, with good products that consumers around the world are willing to buy. The companies, therefore, are using their healthy cash flow from their main lines of business to pay down debt in order to repair their balance sheets.

Even though that is the right thing to do at the level of individual companies, when everybody does it all at the same time, the usual flow of funds in the economy is reversed, i.e., instead of going from household savings to corporate investment through the banks and capital markets, the companies are returning the money back to them. The households, on the other hand, have been saving money as before. With no borrowers left in the system, the entire banking system and capital market is flooded with cash. With so few borrowers left, the competition among the lenders is absolutely fierce, resulting in very low interest rates.

From the macroeconomic perspective, the sum of household savings and net corporate debt repayment, which is the money that is entering the banking system but is not coming out to re-enter the income stream due to the lack of borrowers, constitutes the deflationary gap of the economy. If this deflationary gap is left unattended, the economy will continue to contract by the amount of the gap until the private sector has become too poor to save any money or pay down debt. Such an outcome is usually called depression.

The extraordinary shift in corporate behavior in Japan is shown in the chart, put together from the flow of funds data indicating which sectors of the economy have been saving money (financial surplus), and which sectors have been borrowing and investing money (financial deficit). It is put together in such a way that when all sectors (household, corporate, government, overseas, and financial sectors) are added, they are supposed to add up to zero. In the interest of clarity, however, the financial sector, which should be neutral in the medium term, has been omitted.

In the ideal world, this chart would have the household sector at the very top, corporate sector at the very bottom, and all others in the middle at around zero, indicating that both the government budget and current account are in balance. The figure indicates, however that the corporate sector in Japan, which had borrowed and invested as much as 9 percent of GDP back in the early 1990s, has been in financial surplus since 1998. Today, it is in a surplus position to the tune of 6 percent of GDP or [yen] 30 trillion. This means the shift in corporate behavior subtracted nearly 15 (negative 9 to plus 6) percent from Japan's GDP compared with the early 1990s. It is no wonder that the Japanese economy has been doing so poorly.

Indeed, the only reason Japan did not collapse into a depression in spite of the above shift in corporate behavior is that the government has been borrowing and spending the excess savings in the private sector. And it has been doing that literally from the first day the deflationary gap surfaced back in the early 1990s. As the chart shows, the line for the government sector has the exact opposite slope to that of the corporate sector. It shows that the government, acting as the borrower of last resort, kept both the level of economic activity and money supply from shrinking in the face of massive nationwide effort by the companies to pay down debt.