Fiscal Distress in Japan

The weakness of the Yen isn't a currency story - it's a debt story

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The Bank of Japan (BoJ) this week had what by any stretch of the imagination passes for a hawkish meeting - signaling a possible hike when it next meets in June - yet the Yen is at its lowest level in many years. This might sound puzzling, but it isn’t. When the policy rate is near zero - which in Japan has been true for decades - what matters for the currency is the long end of the yield curve. Short-term rates don’t matter. And the hard truth is that the BoJ continues to buy lots of longer-term government bonds, thereby artificially holding down long-term yields. That avoids a fiscal crisis because the government’s interest expense doesn’t go through the roof, but all this really does is transfer fiscal distress from the bond market to the currency. In my opinion, what the BoJ does with its policy rate is largely irrelevant for the Yen. The only thing that matters is the scale of JGB buying and de facto caps on long-term yields.

The chart above shows the trade-weighted Yen versus its G10 peers in black and the corresponding 30-year rate differential, where I use BoJ weights to construct both of these. The divergence between the two is striking and causes many to conclude that the Yen is undervalued and must rise. The easiest way to see that this isn’t true is to remember that long-term yields in Japan are artificially capped by BoJ bond buying.

The chart above shows 30-year government bond yields on the vertical axis and gross government debt on the horizontal axis. What’s striking is that Japan’s 30-year yield is basically at the same level as that of Germany, even though its public debt is at a much higher level. If markets were free to set the 30-year yield without BoJ interference, it’d be much higher and the Yen would appreciate. But that can’t be allowed because this would cause a fiscal crisis. So Japan’s high debt and the associated fiscal risk premium show up in a weak and falling Yen. This is just another way for markets to price fiscal distress. As long as the BoJ caps long-term yields, that isn’t going to change.

There are ways out of this cul-de-sac. The most obvious one is for the government to sell some of its financial assets and use the proceeds to retire public debt. Japan’s net debt is “only” 130 percent of GDP versus gross debt of 240 percent. The reason it’s so much lower is because of large financial asset holdings that can be sold. This is the most obvious way forward, but - in my opinion - it’ll take continued Yen declines for the government to accept that this is what needs to be done.