Investors have been watching Japan for over a decade now, wondering what happens to a country that has a debt-to-GDP ratio of 234%–too big to realistically pay off. We are starting to get the answer.
For review, Japan was the first country in the modern central banking era to begin a policy of quantitative easing–an unconventional form of monetary policy that is used when interest rates have already been lowered to the zero bound. Quantitative easing, which involves the purchase of “printed” money to buy government bonds, was widely viewed in Japan as a failure, but what most people don’t understand about Japan’s early QE experiments is that they were very small–less than $20 billion a month. It took Prime Minister Shinzo Abe, and BOJ Governor Haruhiko Kuroda to ramp up asset purchases significantly in what was called “Abenomics.”
Shinzo Abe, Japan’s prime minister. Photographer: Akio Kon/Bloomberg
The results of Abenomics have been mixed, but the stock market is certainly higher and the yen is certainly lower, although it’s not clear that either of those two developments have really helped. Japan’s stock market is mostly foreign-owned, and the weaker yen didn’t materially help the balance of trade. Still, there are a lot of people who said that Japan’s endless debt deflation would have been worse without Abenomics, so it has remained firmly in place for five years.
Abenomics rapidly began to cause distortions, as accelerated asset purchases caused the Bank of Japan to hold a huge percentage of outstanding government bonds, at 40% and rising, as well as being the majority holder of index ETFs. Investors who traffic in JGBs have remarked that the market now functions very poorly, since so much of the market is held by the BOJ. It seems that will get worse, not better.
Last year the BOJ implemented a policy of yield curve targeting (ostensibly to help the banks), keeping the overnight rate negative but targeting a 10 year rate at zero percent. The BOJ has been buying longer-dated bonds for years, but this was the first time it ever explicitly capped a rate at longer maturities. Some people wondered how committed the BOJ would be to maintain that cap in the event that JGBs were caught up in a global duration selloff, which we experienced in the last two weeks.
As 10-year JGB yields rose above 0.10% last week, the BOJ announced that it was prepared to buy an unlimited amount of bonds to keep yields close to zero percent. As you can imagine, buying an unlimited amount of 10-year JGBs involves printing a theoretically unlimited amount of yen, so the yen weakened significantly on the news. It still remains about ten percent stronger than it was in 2015.
We are getting closer to the endgame for Japan. What happens if yields rise further? What happens if the yen depreciates significantly? How much could it depreciate? Could Japan have a currency crisis? What happens if the BOJ ends up owning the entire bond market? These are the questions that investors are asking, and nobody really knows the answers. We are in uncharted territory.
I believe that a currency crisis isn’t just possible–it’s inevitable. And it probably happens at about the time that the BOJ owns all or nearly all of the JGB market, and has to resort to canceling the debt. This sounds like a neat magic trick to make the debt go away, but the laws of economics are not to be conned. Anything is possible–a currency crash, a bond market crash–anything. This is the very definition of debt monetization that resulted in hyperinflation in places like Weimar Germany and Zimbabwe. Is Japan different? We shall see.
We will find out soon, as Japan has taken a major step in that direction.