The 'Warning'

Ahead of the G-7 meeting on Friday and Saturday, a Reuters article informed us that the US has issued a 'warning' to Japan not to deliberately devalue its currency. Evidently this 'warning' was meant for domestic consumption, very likely it was aimed at unions and automakers, both of which have continually complained about Japan's currency since the 1970s. Their complaints tend to become more vociferous whenever the yen is in a short term downtrend, but the reality is of course that the yen has been going up against the US dollar with nary a significant interruption since about 1950. In that sense it is quite humorous when the US warns Japan not to devalue the yen. Of course yen debasement is now the official Japanese policy – and in reality there are no differences of opinion on it so far. After all, nearly everyone is now taking part  in the race to debase. Since virtually all governments continue to be mercantilistic in their outlook in spite of giving lip service to the advantages of free trade, spats about exchange rates will always be with us.


“The United States told Japan it would be watching for any sign it was manipulating its currency downward, but Tokyo said it met no resistance to its policies at a meeting of Group of Seven finance ministers which will conclude on Saturday.

As ministers and central bankers met on Friday in a stately home set in rolling countryside 40 miles outside London, differences were also evident over whether to prioritize debt-cutting or promoting economic growth.

U.S. Treasury Secretary Jack Lew said Japan had "growth issues" that needed to be dealt with, but that its attempts to stimulate its economy needed to stay within the bounds of international agreements to avoid competitive devaluations. "I'm just going to refer back to the ground rules and the fact that we've made clear that we'll keep an eye on that," Lew told the CNBC business news channel.

The yen hit a four-year low against the dollar on Friday, beyond the psychologically important 100-yen mark. It also trades at a three-year low against the euro.

The moves were driven in part by Japanese investors shifting into foreign bonds, a move that had been expected since the Bank of Japan unveiled a massive stimulus plan in January.”


(emphasis added)

Taro Aso is evidently unconcerned about the sham warning. After the G-7meeting concluded, he said:


“We explained at the G7 that Japan took bold monetary and fiscal action to end prolonged deflation, with the government and the Bank of Japan working closely together," Aso told reporters after hours of talks with fellow Group of Seven finance ministers and central bankers.

"The G7 didn't have a particular problem … I think Japan's stance is gaining broader understanding," he said.”


(emphasis added)

Given that practically the whole world is currently on this bizarre trip that prosperity can be increased or regained by means of printing money, why should Japan's mad-cap flight forward not meet with 'understanding'?

Below is a chart of the yen against the dollar since 1970 (note we use the inverse notation, i.e., a rising line means a stronger yen):




The yen-dollar rate since 1970 – the main trend has actually been for the yen to rise for more than six decades- click to enlarge.



Nothing to Fear

Channeling the self-soothing proclamations of inflationists throughout history, Haruhiko Kuroda declared after the meeting that JGB yields 'won't spike'. We believe that it remains possible that the inflationary policy will fail to achieve its declared aims and will sooner or later be abandoned again, but that is of course not certain. It depends partly on the determination of the BoJ and what methods it is willing to try.

It is definitely also possible that Kuroda's policy will 'succeed', in which case yields must eventually rise – something he acknowledges. As we have pointed out several times, he cannot have everything. If consumer prices indeed begin to rise, yields below 1% for 10 year JGBs will be history. However, Kuroda apparently expects to remain in perfect control of the process. His idea seems to be that the BoJ will create precisely 2% 'CPI inflation' and that nominal government bond yields will only rise a little bit to reflect that.


“Japanese long-term interest rates should not shoot higher as a result of money flowing out of government bonds, Bank of Japan Governor Haruhiko Kuroda said on Saturday. Kuroda added, however, that it would be natural for long-term rates to rise over time if Japan meets its goal of pushing inflation up towards two percent.

He said a shift in funds from Japanese government bonds to stocks and into lending was already taking place but that the BOJ was increasing its balance of JGB holdings at an annual pace of 50 trillion yen.

"The BOJ dealt with short-term volatility in bond prices by adjusting its market operations," Kuroda told reporters after a two-day meeting of G7 finance officials. "I do not expect a sudden spike in long-term bond yields. In the long-run, if the economy recovers and inflation heads towards two percent, we might see nominal interest rates rise but that's natural."


(emphasis added)

There are several problems with this view. For one thing, Japan's government already spends 25% of its tax revenue to merely service the interest costs on its debt, at a time when 10-year yields have been well below 1% for an extended period and one can therefore expect the mix of outstanding debt to already reflect the ultra-low interest rate environment. Note that as of Friday, even after a large sell-off in the JGB market, 2 year yields are at a mere 11 basis points, 5 year yields at 28 basis points and 10 year yields at 69 basis points. Unfortunately for Japan, its public debt has by now grown so large that even the lowest interest rates in the world can not longer keep debt service costs from rising. In fact, they have been rising for the past six years already.




Japan's fiscal trends: in spite of interest rates falling to rock-bottom levels, debt service costs have begun to inexorably creep higher- click to enlarge.



Here is an overview of Japan's 2013 budget. A full 49.1% of the government's revenue comes from the issuance of bonds (including the pension bond program). Only 46.5% comes from taxes. On the expenditure side, 24% of the total revenue will go toward debt service (note that 'policy spending' excludes the debt service costs in the chart below). Spending on social security, already the by far biggest portion of Japan's government spending has increased by 10.4% in the 2013 budget. This spending item is set to grow at an accelerated pace for many years to come, as Japan's society is now aging rapidly.




Japan's 2013 budget, revenue sources and spending- click to enlarge.



To summarize: the two biggest items of government expenditure are both set to soar in the years ahead. Abe 's idea is probably to attempt to 'inflate the debt away' in a kind of 'slow burn', but that may prove to be impossible because Japan's debt growth is already beyond the point of no return so to speak. Consider that is interest cost were to rise to 2%, the government's debt service costs would soon double (the doubling wouldn't be instantaneous, as only new debt will be issued at the higher rate).

If Japan's social security spending, which currently amounts to 29.2 trillion yen, continues to grow by 10% per year, it will exceed the current year's tax revenues by 5 trillion yen within just four years.

Even assuming that Kuroda-san will indeed have the process of rising interest rate under perfect control, it is hard to see how this can work out. What will happen though if yields on JGBs do spike? What will Japan's government do if JGB yields rise to 5% or even 10%? Note that 10 year JGBs yielded over 8% in 1989 at the peak of the bubble era.



The equanimity with which the world has so far greeted the latest Japanese monetary experiment seems extraordinarily misguided. Note that even the possible failure of the policy would likely have notable consequences (a global 'deflation scare' would undoubtedly ensue), but its possible 'success' seems fraught with immeasurably greater risk. Even if everything goes according to plan, it is difficult to fathom how Japan's government can possible remain solvent once bond yields rise, even if they don't rise by much. However, there is very little reason to believe that everything will actually go according to plan. History is riddled with money printing exercises that have gone horribly wrong. Japan remains the biggest 'gray swan' currently on the horizon.




10 year JGB futures, continuous weekly chart. Since the announcement of Kuroda's new policy, prices of JGBs have begun to fall. Last week the decline accelerated – click to enlarge.





Charts by: Kyodo Graphic, St. Louis Fed, BarCharts





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One Response to “Japan: Free to Inflate in Peace”

  • Floyd:

    I wonder what is the to happen to various derivatives of the Yen and JGB yields.
    Or more precisely, what is to happen to major holders of said securities.
    Aren’t they exposed to huge loses due the Japanese interest rate changes?

Your comment:

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