Source: Jinshi Data
Late last year, when the latest cycle of the yen carry trade was still in its relatively early stages (USD/JPY was trading as low as around 140), there were media outlets explaining why the Japanese economy was effectively dead, with the only thing missing being an announcement of when it would happen. The reason: the $20 trillion carry trade that the Japanese government had been participating in for the past 40 years was a giant time bomb that could not be defused and that, if it went off, would be the end of the Bank of Japan. The collapse of these trades would require central banks to coordinate a rescue effort within days. Not surprisingly, central banks around the world had no idea what was happening, typically panicked afterwards, and unleashed a historic wave of rate cuts within weeks to stabilize the situation.
For those who missed the last analysis, this article touches on the topic again, only this time the analysis argues that this time the carry trade has broken and the Bank of Japan can either do nothing and watch the economy collapse, or panic and reverse last week’s foolish rate hike and increase easing to stem the crash that just pushed the Nikkei into a bear market; however, in either case, unfortunately for Japan, the game is over.
The Japanese government is participating in a $20 trillion carry trade: This is the toxic dilemma the Bank of Japan now faces as it has reached a dead end: on the one hand, if the Bank of Japan decides to tighten policy intentionally, this trade will need to be unwound. On the other hand, if the Bank of Japan drags its feet to continue the carry trade, it will require a higher level of financial repression but could ultimately lead to serious financial stability risks, including a potential collapse of the yen.
As Deutsche Bank's chief foreign exchange strategist Saravelos said, "Whichever option is chosen, there will be huge welfare and distributional consequences for the Japanese population: if the carry trade is unwound, richer and older households will pay the price of higher inflation through higher real interest rates; if the Bank of Japan delays action, younger and poorer households will pay the price through lower future real incomes."
How this political economy question is resolved will be key to understanding the outlook for Japanese policy in the coming years. This will determine not only the path of the yen, but also Japan’s new inflation equilibrium. Ultimately, however, someone will have to bear the costs of inflationary “success.”
Debt consolidation is crucial to understanding why Japan has not faced a debt crisis in the past few decades, despite a public debt/GDP ratio of over 200% and rising. It is also crucial to understanding the impact of Bank of Japan tightening on the economy.
What does the Japanese government's consolidated balance sheet look like? Here are the results from the St. Louis Fed paper. On the liability side, the Japanese government is financed primarily through low-yielding Japanese Government Bonds (JGBs) and even lower-cost bank reserves. Over the past decade, the Bank of Japan has successfully replaced half of the stock of JGBs with cheaper cash, which is now held by banks.
On the asset side, the Japanese government mainly owns loans, for example through the Fiscal Investment Loan Fund (FILF), and foreign assets, mainly through Japan's largest pension fund (GPIF). Taking all this into account, the Japanese government's net debt to GDP ratio is 120%, which is one reason why the debt dynamics are not as bad as they might seem at first glance .
But more important is the asset-liability structure of the debt. As Saravelos explains, at about 500% of GDP or $20 trillion in total balance sheet value, the Japanese government’s balance sheet is simply one giant carry trade. This is exactly why it has been able to sustain ever-growing nominal debt levels. The government raises funds through the very low real interest rates that the Bank of Japan charges domestic depositors, while earning higher returns on higher-interest-bearing domestic and foreign assets.
This creates extra fiscal space for the government as the return gap widens. Crucially, a third of this money is now effectively overnight cash: if the Bank of Japan raises rates, the government will have to start paying all the banks, and the profitability of the carry trade will quickly start to reverse.
Given the massive sell-off in global fixed income markets, why hasn’t this carry trade exploded over the past few years? Everyone else has exited the carry trade, so why not Japan? The answer is simple: On the liability side, the Bank of Japan keeps the government’s funding costs in check, which have remained at zero (or even negative) despite rising inflation. On the asset side, the Japanese government has benefited from a sharp depreciation of the yen, which has increased the value of its foreign assets. This is particularly evident in the GPIF, which has delivered more cumulative returns over the past two decades combined.
The Japanese government has reaped the rewards of both the foreign exchange and fixed income sides of the carry trade. However, it is not just the Japanese government that has benefited. Falling real interest rates have benefited every asset owner in Japan, primarily older, wealthy households. It is often claimed that an aging population is better off with low inflation. In fact, the opposite is true in Japan: older households have proven to be the greater beneficiaries of rising inflation, through both a de facto reduction in real interest rates and an increase in the value of the assets they own.
What would force this carry trade to unwind? The simple answer is persistent inflation. Imagine what would happen if inflation required the Bank of Japan to raise interest rates: the liability side of the government's balance sheet would take a huge hit, as interest payments on bank reserves increased and the value of Japanese government bonds fell. The asset side would also be affected, as real interest rates rose and the appreciation of the yen led to net foreign and potentially domestic asset losses. Wealthy older households would take a similar hit: the value of their assets would fall, and the government's ability to fund pension entitlements would weaken. Younger households, on the other hand, would benefit. Not only would they earn more on their deposits, but the real rate of return on their future savings streams would also increase.
Is there any way for the government to prevent the pain of higher inflation and the necessary fiscal consolidation, especially for older households? There are really only three options: taxing younger households, preventing real interest rates from rising, and not paying bank interest. None of these options is sustainable in the long run. All of them would lead to huge social unrest and political instability.
The extremely easy monetary policy of the past few years has been relatively simple from the perspective of Japan’s political economy: real interest rates have fallen, fiscal space has improved, and income has been redistributed in favor of wealthier older voters. However, if Japan is indeed entering a new phase of structurally higher inflation, the choices ahead will become more difficult. Adjusting to a higher inflation equilibrium will require higher real interest rates and greater fiscal consolidation, which in turn will hurt older and wealthier voters more unless younger voters are taxed more. While this adjustment can be delayed, the cost will be greater financial instability in the future, and a weaker yen. The yen can only begin a sustained upward trend if the Japanese government, through the Bank of Japan’s rate hikes, is forced to unwind the world’s last great carry trade, which has allowed Japan to enjoy a period of eerie social and political calm. However, those days are coming to an end.
