Determinants of Short-Term Real Interest Differentials between Japan and the United States

Many past studies of relative financing costs in the United States and Japan have relied on interest rates from the 1970s and earlier when Japanese financial markets were subject to numerous regulations and controls and were shielded by capital controls from financial markets abroad. Interest rates on bank loans, the most important source of financing in Japan, in fact, systematically underestimated the true costs of borrowing. In the United States, capital controls were being dismantled by the early 1970s, but the prime loan rate used in past studies had by then become an unreliable measure of the true cost of borrowing in the United States. This study shows that-most of the reported gap in short term financing costs between the two countries can be traced to past features of the national markets which have largely disappeared. Now that markets have been deregulated and international capital flows liberalized, national interest rates are closely related to those in the unregulated Eurocurrency markets. And, as this study shows, average real interest differentials in the Eurocurrency markets have been close to zero over the last twenty years.