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Japan appears to be on the cusp of a full-blown currency and bond-market crisis. Although the Japanese authorities spent more than $70 billion in May to prop up the yen, the currency has slumped to a 40-year low and is estimated to be at least 15% undervalued against the US dollar. Meanwhile, Japanese long-term bond yields have surged to multi-decade highs following the end of the Bank of Japan’s yield-curve-control policy. And with no signs of Japan addressing the underlying causes of its currency’s downward spiral anytime soon, there is every reason to fear that the crisis will deepen.
Japan’s current challenges should be a wake-up call for other countries that appear to be on unsustainable public-debt paths, not least the United States, as well as France, Italy, and the United Kingdom. After all, an economic and financial crisis in one country often draws the market’s attention to other countries facing similar problems. That was certainly the case with the Asian currency crisis in 1997, when a Thai currency devaluation triggered similar devaluations in Indonesia, Malaysia, the Philippines, and South Korea. It was also the case with the eurozone crisis in 2010, when a Greek sovereign-debt crisis triggered similar crises in Ireland, Italy, Portugal, and Spain.
There appear to be two main drivers of Japan’s currency and bond market woes: its unsustainable public finances and its relatively low interest rates (compared to the US). At 230%, Japan has by far the highest public debt-to-GDP ratio among G7 countries, and it still runs a primary budget deficit, which adds to the existing debt. Then there is Japan’s declining and aging population, as well as a government that has shifted from targeting a single-year primary budget surplus to a vaguer medium-term debt stabilization policy. Is it any wonder that markets are growing uneasy about the country’s public-debt trajectory?
It does not help that Sanae Takaichi, Japan’s new prime minister, seems uninterested in putting the country on a sounder budget footing anytime soon. Among her first economic-policy moves was to adopt a supplemental budget that increased energy subsidies in response to the shock to international oil prices from the closure of the Strait of Hormuz.
Japan’s large debt burden makes it difficult for the BOJ to raise interest rates even at a time when inflation appears to be accelerating. Tightening monetary policy would only exacerbate the country’s public-finance problems by increasing interest payments. While the US Federal Reserve’s short-term interest rate is at 3.5%, the BOJ’s policy interest rate is at just 1%.
That spread continues to give investors an incentive to borrow cheaply in Japanese yen and lend in higher-yielding dollar-based assets (the “carry trade”). This will remain the case as long as the yen continues to depreciate.
But Herb Stein’s famous aphorism bears repeating: If something cannot go on forever, it will stop. In principle, Japan could get off its unsustainable debt path in an orderly manner if the government made a preemptive and timely economic-policy U-turn to avert a currency and bond-market crisis. Or it could do so in a disorderly manner if a full-blown currency and bond crisis forced the government’s hand. That is what happened in the UK in 2022 in response to Prime Minister Liz Truss’s ill-advised budget measures. Unfortunately, all available signs suggest that Japan is heading in this direction.
A deepening Japanese currency and bond-market crisis is bound to draw attention to other countries with troubling public finances, and especially to the US. At around 100%, the US debt-to-GDP ratio is considerably lower than that of Japan; but the country is on track to maintain a budget deficit of more than 6% of GDP as far as the eye can see. That means its debt ratio will soon reach its highest level since the end of World War II.
Worse, additional factors are making the US more vulnerable to a bond-market crisis. Consider, for example, that foreigners own around one-third of all Treasury bonds outstanding, and that the government is increasingly reliant on hedge funds rather than on more stable bondholders (like insurance companies and pension funds) to meet its borrowing needs.
The bottom line is that highly indebted countries like the US, France, Italy, and the UK all have good reason to address their shaky public finances. The prospect of spillovers from an early Japanese currency and bond-market crisis have made the task only more urgent.
