Japan’s unconventional monetary policy may have passed its use-by date

The bank could raise the cap again – there are analysts speculating the cap will be raised to 0.75 per cent, or even 1 per cent – but that would only defer the moment of reckoning and again invite trades against the bank. The move could also make the key benchmark for Japanese interest rates, and one central to corporate borrowing costs, irrelevant.

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While conniptions in the Japanese bond market might seem of little other than academic interest to those outside Japan, the country’s status as the world’s largest creditor nation and the largest exporter of capital makes any significant development there of considerable relevance to global financial markets.

Japan’s net international investments total more than $US3 trillion ($4.3 trillion). It is the largest holder of US government bonds, with about $US1 trillion of investments. It holds about 8 per cent of France’s government debt, and has major holdings in the UK and Australian governments’ debts.

For most of the decades of Japan’s economic winter and its unconventional monetary policy settings, capital has flowed out of Japan and into international markets in search of positive returns not available in its investors’ home market.

There has also been a decades-long carry trade for hedge funds and traders, who were able to borrow at negligible rates in Japan to fund higher-yielding investments elsewhere.

If Japan’s interest rates rise, the flows of funds would start to reverse and capital would flow out of international markets towards Japan as those investments and trades are unwound. The yen has already appreciated by about 15 per cent against the US dollar since mid-October, suggesting the “Great Unwinding” has already begun.

The December increase in the BoJ’s yield cap triggered volatility across financial markets, with interest rates rising and currencies falling. Another change to the cap could be expected to have similar effects.

In effect, rising interest rates in Japan will tighten global monetary policy by raising rates in other economies as they experience capital outflows. The impact would be exaggerated by the timing of the policy shift, with the US, eurozone and other economies shifting from their post-2008 policies of quantitative easing into quantitative tightening.

Instead of buying bonds they are allowing them to mature without reinvestment, removing the major source of buying and liquidity from their bond markets. The US Federal Reserve Board is now shrinking its balance sheet, which peaked at almost $US9 trillion last year, at a rate of $US95 billion a month.

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Japan, the world’s third-largest economy, is itself awash with debt. Government debt was more than 265 per cent of GDP in 2021 and total debt is more than 1300 per cent of GDP. As a reference point, US government debt last year was about 124 per cent of GDP and total debt 768 per cent.

Thus, issues in its bond market — if the inflation Japan is experiencing is something other than transitory and it has to try to back out of unconventional monetary policies that have been in place since the 1990s, designed to address deflationary pressures — could have severe domestic and international repercussions.

The challenge for Kuroda, his successor and a Japanese government that has long pursued aggressively loose fiscal policies will be how to manage the shift from policies designed to fight deflation towards more conventional settings for an inflationary environment without igniting a financial and economic crisis that has spillover effects for the rest of the world.

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