By Gunther Schnabl
In early August 2024, Japan played a prominent role in a global financial mini-crash. Markets reacted violently to the unexpected July announcement of the Bank of Japan’s decision to raise the key interest rate and halve its monthly bond purchases. That announcement preceded disappointing US employment figures, triggering expectations of rate cuts from the Federal Reserve.
The yen’s sudden appreciation forced many carry traders to hastily dissolve their positions which in turn caused market turmoil.
The Bank of Japan has postponed further interest rate increases given the market’s recovery. But the event served as a reminder that carry trades originating in Japan and the yen–dollar exchange rate significantly affect international financial stability. One possible avenue for containing ongoing inflation risk and exchange rate uncertainty is pegging the yen to the dollar.
Japan’s floating yen has been a source of unrest for decades. In the early 1980s, a depreciated yen and a fast-growing trade surplus in Japan led to accusations of unfair trade practices from Japan’s trading partners. The United States repeatedly encouraged the yen’s appreciation to obtain concessions from Japan in trade negotiations until the mid-1990s.
When the G5 nations announced an appreciation of the yen against the dollar with the September 1985 Plaza Agreement to cure trade imbalances between Japan and the United States, it kickstarteda ‘run to the yen’. The strong appreciation of the yen threw the export-dependent economy into a deep crisis.
The yen’s depreciation starting from 1995 contributed to the 1997 Asian Financial Crisis by eroding the competitiveness of Japan’s neighbours like South Korea and Thailand. Japanese banks faltered having provided extensive credit to Southeast Asia.
The resulting 1998 Japanese financial crisis led to the perpetuation of Japan’s low-interest rate policy and the beginning of quantitative easing. With interest rates in Japan stuck at zero, speculators increasingly engaged in carry trades — raising cheap loans in Japan and investing in regions with significantly higher interest rates. This made them vulnerable to yen appreciation. Ordinary Japanese people — such as those pegged under the famous ‘Mrs Watanabe’ stereotype of Japanese currency traders — also invested abroad as there was hardly any domestic interest income to be found.
The Abenomics policies pursued from 2013 led to the control of the term structure of interest rates, pushing 10-year government bond yields to zero. As bank deposits grew and demand for credit remained sluggish, Japanese banks further extended their investment abroad.
Japan’s life insurance companies and pension funds have accumulated large foreign assets, especially in the United States. The Government Pension Investment Fund has assets of around 246 trillion yen (US$1.7 trillion), of which about half is invested abroad. Exchange rate risks are often only partially hedged because of high costs.
Japan’s net foreign assets increased to around 471.3 trillion yen at the end of 2023 (US$3.4 trillion at the 31 December exchange rate) due to Japan’s status as a large exporter of capital beginning in the 1980s. The prospect of converting the country’s immense foreign assets risks a potential appreciation of the yen. Japanese banks, life insurance companies, pension funds and households have become vulnerable because any appreciation reduces the value of foreign currency assets in terms of yen. The issue has greater importance due to Japan’s rapidly ageing society.
If yen appreciation expectations are strengthened, the risk of another run to the yen increases as many investors may then rush to exchange foreign currency into yen, causing valuation losses for others. Uncontrolled yen–dollar movements have become a risk for both Japanese and global financial stability.
The Bank of Japan has maintained an expansionary monetary policy for 30 years — partially in order to control appreciation pressure. Monetary expansion in the United States tended to be accompanied by even larger expansion in Japan. This approach kept the yield of 10-year Japanese government bonds substantially below that of 10-year Treasury bonds.
While this policy did not cause inflation for many years, consumer price inflation has exceeded the two per cent target since 2022. The Bank of Japan faces a dilemma. Lifting interest rates to contain inflation risks an appreciation of the yen, while keeping interest rates low to prevent appreciation may cause price increases and public discontent.
Unlike in the 1980s, yen deprecation now serves the interests of not only the manufacturing industry but also the financial sector and pension funds. Prime Minister Shigeru Ishiba has signalled that monetary policy must remain accommodative to support economic recovery. The global financial risks stemming from yen appreciation could justify allowing it to depreciate. The burden on Japanese consumers would then further increase.
One potential solution is pegging the yen to the US dollar. This would forestall politically and economically motivated yen depreciation, as the Bank of Japan would be only committed to exchange rate stability and not to the interests of lobbying groups. Japanese consumers would be protected against higher inflation. It might also be wise to eliminate appreciation-induced financial market risks. Since uncertainty would be reduced, the exchange rate peg would make a significant contribution to Japan’s economic stabilisation. Given the Bank of Japan already has limited room to manoeuvre — evident in its recent minuscule interest rate adjustments — the loss of monetary policy independence may be more palatable.
- About the author: Gunther Schnabl is Professor of Economic Policy and International Economics at Leipzig University and Senior Advisor at the Flossbach von Storch Research Institute.
- Source: This article was published by East Asia Forum
