Japanese Stock Market Braces for BOJ Action

TOKYO-- It's no secret that Masaru Hayami, the 75-year-old governor of Japan's central bank, is not a loved man. Even officials at the Bank of Japan have been known to criticize Hayami behind his back.

Although he is chastised by business leaders and government officials for virtually everything he does, Hayami has maintained his composure, repeating his mantra: Japan's economy has now stabilized, thus the country's 18-month-old, zero-interest rate policy must go.

On Friday, when the Bank of Japan policy board meets to discuss monetary policy, he'll have a chance to prove he is a man of his words. Market participants expect the bank will raise short-term interest rates to around 0.27% either on Friday or on Sept. 17, when the bank's subsequent meeting occurs.

A few months back, all the market could talk about was how stocks would crumble if rates were hiked. Now, everyone is afraid of what will happen if the bank doesn't hike rates. Regardless of the meeting's outcome, Japan's stock market, which still hovers at about half of the all-time high reached a decade ago, is unlikely to take it well.

"It will be hell if the BOJ raises rates," says Mitsuru Saito, market economist at Sanwa Securities. "And it will be hell if they don't."

Investors in Japan don't need any more bad news. The benchmark Nikkei index is off about 15% this year, as opposed to the S&P 500, which is flat. Japan funds as a category are down almost 23% over the same period, according to Yahoo!.

Last month, the BOJ board decided to forgo hiking rates because department store operator Sogo went belly up, marking Japan's second-largest corporate failure ever. At that time, the BOJ said it wanted to see how the stock market would react to what is now known as "Sogo shock" before hiking rates.

It's easy to see that the stock market didn't react kindly. Since then, the Nikkei 225 index has shed nearly 8.4%, while the Topix index, a broad measure analogous to the S&P 500, has lost 7.4%. Although there are other factors behind the shoddy performance, fears over a rise in corporate failures certainly played on the market's general anxiety.

Another oft-cited reason for the bank's reluctance to raise rates is political pressure -- pressure that is not easing. Yoshiro Hayashi, the chief of the Liberal Democratic Party's finance panel, said Wednesday that Hayami should quit if rates are hiked. Hayashi even threatened legislative action to amend the Bank of Japan Law, the set of regulations governing the central bank, should the BOJ defy his party's wishes.

While Hayashi's threat may be little more than grandstanding -- the central bank's independence, after all, is guaranteed by revisions to the BOJ law made in April 1998 -- the government does have a few legal tools it can use to cudgel central bankers. One is a provision stating that the bank must "exchange views" sufficiently with the government to create "mutually harmonious" policy. The government may also invoke a rule stipulating that government representatives can suggest voting delays at policy board meetings.

All of this is bad for the stock market. If the BOJ hikes rates, bankruptcies will likely rise as indebted firms struggle with higher interest costs. Worse, if the BOJ does nothing, the central bank's credibility will be shot. Hayami, after all, has been threatening to raise rates since late last year.

A situation like that will only discourage foreign investors, who were the force behind the benchmark Nikkei's 37% rally last year. A government that bullies the central bank will remind them of the Old Japan that fell into financial chaos in the '90s as the government tried to micromanage the details of the world's second-largest economy. Also, the longer the zero-interest rate policy stays, the more dud loans creditor banks will shoulder.

"The Sogo failure proves that the nonperforming loan situation has actually gotten worse over the past two years, even after the government spent millions (of yen) of taxes to prop up [money center] banks," laments Yasuhisa Shiozaki, a young LDP parliamentary member. "The market may react wildly if more companies follow Sogo's footsteps, but most investors are shortsighted. If you think ahead, its better to go through some short-term pain."