The Bank of Japan is in a difficult situation and the decisions that it and its allies make over the coming months could have a wide-reaching impact on global financial markets.
Twin deficits in Japan
Consumers are feeling the pinch from rising food and energy prices as levels of inflation not seen for decades have stretched household budgets to the limit. In this respect, the economic balance sheets of countries are no different. The current account – the difference between money flows into and out of a country – and the budget – the difference between government spending and tax receipts are two useful metrics to gauge how they are managing their spending. Current account deficits indicate that countries are typically importing more than they are exporting and are common for those that do not have many natural resources. Budget deficits indicate that tax receipts are not sufficient to cover government spending and are usually used as a form of expansionary economic policy – to pump more funds into an economy. Japan is now in the challenging position of running twin deficits [1] – both in the current account and budget.
Severely weakening Yen
Historically, Japan operates under a current account surplus, but surges in the price of energy – of which they are a large importer – saw them run a deficit in early 2022. This helped weaken the Yen [2], due to changes in supply and demand dynamics for currencies and made Japanese goods more attractive because they are relatively cheaper for consumers in their respective foreign currencies. However, imports into Japan are now relatively more expensive, which can be problematic as necessity goods such as oil and gas still need to be purchased. Over time, this can worsen the deficit problem and weaken the Yen further, creating a form of vicious circle.
Interest burden removes option of monetary policy
The problem of running a consistent budget deficit is that it can accumulate over time and result in high levels of government debt. Japan now has debt to GDP levels of nearly 260% [3]. Our recent piece on the growing debt of the US emphasised that 130% of debt to GDP was a trigger point beyond which countries should be concerned over the risk of default. As Japanese debts are almost double that rate, one has to wonder if they will ever be able to bring it back under control or ultimately have to default. Such large levels of debt create other problems for the management of the country’s finances. Any increase in interest rates would lead to a significant rise in interest payments on the outstanding debt – leaving them hamstrung in their battle against a falling Yen.
Debt management trumps protecting the Yen, for now
Should the yield on Japanese government bonds rise, this could incentivise foreign buyers to purchase them, thereby increasing demand for the Yen and pushing back up its price. However, if left unchecked, this would likely bankrupt the Japanese government. For this reason, it appears they have chosen to prioritise managing their debt by using Yield Curve Control (YCC), at the risk of further falls in the value of the Yen. This amounts to artificially controlling the promised yield of 10-year Japanese government bonds within a range of -0.25% to 0.25%, which is significantly below that of other major economies. This is carried out by either purchasing or selling said bonds and if need be, printing large amounts of Yen in order to finance these transactions. As per Figure 5, the yield has recently been hitting up against the upper end of that boundary and the Bank of Japan have had to commit to purchasing very large amounts of (essentially unlimited) treasuries. The mass currency printing that financed these purchases has put even more downwards pressure, with the Yen making one of its largest ever monthly moves in April.
Do suppressed Japanese yields bode well for US Treasuries?
The large difference between the 10-year yields for US and Japanese bonds could be positive news for the Federal Reserve. We have already documented the challenges they face [4] in generating demand for Treasuries as most major economies have stopped buying them. The Bank of Japan are by far and away the largest foreign holders and they could be incentivised to capture this additional yield, which should in turn ease the US debt burden. Unfortunately, the problem is not that simple. Institutional investors always remove any currency risk in these transactions by hedging their positions with exchange rate futures and forwards. Because of the large recent movements in the Yen, implied volatility levels have shot up, significantly increasing hedging costs, eroding almost all margin for Japanese investors.
Yield Curve Control cannot last forever
At some point, YCC will have to end and the options for the Japanese government are somewhat limited given the high levels of outstanding debt. Selling their foreign reserves is a possibility but the scale required would likely be bearish for global risk assets and mark a global recession. Alternatively, they could seek favourable arrangements from another global superpower. Asking the US to purchase their bonds would be equivalent to outsourcing YCC but unlikely for an American government to sanction as it could severely weaken the dollar. Paying Russia for their energy imports in Yen could ease some of the currency pressures but is this possible given the recent geopolitical developments? We at Paravene Capital are watching developments closely as any shift in the macroeconomic regime needs to be carefully navigated and is central to the effective deployment of systematic strategies.
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[1] Source: Bank of Japan, Japanese Ministry of Finance.
[2] Source: Bloomberg.
[3] Source: Bloomberg, Statista.
[4] See our previous article on US debt levels and the role of the Federal Reserve here.