As expected, Japan has raised interest rates. As the last remaining major economy with a negative interest rate policy, the Bank of Japan (BOJ) finally ushered in its first rate hike after a long 17 years.
The benchmark interest rate was raised from negative 0.1% to a range between 0% and 0.1%. While it may seem like a minuscule increase of a mere 0.1%, a small step for the BOJ, it is, in reality, a giant leap for Japanese monetary policy.
This move holds immense symbolic significance. It serves as a clear market signal to the world: Japan is done with negative interest rates.
But that's not all.
We've previously discussed the two peculiar monetary policies employed by the BOJ: negative interest rates and yield curve control. The latter is essentially an enhanced version of quantitative easing. On the same day, the BOJ declared an end to this policy as well. Thus, the era of Japan's radical monetary policies has come to an end.
You see, within days of our discussion on the Japanese economy, the BOJ scrapped both policies in one fell swoop. This speaks volumes about the influence of our channel on the BOJ's decisions.
Jokes aside, what's truly intriguing is the market's reaction to Japan's rate hike. Logic suggests that such a momentous, historic decision should send the yen soaring. After all, it's a rate hike, and a historic one at that.
However, instead of appreciating, the yen did the opposite. It tumbled against the US dollar, breaching the 150 mark once again. This defies conventional economic wisdom. It's akin to students bursting into tears upon hearing their teacher announce a holiday. Why the tears? What's so strange about that?
Japan's Economic Landscape and the Rationale for Raising Rates
We've previously provided a comprehensive overview of Japan's recent economic situation. However, this latest development has prompted numerous requests for further elaboration.
So, let's delve into the reasons behind the BOJ's decision to raise rates and explore its implications for the global economy.
First, let's understand the concept of negative interest rates. Imagine an interest rate of -1%. If you borrow $100 from me today, you wouldn't have to pay any interest when you repay me next year. In fact, you'd only need to return $99. The same principle applies to savings. If you deposit $100 in a bank today, you'd only be able to withdraw $99 next year, eroding your principal.
This mechanism was intended to discourage saving and incentivize borrowing and spending, thereby stimulating economic activity. The goal was to steer Japan away from deflation and into a healthy cycle of inflation.
Of course, the -1% example is an exaggeration for illustrative purposes. In reality, the negative rate was only -0.1%, and it applied exclusively to transactions between the BOJ and major Japanese banks. For consumers like you and me, interest rates remained positive or near zero. So, don't get any ideas about exploiting negative rates to borrow and hoard money for profit!
Why then did the BOJ decide to raise rates now?
The primary reason is the arrival of inflation.
As we discussed in a previous video, Japan had already begun to experience inflation in recent years. However, the BOJ needed to ascertain whether it was a sustained trend or a fleeting phenomenon.
The key lay in observing wage growth, specifically the outcome of Japan's renowned annual wage negotiations known as "Shunto." The results were announced in mid-March, exceeding market expectations. Major Japanese corporations agreed to raise wages by 5.28%, surpassing not only the inflation rate of around 3% but also marking the most substantial wage increase in 33 years.
This was the confirmation the BOJ needed. They wasted no time in pulling the trigger on a rate hike. The market had anticipated action by April, giving the BOJ some leeway to incorporate the Shunto outcome. However, the central bank, eager to act swiftly, surprised everyone with its prompt response.
The Curious Case of the Falling Yen: A Case of Misinterpretation
Let's address the elephant in the room: why did the yen depreciate despite the rate hike? Why did the students weep even though the teacher announced a holiday?
While a rate hike was largely priced into market expectations, the BOJ's move, though early, lacked conviction in its magnitude. The central bank remained committed to its bond-buying program and provided little clarity on its future tightening plans. This cautious, almost lackluster approach suggests that the BOJ will likely maintain this prudence when evaluating future rate hikes.
This explains the seemingly paradoxical phenomenon of a weakening yen despite an interest rate increase. The depreciation stems not from the rate hike itself, but from its underwhelming size and the perceived lack of resolve in the BOJ's stance. It's like students anticipating a week-long holiday, only to be granted a single day off with a pile of homework. The disappointment is understandable, isn't it?
Implications of Japan's Policy Shift: A Global Perspective
The BOJ has effectively dismantled a system that the entire economy had become accustomed to, virtually overnight. What does this mean? What potential consequences might it have?
Before we proceed, it's crucial to emphasize that these are purely theoretical considerations. Real-world scenarios are influenced by a myriad of factors, and our analysis focuses solely on the isolated impact of interest rate hikes.
Firstly, higher interest rates translate to higher yields on Japanese assets, making them more appealing compared to their foreign counterparts. This could potentially attract foreign investment.
Japan boasts the world's largest net international investment position, with Japanese assets scattered across the globe. This dominance has persisted for an impressive 32 years. In 2022, this figure stood at approximately $2.83 trillion, equivalent to two-thirds of Japan's GDP.
It's crucial to note that we're referring to net assets, which represent total assets minus liabilities. While Japan holds the top spot in terms of net international investment position, the United States reigns supreme in gross assets.
Let's test your knowledge! Which country holds the lowest net international investment position, implying the largest external debt? You guessed it: the United States! Its net international investment position is a staggering negative $20 trillion, surpassing five times Japan's GDP and exceeding China's GDP. We encourage you to share your thoughts on this phenomenon in the comments section below.
Returning to Japan, the abundance of overseas assets can be attributed to low domestic investment returns. With the central bank pushing interest rates into negative territory and a sluggish economy, domestic investment opportunities have been scarce. Consequently, Japanese investors have sought refuge in foreign assets, such as real estate in New York or European stocks.
Furthermore, Japan's low interest rates created an arbitrage opportunity. Investors could borrow cheaply in yen and invest in higher-yielding assets denominated in US dollars or euros. This practice, known as "carry trade," gained significant traction, particularly in the latter stages of the pandemic when Japan remained one of the few major economies refraining from rate hikes.
In essence, a substantial amount of Japanese capital flowed overseas. However, with the BOJ's recent rate hike, domestic yields are expected to rise, diminishing the allure of foreign investments. Consequently, Japanese investors are likely to repatriate their capital, leading to what we call "yen repatriation" rather than simply "foreign investment inflow."
The consequences of yen repatriation are relatively straightforward. As investors divest from foreign assets and convert their holdings back into yen, those foreign assets are likely to decline in value, while the yen appreciates. Conversely, Japanese domestic assets are likely to experience upward pressure.
To elaborate further, the specific foreign assets most susceptible to decline would depend on Japan's historical investment patterns. According to estimates from the Japanese Ministry of Finance, North America, primarily the United States, constitutes Japan's largest investment destination, with an almost even split between stocks and bonds. This aligns with Japan's status as the world's largest holder of US Treasuries, possessing over $1 trillion.
Europe follows as the second-largest recipient of Japanese investment, accounting for 25%. However, the third-largest destination is rather intriguing: Latin America, surpassing Asia.
One might wonder why Japan holds such substantial assets in Latin America. Could there be ulterior motives at play? A closer examination of individual countries reveals a fascinating detail.
Ranking second only to the United States in terms of Japanese investment is not Brazil, Argentina, or Mexico, but the Cayman Islands. This renowned tax haven serves as a shell, suggesting that the funds likely find their way back to the United States or Europe through indirect channels.
This highlights the importance of scrutinizing financial data. A cursory glance might lead to the erroneous conclusion that Japan harbors a particular fondness for investing in Latin America.
Therefore, we can surmise that the markets most vulnerable to Japan's rate hike are those in the United States and Europe. Some analysts have even gone so far as to claim that Japan's policy shift could trigger a sharp decline in US equities. While this scenario is not entirely implausible, it remains highly unlikely.
However, emerging markets in Southeast Asia that are heavily reliant on foreign capital might experience greater volatility. It's worth noting that the Asian financial crisis was partly fueled by a repatriation of Japanese capital.
Let's move on to the second potential consequence of Japan's rate hike: higher borrowing costs for the Japanese government.
With its already colossal debt levels, this could, at best, constrain the government's ability to implement fiscal stimulus measures. At worst, it could raise concerns about Japan's creditworthiness, potentially triggering a sovereign debt crisis.
The BOJ is well aware of these concerns and has taken steps to mitigate potential volatility in the Japanese government bond market. While the central bank has abandoned its unlimited bond-buying program, it has committed to maintaining its current level of purchases. This reassures investors that the printing presses are still running and discourages them from dumping government bonds.
This commitment explains why the market perceives the BOJ's tightening measures as relatively dovish. In the short term, the impact on the Japanese government's borrowing costs will be limited.
It's also important to clarify a common misconception: the impact of rate hikes on government finances is gradual, not immediate. The interest rates on existing debt remain fixed and are unaffected by subsequent rate increases. Only newly issued debt will carry higher interest rates. As new debt gradually replaces maturing debt, the impact of rate hikes on the government's debt servicing costs will become more pronounced over time.
Even if the BOJ were to embark on an unexpected and dramatic rate hike to, say, 20%, the Japanese government wouldn't face immediate insolvency.
Apart from the government, higher interest rates also affect borrowing costs for consumers and businesses. Japan is home to over 500,000 "zombie companies" that have been kept afloat by near-zero interest rates. As borrowing costs rise, these companies could face significant challenges. While the BOJ has pledged continued support for government bonds, it has remained silent on its stance towards corporate debt. This suggests that a wave of bankruptcies among weaker Japanese companies is a distinct possibility.
At its core, the most fundamental and widespread impact of rate hikes is a dampening effect on economic activity. In more severe cases, it could even trigger a credit crunch.
However, one sector that stands to benefit from this policy shift is the financial industry. Banks thrive on higher interest rates, which widen their profit margins. With rates moving out of negative territory, Japanese financial institutions can breathe a sigh of relief as their profitability improves. This renewed optimism could potentially revitalize the entire financial system.
The impact of rate hikes on the Japanese stock market is uncertain. On the one hand, capital repatriation and a return to normal inflation could be viewed as positive factors. On the other hand, the potential for slower economic growth, downward pressure on valuations, and a stronger yen weighing on exports could have negative implications. The net effect remains to be seen.
Conclusion
We've explored various potential consequences of Japan's decision to raise interest rates. It's important to reiterate that these are just some of the potential ripple effects of the BOJ's policy shift, not just the immediate impact of the 0.1% rate hike. In reality, a 0.1% increase is merely a drop in the ocean.
The key takeaway is that these are hypothetical scenarios that could unfold if the BOJ continues to raise interest rates.
The recent weakness in the yen, for instance, can be largely attributed to developments in the United States. Rising inflation, uncertainty surrounding the Federal Reserve's future rate decisions, and higher US Treasury yields have all contributed to a widening interest rate differential between Japan and the United States.
This persistent interest rate gap makes carry trades, which involve shorting the yen and buying US dollars, an attractive proposition for investors. Some are even willing to overlook the risk of BOJ intervention in the currency market to capitalize on this opportunity. This explains the seemingly counterintuitive phenomenon of the yen weakening despite a rate hike in Japan.
As for the situation in the United States, it remains fluid. We'll revisit this topic when the dust settles and provide further analysis.