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Bank of Japan and the Carry Trade Bubble: What Japan's Recent Rate Hike means for the Country’s Recovery and the Yen Carry Trade


On February 21, the Bank of Japan voted to raise the unsecured overnight call rate, used as a benchmark for the short-term money market, by a quarter of a percentage point to .5 percent.  The move came as part of an attempt to address the problem of the country’s overly…


On February 21, the Bank of Japan voted to raise the unsecured overnight call rate, used as a benchmark for the short-term money market, by a quarter of a percentage point to .5 percent.  The move came as part of an attempt to address the problem of the country’s overly cheap credit. Japan has used extremely low rates as a method of economic recovery after the 1990s recession.  The problem with this approach is that it has led to the development of a yen carry trade whereby speculators use cheaply bought yen to invest in high-risk overseas markets.  The Bank’s recent moves have not always been popular, especially in Japan. Opponents to the rate increase say Japan’s recovery is still in its early stages and ending the availability of cheap credit could jeopardize future growth.  The Bank is therefore caught in a balancing act.  It needs to move away from low call rates but also has to be careful not to prevent growth altogether.

Rate Change   

Japan has hadan ultra-loose monetary policy since the late 1990s and has not had a benchmark rate of over .5 percent since September 1998.i  These near-zero rates were supposed to encourage borrowing and stimulate consumer demand, usually taken as the best ways to recover from a recession. Bank governor Toshihiko Fukui now wants to repeal these emergency measures.  Last July, the Bank ended the unusual policy of free credit and set the overnight call rate to .25 percent.  Japan had posted 1.2 percent GDP growth in the last quarter of 2006, and proponents of the Bank’s move say that the country’s stronger-than expected growth shows that Japan no longer needs such extremely low rates.ii Fukui foresees more moderate growth for the Japanese economy and says artificially low rates can hurt prospects for a long-term recovery.  

The Yen Carry Trade

The other reason for the rate change has to do with the yen-carry trade and the consequences of cheap credit for the global economy.  There’s a huge gap between Japan’s benchmark rate and the rates of other countries.  The United States and Europe have an average call rate of about 5.25 percent.iii  The large gap has meant international investors borrow from Japan to invest in risky overseas markets.  Japan’s cheap credit has therefore helped prop up the global economy, and economists fear the sudden end of low rates could lead to a global recession.  At the same time, there is a need to gradually undo the carry trade.  The cheap yen has led to a form of moral hazard whereby speculators are less concerned about loss and tend to make rash investment decisions. Japan’s easy money has led to large real estate and stock market bubbles, the collapse of which would lead to recession in the United States, India, South Korea, and Eastern Europe.iv

The carry trade has also had consequences for Japan’s domestic economy.  The yen has the lowest value of major currencies, valued at roughly 120 yen to 1 USD, and its depreciation can be directly tied to the carry-trade.  International investors have begun to sell yen to buy more high-yielding currencies like the euro and dollar and have therefore contributed to the yen’s depreciation.  The Bank of Japan wants to eventually address the artificially low value of the yen and sees the end of the carry trade as necessary for a more balanced exchange rate.  

Many Oppose the Recent Moves

Many Japanese, however, oppose the Bank’s recent moves.  Japanese exporters, on which the country’s recovery greatly depends, have benefited fromthe undervalued yen and are reluctant to see any appreciation of the currency.v  What’s more, much of the carry trade has been due to individual Japanese investors.  Investors look to overseas markets to increase their rate of return and more expensive credit would hurt domestic incomes.  Prime Minister Shinzo Abe has been another opponent of the Bank’s reforms.  Although he understands the need for an eventual move away from free credit, Abe has emphasized the need for economic recovery and employment.  Abe and his supporters say that consumer prices have not grown as expected showing that deflation remains a big problem for the economy.vi The difference in opinion between Abe and the BOJ raises the question of whether the Bank will fall in line with government policy or take a more independent course. 

Experts debate whether all the hype over Japan’s rate change is really warranted.  The recent rate hikes have been extremely modest. Economists say the Bank of Japan must be prepared to take more aggressive measures and raise the call rate to 1 or 2 percent before the reforms can have any effect on the carry trade.  Regardless of the actual effect of the new benchmark rate, the Bank of Japan’s moves speak to challenges ahead for the Japanese economy.  The economy seems to have recovered from the 1990s, but the heavy use of free credit raises the question whether the recovery can be sustained without these measures. The international element has been another important variable.  Any abrupt change in Japan’s benchmark rate will have a knock-on effect for global stock markets. 

Source: www.asiaecon.org |

 

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