De Facto Removal of YCC may Raise Long-term Interest Rates up to 1% over the Next 2 Years

The Bank of Japan took a significant step in October 2023 by effectively lifting Yield Curve Control (YCC), delegating the determination of long-term interest rates to the market. They also initiated discussions on the exit strategy from unconventional monetary policies, which had not been previously discussed since it was “premature.” A crucial keyword to understand the 2024 financial market trends will be a “world with interest rates.” Long-term interest rates could rise to approximately 1.21% in the “gradual scenario,” 1.38% in the “baseline scenario,” and up to around 1.75% in the “accelerated scenario” by December 2025. The maximum increase in long-term interest rates over the next two years is estimated to be 1%.
The COVID-19 pandemic has led to an expansion of bad debts through loans with no interest and no collateral (so-called “zero-zero loans”) provided by government-affiliated financial institutions to small and medium-sized enterprises (SMEs). Based on the remaining balances of zero-zero loans in Credit Guarantee Corporations (CGCs), we show that regional banks had the highest balance per bank, ranging from 50 to 200 billion yen, while second-tier regional banks had balances ranging from 50 to 100 billion yen at the end of fiscal year 2020, ending March 2021. The proportion of zero-zero loans to the total lending balance was concentrated in the range of 3-8% for regional banks and 5-8% for second-tier regional banks. However, some institutions held zero-zero loan balances exceeding 300 billion yen per institution. A rise in corporate bankruptcies utilizing COVID-19-related loans are observed now, which can potentially lead to the deterioration of these loans.
We consider institutional lending during a crisis examining the relationship between lending by private financial institutions using the credit guarantee system and non-performing loans (NPLs). We conducted panel data analysis using data from fiscal year 2011 to 2022 and results show that a 1 percentage point increase in the guarantee utilization rate (average utilization rate from one to three years prior) leads to a 0.14% increase in the NPL ratio. When estimated by guarantee ratio, an increase in the utilization rate of 100% guarantees corresponds to an increase in the NPL ratio, while in the case of 80% guarantees, the NPL ratio decreases. One policy option would be to maintain the principle of shared responsibility even during a crisis and gradually reduce the guarantee ratio from 95% instead of adopting a 100% guarantee ratio, which could help reduce future fiscal costs.