The Japanese government's $20 trillion carry trade finally exploded

Source: Jinshi Data

At the end of last year, when the latest cycle of the yen carry trade was still in its relatively early stages (when the USD/JPY was as low as around 140), some media explained why the Japanese economy was effectively dead, and the only thing missing was an announcement of the time of death. The reason: the $20 trillion carry trade that the Japanese government has been involved in for the past 40 years is a huge time bomb that cannot be defused, and once it explodes, the Bank of Japan is finished. The collapse of these trades will require central banks to coordinate rescue operations within days. Not surprisingly, central banks around the world have no idea what is happening, usually panic afterwards, and unleash a historic wave of rate cuts within weeks to stabilize the situation.

For those who missed the last analysis, this article mentions the topic again, only this time the analysis believes thatthis time the carry trade has broken down, and the Bank of Japan can either do nothing and watch the economy collapse, or panic and reverse last week's foolish rate hike and increase easing to curb the crash that just pushed the Nikkei into a bear market; however, in either case, unfortunately for Japan, the game is over.

The Japanese government is participating in a $20 trillion carry trade: This is the toxic dilemma the Bank of Japan now faces as it reaches a dead end: on the one hand, if the Bank of Japan decides to intentionally tighten policy, this trade will need to be unwound. On the other hand, if the Bank of Japan drags its feet to continue the carry trade, it will require a higher level of financial repression, but could ultimately pose serious financial stability risks, including a potential collapse of the yen.

As Deutsche Bank Chief FX Strategist Saravelos puts it, "Whichever option is chosen, there will be huge welfare and distributional implications for the Japanese population: if the carry trade is unwound, richer and older households will pay the price of higher inflation through higher real interest rates; if the Bank of Japan delays, younger and poorer households will pay the price through lower future real incomes."

How this political-economic problem is resolved will be key to understanding the outlook for Japanese policy in the coming years. This will determine not only the path of the yen, but also Japan's new inflation equilibrium. Ultimately, however, someone will have to bear the cost of inflationary "success."

The consolidation of debt is crucial to understanding why Japan has not faced a debt crisis over the past few decades, despite a public debt/GDP ratio of over 200% and rising. It is also crucial to understanding the impact of BoJ tightening on the economy.

What does the Japanese government's consolidated balance sheet look like? Here are the results from the St. Louis Fed paper. On the liability side, the Japanese government is financed primarily through low-yielding Japanese Government Bonds (JGBs) and lower-cost bank reserves. Over the past decade, the BoJ has successfully replaced half of the stock of JGBs with cheaper cash, which is now held by banks.

On the asset side, the Japanese government mainly owns loans, such as through the Fiscal Investment Loan Fund (FILF), and foreign assets, mainly through Japan's largest pension fund (GPIF). Taking all this into account, the Japanese government's net debt to GDP ratio is 120%, which is one reason why the debt dynamics are not as bad as they might seem at first glance.

But more important is the asset-liability structure of the debt. As Saravelos explains, at around 500% of GDP or $20 trillion in total balance sheet value, the Japanese government’s balance sheet is simply one giant carry trade. This is precisely the key to why it has been able to sustain ever-growing levels of nominal debt. The government raises money through the very low real interest rate that the BoJ charges domestic depositors, while earning higher returns on higher-interest-bearing domestic and foreign assets.

This creates additional fiscal space for the Japanese government as the return differential widens. Crucially, a third of this money is now effectively overnight cash: If the BoJ raises rates, the government will have to start paying all the banks for money, and the profitability of the carry trade will quickly begin to reverse.

Given the massive sell-off in global fixed income markets, why hasn’t this carry trade exploded over the past few years? Everyone else has exited the carry trade, so why not Japan? The answer is simple: on the liability side, the BoJ controls the government’s funding costs, which have remained at zero (or even negative) despite rising inflation. On the asset side, the Japanese government has benefited from the sharp depreciation of the yen, which has increased the value of its foreign assets. This has been particularly evident in the GPIF, where the cumulative returns over the past few years have exceeded those of the past two decades combined.

The Japanese government has received returns on both the foreign exchange and fixed income sides of the carry trade. However, it is not just the Japanese government that has benefited. Falling real interest rates have benefited every asset owner in Japan, primarily older, wealthy households. It is often claimed that an aging population is better off with low inflation. In fact, the opposite is true in Japan: older households have proven to be greater beneficiaries of rising inflation, through the de facto reduction in real interest rates and the increase in the value of the assets they own.

What would force this carry trade to unwind? The simple answer is persistent inflation. Imagine what would happen if inflation required the Bank of Japan to raise interest rates: the liability side of the government's balance sheet would take a huge hit, as interest payments on bank reserves increase and the value of Japanese government bonds declines. The asset side would also be affected, as real interest rates rise and the appreciation of the yen leads to net foreign and potentially domestic asset losses. Wealthy older households will be hit similarly: the value of their assets will fall, and the government's ability to fund pension entitlements will be weakened. Younger households, on the other hand, will benefit. Not only will they earn more on their savings, but the real rate of return on their future savings stream will also increase.

Is there any way for the government to prevent the pain of higher inflation and the necessary fiscal consolidation, especially for older households? There are really only three options: tax younger households, prevent real interest rates from rising, and not pay bank interest. None of these options is sustainable in the long run. All of them would lead to great social unrest and political instability.

The extremely easy monetary policy of the past few years has been relatively simple from the perspective of Japan's political economy: real interest rates have fallen, fiscal space has improved, and income has been redistributed in favor of wealthy older voters. However, if Japan is indeed entering a new phase of structurally higher inflation, the choices ahead will become more difficult. Adjusting to a higher inflation equilibrium will require higher real interest rates and greater fiscal consolidation, which in turn will hurt older and wealthier voters more unless younger voters are taxed. While this adjustment can be delayed, the cost will be greater financial instability in the future, as well as a weaker yen. The yen can only begin a sustained upward trend if the Japanese government, through a rate hike by the Bank of Japan, is forced to unwind the world's last great carry trade, which has allowed Japan to enjoy a period of eerie social and political calm. Those days are coming to an end, however.