Michael M. Hutchison

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 93-23, june 18, 1993
Interdependence: u.s. and Japanese
Real Interest Rates
Over the last decade, japan's integration into the
world economy has increased substantially. japan
became the world's largest capital exporter in the
1980s with net foreign assets rising from $11.5 bil-
lion at the end of 1980 to more than $380 billion
at the end of 1991. This period was also marked
by far-reaching financial liberalization in japan,
the rapid expansion ofjapanese financial insti-
tutions abroad, and the growing importance of
Tokyo as a world financial center. In international
trade, Japan is among the world's largest expor-
ters and importers, topping the list in exports of
many sophisticated industrial products and sev-
eral categories of imported raw materials. japan's
growing economic size, importance in interna-
tional trade, and the magnitude of its capital
outflows also suggest that it may be having an
important influence over world economic
developments.
This Weekly Letter reports on research (Hutch-
ison and Singh 1993) investigating the extent to
whichjapan's integration with the world economy
has led to greater real interest rate interdepen-
dence. It presents evidence that u.s. and Japa-
nese real interest rates are closely linked. It also
shows that causal influence runs both ways. Not
only does the US. have a significant impact on
real interest rates in japan, but real interest rates
in the u.s. are greatly influenced by economic
developments in japan.
The real interest rate gap
Highly integrated markets permit more efficient
allocation of capital across national boundaries.
Butthese international capital flows also link real
interest rates in different countries. Since real in-
terest rates (that is, nominal rates adjusted for ex-
pected inflation) are important determinants of
national saving and investment patterns, these
links make national economies more vulnerable
to foreign economic developments and limit their
ability to pursue independent macroeconomic
policies. With highly integrated markets, for ex-
ample, a rise in real interest rates in japan would
be transmitted to the u.s. via higher domestic
real interest rates, in turn dampening u.s. eco-
nomic activity.
Given the large gross and net capital flows be-
tween the u.s. and japan in recent years, one
might expect little differential between each
country's real interest rates. Buta numberofstudies
have found large, albeitdecreasing, short-term real
rate differentials between the U.S. and japan, for
both debt and equity instruments.
To understand why rates would differ between
the two countries, consider that the real interest
rate differential is the sum of (1) the nominal
interest rate differential and (2) the price inflation
differential (both adjusted for expected exchange
rate change). The nominal interest rate differ-
ential reflects the degree of integration of finan-
cial markets: Perfectly integrated markets with
unlimited arbitrage possibilities lead to a small
or zero exchange-rate-adjusted interest differ-
ential, controlling for political and default risks. A
zero differential is called uncovered interest rate
parity (UIP). Increasing liberalization of financial
markets in Japan has meant fewer impediments
to arbitrage and consequently smaller deviations
in UIP. Specific liberalization measures included
lifting restrictions on nonresidents' investments'in
japanese securities in February 1979 and Gen-
saki transactions (bond trading with repurchase
agreements) in May 1979. Another important
step was the enactment ofthe new japanese For-
eign Exchange and Foreign Trade Control Law
(December 1980), which for the first time lifted
all restrictions on capital flows unless explicitly
prohibited. These measures allowed greater
arbitrage opportunities between the domestic
and foreign financial markets.
Therefore, it is more likely that the source of the
real interest rate differential is in the price infla-
tion differential, which reflects the degree of inte-
gration of goods markets. If goods markets in two
countries are completely integrated, price levels
and price inflation of internationally traded prod-
ucts measured in a common currency shouldFRBSF
Figure 1
U.S.-Japan Real Interest Rate Differential
Percent
91 89 87 85 83 81
4.0
2.0
0.0 4-jJ------"''''''--~~---....__I_--
over time, but there may be arbitrage pressures
bringing it back to zero. Formal statistical tests
also suggest that the real interest rate differential
is transitory. This means that over longer peri-
ods of time there is a tendency for real interest
rates in Japan and the U.s. to move closely to-
gether. Marston (1992) also finds that real interest
rate differentials in the Eurodollar and Euroyen
markets (using WPI deflators) vary widely over
short sample periods, but that average differ-
entials are close to zero over long sample
periods.
How long does it take for real interest rates to
reach their equilibrium values? And to what ex-
tent do rates in Japan adjust compared to rates
in the U.S. fol!owing an initial disturbance? To
address these issues we estimate a simple dy-
namic model (an "error correction model") of
U.S. and Japanese real interest rates which takes
into account short-run adjustment dynamics as
well as the tendency for real interest rate parity to
hold in equilibrium over the long run. The model
is estimated over 1981.Ql-1991.Q3. Simulations
of the model allow us to trace out the path of the
real interest real differential response to unex-
pected jumps in the u.s. or Japanese rates. Fig-
ure 2 illustrates the behavior of the interest rate·
differential when U.S. real rates rise 100 basis
points (solid line) and when Japanese real rates
rise 100 basis points (dashed line). These esti-
mates show that the real interest rate differential
adjusts to the long-run equilibrium in about four
to eight quarters, regardless of the source of the
shock.
'2.0
A deviation from PPP means that international
goods prices are not equal across countries,
which in turn may create profitable arbitrage
opportunities. Taking advantage of these oppor-
tunities in goods markets takes time, but the
larger the price differences, the greater is the
incentive to find ways around the obstacles limit-
ing international market integration. This is why
many studiesfind evidence that arbitrage works
to reduce PPP deviations over longer periods as
the economy settles down to "equilibrium:'
Hence, investigating "equilibrium" real interest
rate relationships between countries, where the
wedge between rates associated with PPP devi-
ations is less due to arbitrage, should lead to a
better measure ofthe true degree of linkage
between Japan and the u.s.
be roughly comparable (after taking into account
transactions costs, tax differences, and so on).
This is called purchasing power parity (PPP). Big
differences in inflation rates that are not offset by
corresponding exchange rate changes (so that
inflation rates expressed in a common currency
also differ) generally mean big impediments to
goods arbitrage, which effectively separates na-
tional product markets. Clearly, goods markets in
the U.s. and Japan are not fully integrated, par-
ticularly in the short term when institutional,
legal, technical, and informational barriers limit
arbitrage possibilities. These impediments in-
clude import tariffs, voluntary export restraints
(VER or informal quotas), transport costs, restric-
tive distribution systems, and so on. Thus swings
in purchasing power between the u.s. and Japan
in the 1980s may be responsible for the short-
term real interest rate differentials despite highly
integrated financial markets.
Measuring real interest rate linkages
Prima facie evidence provides some support for
the argument that real interest rate deviations
tend to disappear over longer periods of time.
Figure 1 shows the ex post real interest rate differ-
ential (four-quarter moving average) between the
U.s. and Japan for the 1981.Ql-1991.Q3 period
when international financial transactions were
substantially liberalized. The data are quarterly
and constructed from short-term (3-month) mar-
ket determined interest rates (Gensaki rate in
Japan; Treasury Bill rate in the U.s.) less realized
inflation.
The figure suggests that the real interest rate dif-
ferential between the two countries varies widely
Since the U.S. economy is much larger than the
Japanese economy, one might expect that JapanFigure 2
Real Interest Differential Response to Rise in
u.s. Rates (solid) and Japanese Rates (dashed)
Figure 3
Response of u.s. Real Interest Rates
to 100 Basis Point Rise in Japanese Rates
Basis Points Basis Points
12 10 8 6 4 2 o
•
• 41 • .., .. • 41 ••.. • • • • • • • • - ......
100
75
50
25 ••••_ .~~ ••• ... ...., ...
... At ..... o-;----';;~~"---.----"-"---'---------
•
-25 .-
• •
-50 •
-75
-100 -t--.....,..-,---,----,--,..--r---.----r-,---r-.--.,...---,
12 10 8 6 4 2
• • • • • • . . . .
o
100
75
50
25
O-t------''''C;;;:~~;;;;;;;:;~--­
-25
-50
-75
-1 00 +--+---r-'---,---r-,-,--,--,----r--..,---r-'---,---,
would bear the lion's share ofthe adjustment
when a temporary gap in the interest rate differ-
ential opens up. However, additional simulations
suggest that the adjustments are more symmetri-
cal. Figure 3 shows the response of u.s. real
interest rates given an unexpected lOa-basis
point jump in Japanese rates. The dashed lines
show 90 percent statistical confidence bounds
around the simulated path. The simulation indi-
cates that u.s. real interest rates settle down after
about five quarters and rise about 40 basis points
following a lOa-basis point shock emanating from
Japan. This is about the same response of japa-
nese rates to shocks emanating from the u.s. (see
Hutchison and Singh 1993).
Conclusion
Our results indicate a very high degree of real
interest rate linkage between the u.s. and Japan
since the early 1980s, perhaps in response to the
financial liberalization measures taken in Japan.
Gaps in real interest rates between the two coun-
tries also appear to close quickly, and japan
seems to play an important role in the determi-
nation of rates in the u.S.
These results are surprising in that they indicate
a higher degree of linkage and attribute greater
economic importance to Japan than do other
studies. Could they be overstated? Perhaps. The
period over which markets have been liberalized
in Japan is fairly short, which limits the power of
statistical tests attempting to measure equilibrium
real interest rate differentials. It is also difficult to
separate "causal" relationships in real rate move-
ments, which are related to economic importance
and interdependence, from simply "linkage" re-
lationships, which are related to arbitrage and
economic integration.
In most respects, however, it is not surprising that
economic developments in Japan play an impor-
tant role in the determination of U.S. and world
real interestrates. japan's importance in other
areas, such as international business practices,
technology development, and international trade,
is beyond dispute. The findings here are fully
consistent with these other signs ofJapan's grow-
ing economic importance, as well as interdepen-
dence, in the world economy.
Michael M. Hutchison
Associate Professor
University of California, Santa Cruz
and Visiting Scholar, FRBSF
References
Hutchison, Michael, and Nirvikar Singh. 1993. "Long-
Term International Capital Mobility: New Evidence
from Equilibrium Real Interest Rate Linkages:'
Working Paper No. 93-06 (April). Federal Reserve
Bank of San Francisco, Center for Pacific Basin
Monetary and Economic Studies.
Marston, Richard. 1992. "Determinants of Short-term
Real Interest Rate Differentials between Japan and
the United States." NBER Working Paper No. 4167
(September).
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Index to Recent Issues of FRBSF Weekly Letter
DATE
12/25
1/1
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1 j'Y) I' "'-"'-
1/29
2/5
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3/5
, 3/12
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4/23
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6/4
NUMBER
92-45
93-01
93-02
93~03
93-04
93"05
93-06
93-07
93-08
93-09
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93-11
93-12
93-13
93-14
93-15
93-16
93-17
93-18
93-19
93c20
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93-22
TITLE
Labor Market Structure and Monetary Policy
An Alternative Strategy for Monetary Policy
The Recession, the Recovery, and the Productivity Slowdown
U.S. Banking Turnaround
Competitive Forces and Profit Persistence in Banking
The Sources of the Growth Slowdown
GOP Fluctuations: Permanent or Temporary?
The Twelfth District Agricultural Outlook
Saving-Investment Linkages in the Pacific Basin
A Single Market for Europe?
Risks in the Swaps Market
On the Changing Composition of Bank Portfolios
Interest Rate Spreads as Indicators for Monetary Policy
The Lonesome Twin
Why Has Employment Grown So Slowly?
Interpreting the Term Structure of Interest Rates
California Banking Problems
Is Banking on the Brink? Another Look
European Exchange Rate Credibility before the Fall
Computers and Productivity
Western Metal Mining
Federal Reserve Independence and the Accord of 1951
China on the Fast Track
AUTHOR
Huh
Motley/Judd
Cogley
Zimmerman
Levonian
Motley
Moreno
Dean
Kim
Glick/Hutchison
Laderman
Neuberger
Huh
Throop
Trehan
Cogley
Zimmerman
Levonian
Rose
Schmidt
Schmidt
Walsh
Cheng
The FRBSF Weekly Letter appears on an abbreviated schedule in June, July, August, and December.

LongTerm International Capital Mobility: New Evidence from Equilibrium Real Interest Rate Linkages:'

Interdependence: U.S. and Japanese real interest rates

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Interdependence: U.S. and Japanese real interest rates

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