Japan 'on road to normality'

TOKYO - Japanese interest rates have been raised for the first time in almost six years as a decade-long bout of deflation ends and the economy heads towards its longest postwar expansion.

Bank of Japan Governor Toshihiko Fukui and his policy-board colleagues yesterday increased the key overnight rate between banks to 0.25 per cent from almost zero effective immediately.

The end to the zero-rate policy is a recognition of plans by Japanese companies such as Toshiba to invest at the fastest pace in 16 years, after closing factories and slashing debt built up during the bubble economy of the 1980s. The yen held earlier losses after the BoJ said it would probably keep "very low" interest rates for "some time" to protect the economy's expansion.

"Zero interest rates in the long run place the wrong incentives and make for an inefficient allocation of scarce resources," said Jan Lambregts, head of research at Rabobank in Singapore. The world's central banks were concerned companies would become "addicted to such low rates".

Sixteen central banks raised borrowing costs in June as record oil and metal prices fuelled inflation. The US Federal Reserve has increased rates 17 times to 5.25 percent from 1 percent in June 2004. The European Central Bank lifted its key rate to 2.75 per cent, its third increase since December.

All 16 economists surveyed by Bloomberg News expected the Japanese decision and nine of them consider the increase will be the last for this year. Eight said the key rate will be capped at 0.75 per cent or below by the end of next year.

"It will be difficult to clear the hurdles for a second rate increase" as government opposition lingers, said Kazuhiko Sano, chief strategist at Nikko Citigroup in Tokyo.

The central bank has been under pressure from government officials, including Finance Minister Sadakazu Tanigaki, who are concerned that higher borrowing costs will hamper government efforts to stop the expansion of public debt, forecast to reach 151 per cent of gross domestic product by March.

A one percentage point gain in 10-year bond yields will increase the government's annual debt-servicing costs by 1.6 trillion yen, the Ministry of Finance says.

"The bank will adjust the level of the policy interest rate gradually in the light of developments in economic activity and prices" if they follow the projections presented in the April report on the outlook for the economy, the bank says. "An accommodative monetary environment ensuing from low interest rates will probably be maintained for some time."

The Government opposed the bank's last rate increase in August 2000. Seven months later, the bank had to cut rates back to almost zero as an internet-led global economic boom faltered.

Fukui said the bank must "carefully gauge the impact the first rate increase will have on the burden for companies" and the overall economy before increasing rates again.

The BoJ ended a five-year deflation- fighting policy of pumping up to 35 trillion yen ($303 billion) into the banking system in March. Consumer prices have now racked up seven months of gains, unemployment is at an eight-year low and lending by banks grew at the fastest pace in a decade in June.

Japan's economy expanded for 53 months through the end of June, the longest since 57 months of growth from 1965 to 1970.

The Government forecasts the economy will expand 2.1 per cent in the year ending March 31, 2007.

"It's a welcome sign that Japan is on the road to normality. Japan has come out of its deflation trip," said Thomas Mayer, chief European economist at Deutsche Bank in London. "The Bank of Japan's move is a sign that this is clearly the case."

Japan's largest companies plan to increase investment this year at the fastest pace since 1990, the BoJ's Tankan business confidence survey showed last week.

Toshiba, the nation's biggest chipmaker, will build its fourth flash memory factory in Japan next year. The Tokyo-based company cut by more than half its interest-bearing debt in the past five years.

Honda, the country's third-largest car-maker, is constructing its first car plant in Japan in 30 years and Matsushita Electric Industrial is erecting a huge plasma display factory.

"The zero-rate policy was an abnormal condition," said Kunio Nakamura, chairman of Matsushita. "Japanese companies have made efforts to decrease debt in the past 10 years so many companies won't be affected by the rate hike."

The bank also raised its discount rate, with which it makes overnight loans directly to financial institutions, to 0.4 per cent from 0.1 per cent.

- BLOOMBERG