Explanation
Over the past 30 years, Japan’s monetary policy has been characterized by near zero interest rates and massive quantitative easing (QE) aimed at countering sustained deflation and stimulating economic growth. . The outcome of decades of adjustment policy is that the Bank of Japan (BOJ) has accumulated a balance sheet equivalent to 125% of Japan’s GDP, surpassing other major central banks. Japanese government bonds (JGB) control the balance sheet, accounting for more than three-quarters of the total. More than half of Japan’s outstanding government debt is listed on the BOJ’s balance sheet.
Its extraordinary accumulation has created acute vulnerability. As interest rates rise, the value of JGBS can plummet due to increased risk of inflation and periods (long-mature bonds will drop sharply as interest rates rise). Furthermore, the BOJ’s responsibility, yen, is essentially tied to the proportion of “hard” assets on the bank’s balance sheet. A major sale of JGBS could erode the value of the yen, causing wider financial instability. As a result, the double vulnerability of Japanese government bonds (JGB) and the yen on long-term sales could have a major impact on the global market.
At the meeting on January 24th, BOJ chose to raise interest rates to 0.50%. This is the highest level in 2017. The current movement comes as BOJ has struggled for decades to normalize interest rates. Previous attempts have been derailed by the sensitivity of both the Japanese economy and the financial system’s sensitivity to higher borrowing costs. Current inflationary pressures could force BOJs to continue to raise interest rates despite rising risks on the balance sheet. Recent data shows that inflation expectations are rising among Japanese households and businesses, and after decades of relative stability, the purchasing power of the yen has begun to decline.
This shift could lead to global investors reassessing Yen religion’s exposure to fixed income assets and redistribution of portfolios from domestic bonds. Japanese banks, which hold a quarter of all non-BOJ-owned JGBs, could also become sellers if their bond portfolio losses (many of which are designated as pending maturation (HTM) The recent failure of SVB financial groups in the US provides risk warning substances related to unedited bond portfolios, particularly when market losses are too large to ignore.
A sharp drop in both JGB prices and the yen could have widespread results on a global scale. Historically, Japan’s financial stress has encouraged risk-off flow as investors sold foreign assets to repatriate to their home countries, increasing the value of the yen. If Japan’s trust in financial stability declines, capital outflows could exceed repatriation inflows, further weakening the yen and exacerbating confusion.
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If any of them occurs, the BOJ will adopt emergency measures to stabilize the market: a new, more aggressive round of quantitative mitigation, yield curve control, capital management, and other interventions. However, central banks’ ability to respond to the crisis is constrained by an already bloated balance sheet. In the worst-case scenario, it could be that BOJs are buying a significant percentage of JGBs they don’t yet own to curb the rising yield. That will likely lead to a sharp, perhaps long-term match of currency depreciation.
If capital flees Japan, global bond yields, particularly the US Treasury Department yields, could drop as risk-averse investors rush to safe shelters. Gold and crypto will likely surge. On the other hand, the stock market could face downward pressures as both Japanese and foreign investors reduce exposure to most risky assets. A rather weak yen further strengthens currencies, including the dollar, pound and euro. It can lead to trade tensions, especially if the sudden strengthened dollar weakens or neutralizes the effectiveness of tariffs. The well-documented susceptibility of island nations to earthquakes and tsunamis may also contribute to the development of the risks outlined here.
This is not a prediction, but a scenario that withstands close surveillance. Japan’s current financial dynamics reflect inflationary pressures, rising interest rates, and the volatile balance of largely disturbed central bank balance sheets. The potential for a volatile financial crisis has emerged as BOJs play a major role in government securities markets, along with deteriorating liquidity and growing risks associated with their balance sheets. In addition to the indirect risks posed to the US, Japan’s increasingly unstable economic situation serves as a story of attention for US policymakers increasingly leaning towards central bank intervention.
The views expressed in this article are the views of the authors and do not necessarily reflect those of the epoch era.
