The Cost of Capital in the United States and Japan

It is often said that the cost of capital is substantially lower for Japanese firms than for their U.S. competitors. This differential, which typically is traced to Japan's higher savings rate, is usually cited as central to the success of Japanese firms. This Note surveys the empirical evidence on the capital cost differential. The evidence supporting lower capital cost in Japan is mixed, at best. Substantial evidence indicates that, at least since the mid-1980s, Japanese and U.S. capital markets have been highly integrated, which means that nominal interest rates in the two countries have been the same after controlling for exchange rate expectations as embodied in forward currency rates. Nevertheless, real capital costs may have systematically differed because of violations of purchasing power parity: exchange rate expectations may not have coincided with expectations about relative inflation rates. Most estimates suggest that real interest rates in Japan may have been somewhat lower than those in the United States, but estimation of inflation expectations is problematic. Real equity costs may or may not have been lower in Japan; estimates vary widely depending on the methodology used. The range of uncertainty is so great that it is unclear whether any systematic difference exists between the Japanese and U.S. overall cost of funds or, adjusting for taxes, cost of capital.