The Japanese economy has recently made great strides in normalizing following its multi-decade malaise.
A modest economic expansion and the return of the Nikkei 225 to global prominence are two examples of this brighter outlook.
But the crushing level of debt carried by the government is a significant constraint on fiscal action that carries with it policy implications for both the Bank of Japan and Ministry of Finance.
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Japan is like other mature economies with challenging debt and deficit dynamics. Yet unlike those economies, it is experiencing a mild speculative attack on its currency as its central bank resists setting rates higher to protect the yen.
In so many ways, the price of protecting the Japanese social contract of maintaining stable unemployment following its financial crisis in the early 1990’s is coming due.
For decades, Japan used an extremely accommodative monetary policy and piled up public debt to prop up its aging economy.
Now, the currency market is saying enough is enough.
The Bank of Japan owns more than 50% of the government’s bonds, which is one reason that demand for government paper is, to be diplomatic, challenging at best.
And because a currency’s value is determined by the demand for the economy’s assets and securities, the yen has fallen to multi-decade lows against the dollar.
The Bank of Japan’s recent decision to raise its policy rate to 1% is a step in the right direction, but is still not enough.
To protect the yen, the central bank will have to lift rates further or accept a weaker currency, which would raise the cost of imports.
On July 6, the yen was trading above 160 to the dollar, which is above the level that investors assume would trigger intervention by the Bank of Japan and Ministry of Finance.
While monetary and fiscal authorities have sought to use public pressure to raise the value of the yen, the yen has declined to levels not observed since 1986, following the Plaza Accord.
In that agreement, the United States, Japan and the then G-5 intervened into foreign exchange markets to devalue of the greenback against the yen.
One does not have to look at the current situation to consider further deprecation of the yen toward 170 if there is not a sustained intervention.
And this is why we think that the long overdue bill for protecting the Japanese social contract is coming due.
After the financial crisis, the U.S. economy accepted an increase in unemployment and a disruption to its housing market—from which it has yet to recover—that resulted in a steady, though slow, economic recovery.
That decision protected the U.S. economy but profoundly disrupted its social and political equilibrium.
Japan, by contrast, chose to protect its labor market and accepted a prolonged period of slow growth, a functionally bankrupt financial sector, and insufficient investment.
In addition, Japan’s aging economy was plagued by a lack of demand, a lack of immigration to reinvigorate its aging workforce, and, we would argue, a lack of incentive to invest.
Those decisions retained social and political harmony yet left its economy adrift for the following three decades.
The result was an economy afflicted by episodes of low growth, disinflation and deflation.
The disincentive to invest in Japan is implied by the lack of return on its short-term and long-term investments.
Near-zero interest rates and a 1% to 2% return on a 10-year investment are not enough to cover the higher rates of inflation.
In that environment, investors respond by keeping money in cash or in higher-yielding U.S. Treasury bonds enhanced by the returns on an appreciating dollar.
Finally, it has been two decades since Japan’s unfunded spending pushed its accumulated government debt above 100% of gross domestic product.
Debt becomes a problem only when it can no longer be repaid, and Japan’s debt is now more than twice the output of its economy.
At what point does debt become so onerous that investors require higher rates of interest to cover the risk of holding a security that might go into default?
That time has arrived.
Japan’s long-term interest rates have finally moved above zero, with the 10-year Japanese government bond yield now testing 2.7%, a 30-year high, which would ordinarily be considered a sign of a healthier economy.
But with U.S. Treasury yields 180 basis points higher, who, other than domestic investors, would buy debt denominated in a suspect currency?
The takeaway
The cost of protecting the cultural and societal aspects of Japan’s economy has come to a head, with public debt now at more than 200% of its yearly economic output.
The increased risk of holding a yen-denominated asset, whether it’s a financial security or a fixed asset, has weighed heavily on the yen in the decades since the financial crisis. This is a situation that could feed on itself.
To address this long-awaited confluence of events will require higher interest rates or a profoundly weaker currency and higher inflation.
