Negative Swap Rates Wreck Hedging in Blow for Japan Loan Demand

  • Japan loan growth slowed to weakest in three years in March
  • `Swaps aren't functioning properly,' Credit Agricole says

Negative rates for swapping interest payments are hindering the ability of corporate borrowers to hedge their liabilities -- another way in which the Bank of Japan’s unorthodox attempt to revive lending could backfire.

QuickTake Negative Interest Rates

The fixed rate paid in exchange for floating-rate payments for a year in Japan’s interest rate swap market fell below zero after the BOJ started charging banks for reserves in February, and was at minus 0.049 percent on Thursday. Floating-rate loans in Japan aren’t allowed to have repayment rates below zero, causing a disconnect with traditional hedging methods.

“Interest-rate swaps aren’t functioning properly” as hedging tools, said Satoshi Oda, the head of the syndication department at Credit Agricole SA in Tokyo. “Without swaps, banks will have trouble making floating-rate loans and will need to extend fixed-rate loans, but most banks don’t like lending at fixed rates, so they’re becoming hesitant about making new loans.”

Lending growth in Japan excluding trusts slowed to 2 percent in March from a year earlier, the weakest pace in three years, according to BOJ data released Tuesday. Sumitomo Mitsui Trust Bank Ltd. sees a drop in swap-market activity as companies avoid using the contracts amid uncertainty about whether regulators will allow floating-rate repayments below zero.

When companies take out such loans, they often enter into a derivative deal to hedge, agreeing to pay the fixed swap rate in return for a floating-rate payment that protects them if borrowing costs rise. However, while loan deals stipulate that repayment rates won’t be negative, depriving companies of that benefit, swap transactions do allow for negative payments, meaning the hedger could wind up exposed to risks in both the swap and loan market.

Japan’s Financial Law Board, a committee that advises on banking regulations, said in a February report that it’s “rational” to assume that a lender won’t have to pay the borrower if the interest rate on a floating-rate loan turns negative.

BOJ Governor Haruhiko Kuroda said last month that while trading volumes plunged in the money market after the negative-rate policy was started because financial institutions weren’t prepared for such deals, he expected turnover to rise as firms get used to the measure. Japan’s financial markets would have been in worse shape if the central bank hadn’t started minus rates, Kuroda said in New York this week.

Activity in yen interest-rate swaps has dropped since February, said Tateo Komatsu, a deputy general manager of global markets at Sumitomo Mitsui Trust Bank.

Fixed-rate Loans

While banks want to increase lending, they probably won’t extend loans having rates below zero, according to Takashi Miura, an analyst at Credit Suisse Group AG in Tokyo. Fixed-rate lending is on the rise on expectations that interest rates will head even lower, he said.

Even so, Japanese banks prefer to lend in floating rates to match their liabilities, which are mainly short-term saving deposits, according to Oda at Credit Agricole.

Average interest rates on new loans in Japan fell to 0.793 percent in February, a record low, according to BOJ data. Benchmark 10-year sovereign bonds yielded minus 0.09 percent in Tokyo on Thursday, after dropping to an unprecedented minus 0.135 percent on March 18.

“You don’t get the impression now that companies are happy with negative interest rates and that they want to borrow a lot, and that banks want to lend too,” said Soutarou Kamide, the general manager of the REIT management department at Diamond Realty Management, a unit of Mitsubishi Corp. “People are in a wait-and-see mode.”

Before it's here, it's on the Bloomberg Terminal.