The Importance of Fiscal Prudence: Lessons from the Yen’s Depreciation

The spectacular fall of the Japanese Yen, and the equally dramatic joint rescue mounted by the Bank of Japan and the US Federal Reserve, underscores the rapidity with which a currency can be hit by a crisis of confidence. 

The episode illustrates that a current account surplus and a large net investment position do not guarantee exchange rate stability, especially in the face of changing and uncertain global financial conditions.

India has a completely different macroeconomic profile from Japan — our economy routinely grows at 6% or more, runs a current account deficit funded by capital inflows, and faces comparatively higher inflation and interest rates. Yet, both countries are facing a steep fall in their currencies. The Yen hit a 40-year low of 163 against the US dollar in July 2026. A dollar bought 89 rupees at the start of the year. Today, it is worth about 96 rupees: this represents a weakening of over 5%. As the RBI battles to contain rupee volatility and manage confidence in the currency, it may be worthwhile to draw some lessons for India from the (ongoing) Yen depreciation. 

First, having the bulk of national debt denominated in domestic currency reduces the exchange rate risk, but does not guarantee protection from bond market meltdowns. Almost the entire debt of the Japanese government is denominated in Yen, and about 88% is held by domestic investors. In March 2026, the Bank of Japan held 47.9% of outstanding Japanese Government Bonds; banks and insurance companies held another 30%; and foreign investors owned only 8%. 

India’s case is somewhat similar: nearly 96% of outstanding government liabilities is domestic, and foreign portfolio investors own less than 3% of government securities (data for 2025-26). The advantage of this structure is that national debt remains insulated from exchange rate fluctuations; so, the government’s interest burden does not depend on whether the local currency is appreciating or not. 

The disadvantage of this, though, is that in a confidence crisis, investors sell-off bonds, yields shoot up, and borrowing costs rise anyway. The takeaway? India cannot afford to be complacent about its debt ownership profile. Indeed, during the 2013 taper tantrum, India’s 10-year benchmark yield briefly crossed the psychological threshold of 9% in response to bond selloffs by FPIs. 

Second, in turbulent times, the composition of a country’s balance of payments assumes more importance than aggregate numbers. In 2025, Japan’s current account surplus was 4.9% of GDP, and it sent over $200 billion overseas as direct investment.  Japan is among the top five exporters in the world. But here’s the chink in Japan’s balance of payments armour: it imports 90% of its crude, and the recent rise in crude oil prices is likely to inflate its 2026 import bill.

These fears have pushed the yen down in much the same way that crude price hikes have pushed the rupee lower. Japan also imports over 60% of its calories; and a weaker yen raises the risk of imported inflation.

That’s one reason for the rise in bond yields – the markets expect the Bank of Japan to raise rates to combat inflationary pressures. India has discovered, also, that markets are experts at spotting cracks in its BoP structure. In 2013, when the taper tantrum shook global markets, India was classified as a “Fragile Five” economy because of its large current account deficit, though it continued to receive dollar capital inflows.

The recent weakening of the rupee reflects an opposite dynamic driven by a decline in net foreign capital inflows despite India maintaining a modest current account deficit.

Going forward, the markets will look to assess the impact of AI on India’s IT service revenues. If AI adoption slows billing growth of IT firms, the existing model where India relies on services exports to contain the current account deficit will see a disruption. On the other hand, if IT firms are able to productively deploy AI, the service sector may continue to remain an export powerhouse.

Third, bond markets dislike fiscal imprudence, and are unforgiving of fiscal dominance. In June, Japanese Prime Minister Sanae Takaichi set out a $2.3 trillion investment plan to bring public and private spending into 17 strategic sectors over the long term. She followed up with a promise to reduce consumption tax on food items from 8% to 1% for a two-year period to ease households’ cost of living.

This spooked the markets as a fiscal stimulus would require additional borrowing on top of the already huge national debt (estimated at over 200% of GDP). Unfortunately, the Bank of Japan made matters worse by holding rates at its last policy meeting, despite rising domestic inflation and a hawkish US Fed. 

BoJ now has two options. It can hold rates and watch the yen weaken. Or it can raise rates swiftly to stabilise the yen, and simultaneously increase the interest outgo of an already indebted government. Intervention is a stop-gap approach that buys time, but does not change the fact that the more BoJ leans towards the first option, the greater the risk of fiscal dominance.

If BoJ keeps rates lower than expected just to manage the fiscal, it is likely markets will hammer the exchange rate and bond prices until policy action is taken. The message is straightforward: clear and decisive communication by the central bank along with timely policy action is crucial for retaining investor confidence. 

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