- Japan will continue to be an appealing currency haven for global markets.
- Some global developments, including a massive bond sell-off, will benefit Japan, and there is reason to believe that inflation will return to the country in 2017 and thus boost economic growth.
- Still, Japan will need to watch rising bond yields closely; the higher they go, the higher Japan's debt repayments will become, and the closer it will get to a debt spiral.
Despite the upheavals of 2016, Japan plans to begin the new year by staying its economic course. In a Dec. 20 monetary policy meeting, the Bank of Japan chose to hold its interest rates steady — an unsurprising decision, given that in September the bank launched a major overhaul of its monetary policy, shifting from a quantitative focus on bond-buying to a more relative approach aimed at keeping bond prices stable. Still, much has changed in the global economy in the past three months, and the Japanese government must now contend with an entirely different set of circumstances in 2017. Some of these changes are for the better, but some could also create new problems over the coming year.
For 25 years, Japan has been caught in a prolonged economic slump, beginning with a bursting asset bubble in the early 1990s. The country has been struggling to escape a trap of low growth stagnation ever since. A key factor of this period has been ever-decreasing prices, or deflation, which have created a national mindset toward delayed spending. The Bank of Japan's first challenge has thus been to create sustained inflation, after which, in theory, Japanese consumers will begin to spend again, driving the economy back toward sustainable growth.
In pursuit of inflation, the Bank of Japan has led its Western counterparts on ever more experimental monetary policies (the Bank of Japan first tried zero interest rates and quantitative easing at the turn of the century, while other central banks did so after 2008) in an effort to stimulate inflation. As part of its campaign, the Bank of Japan has bought increasing numbers of bonds, to the extent that its influence began to disrupt the domestic market, making it clear that the policy could not continue indefinitely. Meanwhile, the government has become increasingly indebted, with public spending stepping in to make up for weak private spending; Japan's 250 percent debt-to-GDP ratio leads the world. It has long been discussed that these debt levels could prove disastrous: If the market lost faith in Japan, there could be a rapid sell-off, sending bond repayment rates soaring and putting the country even further in debt. (The market trade anticipating this disaster has been so common, and so consistently wrong, that it has earned the nickname "The Widowmaker." In 2016, a large hedge fund made the same bet and took massive losses).
But many continue to see Japan as a currency haven. The world's third largest economy was built on a weak currency, which produced consistent current account surpluses and thus wealth accumulation. Markets are naturally drawn to such relative security, which has the unfortunate effect of driving up the strength of the yen. Because Japan needs a weak currency to function at its best, its status as a haven has created problems.
By 2016, the Bank of Japan appeared to be at the end of the line. Quantitative easing was hitting its limits, and inflation was nowhere to be found. At the same time, a push into negative interest rates at the start of the year was harming profits in the domestic banking system. The result was a shift of emphasis by the Japanese administration. Japanese Prime Minister Shinzo Abe began to expound on the idea of the world's governments increasing their spending, and his country has led the way. In June, Tokyo announced the delay of a planned consumption tax hike, which would have helped tighten the budget deficit, and in August it announced a new fiscal stimulus to help boost the economy. The Bank of Japan also altered its role in September: Instead of buying huge numbers of bonds every month, it would support the government's spending effort by keeping its debt repayment costs under control, buying just enough bonds to keep 10-year government debt yields at 0 percent. It was the central bank's promise to the government that it could spend what it needed to without worrying about a debt spiral.
The World Turns
That was the picture in Japan. But big changes were happening in the world.
The start of the great bond reversal can be traced back to July 8. Up until that day the demand for U.S. 10-year government bonds had been constantly growing, but upon market open on July 11, it shrank slightly. Since then, a generalized global bond sell-off has been gathering pace. It probably did not figure strongly in the Bank of Japan's September calculations, but since the November U.S. election it has increased markedly. On July 8, U.S. 10-year interest rates were at 1.36 percent, and on Dec. 22 they were at 2.54 percent. This bond sell-off is largely driven by a general expectation of increased inflation. Commodity prices that had been dropping stabilized in the first half of the year. The election of a U.S. administration dedicated to greater fiscal spending likewise drove the likelihood of increased inflation even higher. And the Federal Reserve, tasked with keeping inflation under control, has had to raise interest rates, which it did in December, raising the value of the dollar.
Many of these developments benefit Japan, and there is reason to believe that the country will see inflation in 2017. First and foremost, commodity price stabilization removes much of the deflationary pressure that has weighed down Japan in recent years.
Second, the strong dollar coincides with a weak yen, and this time not so much as a result of Japanese bond-buying (as had been the case since the start of Abe's raft of economic reforms, better known as Abenomics, in 2013) but more as a result of external shifts, which might prove more sustainable. It not only helps Japanese exporters and, potentially, economic growth, but it also increases the chances of inflation as the price of imports goes up naturally.
Third, the Japanese job market is now exceptionally tight. Unemployment is at 3 percent (the lowest since 1995) and the new job offers to applicant ratio is at 2.11 (the highest since 1991). These measures must be taken with a grain of salt, because many Japanese work part-time, meaning they are less able to negotiate wages. Still, there is a case to be made that wage inflation could be imminent.
Together, these developments can broadly be seen as favorable for Japan's aspirations of escaping its economic slump. Inflation may be about to appear, while the weak yen should stimulate Japanese exports and encourage growth.
But new hope also brings new risks. The global bond sell-off has reached Japan, and the Bank of Japan's 0 percent yield target has been coming under pressure over the last month as Japan's government bonds attempt to cheapen alongside their counterparts in other markets. If it wishes to maintain 10-year yields at 0 percent, the Bank of Japan will have to buy bonds in large quantities, which, if the trend continues, puts it back in the position it was facing before September — where it might run out of bonds to buy. Alternatively, the Bank of Japan could lift its target to 1 or 2 percent, allowing the bond yields to rise along with their Western counterparts. However, having only just installed the new format, the Bank of Japan is reluctant to make dramatic changes.
Japan will need to watch rising yields closely, since the higher they go, the higher Japan's debt repayments become and the closer the "Widowmaker" debt spiral scenario looms. Committing the central bank to sustaining bond yield levels provides a useful safety net without which the debt repayment costs might have quickly become uncomfortable. But as mentioned at the time, the policy is a crutch that can prove hard to give up, capable of creating bigger problems in the future.
Finally, it cannot be discounted that global trends might reverse. Commodity price stability is by no means certain. More sharp drops could snuff out signs of inflation as swiftly as they arrived. Equally, currencies are famously flighty, and Japan's appeal as a safe haven seems at this point undiminished. If global markets take fright, the yen could strengthen rapidly once again.
If current trends continue, 2017 could be the year Japan finally sees some sustainable inflation. Yet it could easily bring new problems as well.