Rising interest rates have challenged some markets, but in Japan, where rates have languished in negative territory for almost a decade, a rate increase is generally welcome news for investors

After waiting almost two decades, interest rates in Japan are finally going up. While the monetary policy shift has led to volatility, higher rates may have an overall positive impact for long-term growth and investment.

In March, the Bank of Japan (BOJ) raised interest rates for the first time in 17 years, increasing its benchmark rate to between 0%-0.1% and ending an eight-year period of negative rates. At the end of July, the BOJ raised rates again, announcing a jump to around 0.25%.

The increases have closed the chapter on a massive monetary stimulus program the BOJ led to counter a protracted period of stagnant growth and lingering deflation.

Long-term outlook hopeful

The BOJ’s monetary policy shift has been far from painless. Before the central bank began raising rates, the yen had weakened significantly against the dollar as the Federal Reserve raised rates in the US to combat inflation there. The softer yen boosted the foreign earnings of Japanese companies, while the differential in interest rates encouraged “carry trades,” in which forex traders borrow in low-yielding currencies to fund investments in higher-yielding ones.

However, as the BOJ has raised rates, carry trades have been unwound and Japanese stocks have experienced volatility as higher rates have seen the yen strengthen. This saw the benchmark Tokyo Price Index (TOPIX) shed more than 12% during the first week of August, its worst performance since 1987.

The TOPIX did claw back some of those losses, and by August 9, it was showing small gains year to date. Further, short-term volatility could still materialize, but with the BOJ signaling it will not raise rates through periods of market uncertainty, stock markets have settled.

Despite these recent volatile conditions, there is hope that over the long term, the rate hikes and emergence of moderate inflation will benefit the Japanese economy by energizing labor markets and encouraging corporate consolidation.

An opportunity for lenders

Higher rates will be particularly positive for lenders, with domestic banks now in position to see improvements in net interest margins. There is also increasing interest from international banks and investors to build their exposure to Japanese debt markets as rates increase and the prospects of returns improve.

For years, international players have been unable to compete against Japan’s domestic banks and gain traction in the market, given that the cost of capital for Japanese lenders has been so low. A narrowing differential between rates in Japan, where rates are going up, and US and European markets, where rates are tracking down, will bring more balance between local and foreign sources of financing.

This is a timely development. Japan’s biggest banks are exploring ways to deepen syndication channels as they start to push up against balance sheet constraints, particularly when it comes to financing buyouts.

Historically, Japan’s mega banks have underwritten most of the debt raised to finance Japanese buyouts. They hold a large portion of this financing on their own books and syndicate some of the capital to smaller regional banks.

However, the rapid growth of Japan’s buyout industry—AVJC Research notes that US$84 billion was funneled into Japanese buyouts between 2021-23, which is the total for the past 13 years—does raise the risk of local lenders hitting a ceiling regarding balance sheet and human resources capacity if the market continues to expand at a similar rate. The entry of more banks and credit investors from abroad into the market could have a significant positive impact on removing capacity constraints.

Policymakers and trade associations are also hopeful that the market can open up to address concerns around concentration risk. A report produced by a study group of market leading practitioners and hosted by the Japanese Bankers Association showed that the amount of buyout loans on the books of the country’s three largest banks was double the level recorded in 2019 as of March 2023. The report concluded that the introduction of tools for further market visibility and increased discipline for the further development of the primary and secondary loan markets would be welcome changes.

Large lenders have already shifted from holding all buyout debt on their balance sheets. The amount of debt that is syndicated has increased, with regional banks and other financial institutions (such as insurance companies and lease companies) being the main buyers. Japan’s mega banks have also explored setting up and syndicating to funds focused on financing buyouts to absorb growth in buyout financing transaction flow.

Attracting a wider investor base from abroad will support these domestic initiatives and help to increase the diversity of Japan’s financing ecosystem. This will establish a more appropriate approach to buyout financing risk and, over the long-term, could promote the growth of a market with a broader group of investors participating in a similar manner as the US and European high yield market and the US Term Loan B space—although there is still a way to make this a reality.

Foreign lenders will have to adapt to Japanese markets—leverage levels tend to be higher than those typically in other jurisdictions and the tenor of the loans are generally longer, although covenants and terms are usually more conservative.

Despite these domestic market nuances, international credit investors and banks are clearly looking more closely into opportunities in Japan. Their appetite for more activity in the country is likely only to increase as the BOJ raises interest rates further and the delta between the cost of capital in Japan and other jurisdictions narrows.

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