Will Japan bring down the world economy? | The Economist

We're talking Japan and its influence on the  world economy. Let's start by unpacking what has. actually happened here. So the the recent event is  the intervention in the currency market by Japan. uh but more notably by America too. The first  uh uh such intervention in about three decades. Uh Josh, could you explain what's happened? Yeah.  So, Scott Bessant, the US Treasury Secretary, has basically bought an awful lot of yen in order  to to prop up its value to try and stop it from.

weakening. Um, there are a couple of unusual  things about this. One is that he used euros. rather than dollars to buy the yen. The other  is the way we know how much yen he bought, which. there's there's a lot about this administration  that we sometimes kind of criticize. One thing. I adore is the kind of high camp theatricality.  And it's it's just a very theatrical way that we. know. We know tha he's bought five to10 billion  dollars worth of yen because he allowed a. photographer to take a picture of his notepad at  a cabinet meeting. Uh and the notepad says to do.

um buy Japanese yen brackets JPY in case anybody  missed it. That's the that's the symbol for the. Japanese yen. 5 to10 billion. That's the only  thing on the to-do list. Buy Japanese yen. Five to10 billion dollars. That's all. I mean,  like, you couldn't get more theatrical unless. you kind of paid Patty Leone to kind of belt  it from the rooftops. And this has been a. ongoing battle for the Japanese uh uh government,  which uh as I said, America's intervention.

was was was new, but Japan has been defending uh  its currency for a while now. So Ethan, in the. context of that, how much did this intervention  matter, do you think? Yeah, it's a good question, Henry. And I mean, I think it's worth saying  from the Japanese perspective, this is an. intensification of efforts that had already been  underway. Uh came on the back of a $73 billion. unilateral intervention just by the Japanese  governments in May and repeated efforts by the.

finance minister and other officials in Japan  to job the market, to get the yen to cooperate. You know, it used to be that a weekend was  considered a good thing for the Japanese economy. It boosted exports. Japan has a lot of very  strong multinationals where weekend, you know, improves their competitiveness abroad. But now  it's it's seen as as really a problem for them. It. pushes up import costs. It's seen as feeding  into, you know, above 2% inflation in Japan. It's pinching uh, you know, consumers and it's  leading to issues with over tourism, which has. become a political issue for the government. So  I you know I think the politics here are are are.

shifting and you're you're seeing that in the way  that the government is responding to yen weakness. Uh you know Takaichi Sanae the prime minister of  Japan is a longtime skeptic of higher interest. rates. Uh you know she before becoming prime  minister said that rate hikes were stupid. is the word she chose to use. And her tune has  since changed on interest rate hikes as the yen. has become more of an issue. That's why it  matters in the Japanese context. For America,

I think it matters because of the interactions  between Japan and the US Treasury market, which I know we'll talk more about later in the  show. And then just more broadly for the world, for global financial markets, it matters because  of the deep linkages between what happens in Japan. and the rest of the world. I think step one is  saying, why is the yen so weak? And anyone who. watched or read our coverage of our Big Mac index  anniversary and and refresh a few weeks back will.

remember that Japan is one of the most undervalued  currencies according to the Big Mac index. So. that that currency is weak. It's weak in defiance  of fundamentals and that's essentially because. interest rates in Japan have been so low for  so long and that's what has made the economy. stand out. And of course, if you're an investor,  you want to hold a currency where interest rates. are higher. That's right. I mean, Japan for  a long time has had deflation as its primary.

economic issue. Low growth, uh, low inflation,  occasionally negative inflation. And what that's. meant is when you have those sort of economic  conditions, you need lower interest rates. So, from an in from an investor perspective,  that makes it a very attractive funding currency. In other words, you'd like to borrow if there's  low interest rates in a country. That lets you. take that borrowed money from Japan, finance at a  low interest rate and invest it somewhere across. borders and pick up uh the difference. So that  that has been a long-standing feature of global.

financial markets. The question now is, you know,  Japan used to have negative0.1% interest rates, but that's changed. Inflation's back. It's been  above 2% for something like four years now, and interest rates are rising. They're  now at about 1%. The expectation is that. the Bank of Japan, the central bank, will hike  again to 1.25% to 5% sometime later this year. So is that going to destabilize this this this  so-called carry trade? And essentially the issue. is that this has happened on a massive scale the  borrowing in in in yen to hold higher yielding.

assets overseas not least US treasuries and  this chart shows that Japan is indeed the. biggest holder of US uh US treasuries. So this is  happening on a on a large scale right Josh? Right. Exactly. And that's why Scott Bessant does need to  be worried about Japan. They are such a big holder. of treasuries. If something goes wrong, they start  to dump their Treasury holdings that would send. US borrowing costs up. But it's not just that.  Traders call Japan the world's ATM. As Ethan said,

it's s it's such a low yielding currency that  you can easily borrow in it and buy other assets. And that goes well beyond treasuries, right? That  goes to [ __ ] Japanese stocks, that goes to other. Asian stocks, that even goes to US tech stocks.  So if we start to see this carry trade unwind, if. we start to see, you know, interest rates go up,  it becomes more expensive to borrow in the yen, um it's not so attractive to use that as your  funding currency anymore. You can see selloffs. across the world. And that's why we're asking, you  know, can Japan break the financial system because.

it's such an important part of it. Okay, so that  brings us on to the big question. Will Japan bring. down the global financial system? Well, if  it doesn't manage the dream scenario where it. just gradually kind of unwinds its its big carry  trade, it could do. And the worrying thing is that. we have a financial system that already has points  of fragility that have nothing to do with Japan. We have talked to death about how uh how high  stock market valuations are, how vulnerable they.

are to a crash. two summers ago, you know, when  when part of the carry trade was unwinding, you. know, but this is this is tech stocks um falling  from a very high level. They have much further. to fall. They're much more highly valued now than  they were two summers ago. So, that's a point of. vulnerability. You have this kind of inward turn  already happening within countries, you know, uh crossber capital flows reorienting themselves  along geopolitical lines. This could be one of. those kind of catalysts that that that really  accelerates that. And you can't really predict.

if you have kind of this inward turn. You can't  really predict what shape the financial system. takes after that. So yes, I worry that it  could bring down the the financial system. I do hold out hope though that we just get  repeated episodes like over the past few weeks. This big point of vulnerability, the um the  the the essentially the Japanese government's. consolidated position winds down and down and  down and then eventually we don't have it anymore.

And that's maybe one problem less for for  the world to worry about. Let me give the. more optimistic take here, which is that I  I think even though the position is scary, I think governments are pretty good at crisis  fighting generally speaking. And I think Japan. has a lot of levers to pull if something, you  know, started to turn pear-shaped quite quickly. I I mean the asset side of the balance sheet enory  is one of those levers. A lot of those assets, you know, could be unwound, could be monetized  uh if need be. there is a really significant. stock of foreign reserves to defend the currency  if they needed to. Uh the August 2024 episode.

though it created this volatility. Nothing really  broke. This was not a GFC or or a pandemic-style. scenario. It was a warning signal but nothing  you know absolutely dire. And so I I I think with. the leverage the government has to pull, the  funds available to its disposal and coordination. with uh you know its friends in America, I think  a crisis situation probably could be averted. But uh you know that's probably what people would  have said in the 80s before the the the gigantic.

bubble burst in Japan. But um I I I think I have  faith that governments tend to be good at crisis. fighting even if they're not always good at making  good decisions when things aren't in crisis.