The Bank of Japan’s Seductive Widow-Maker Trade

CAMBRIDGE – Could Japan become the world’s next great growth story? Billionaire and legendary investor Warren Buffett seems to think so. And the International Monetary Fund expects the Japanese economy to grow by 1.4% in 2023 – an impressive figure for a country whose population has steadily declined for the past 14 years.

But the Japanese economy could also be a ticking time bomb. Its labor market is tight, inflation remains stubbornly high despite the introduction of gasoline subsidies, and the yen’s real exchange rate has reached a three-decade low. After decades of maintaining near-zero interest rates, it is unclear whether the Bank of Japan can raise them without sparking a systemic financial crisis.

While the BOJ’s new governor, Kazuo Ueda, has said that the Bank will maintain its ultra-loose monetary policy, he also acknowledged the global economy’s “very high uncertainty.” Given the forces driving up inflation and interest rates worldwide, it is increasingly clear that Japanese monetary policy can no longer be conducted in isolation.

Over the years, many investors have bet against the BOJ, shorting Japanese bonds on the assumption that the zero-interest-rate policy could not last. Time and again, the speculators were crushed. Now, however, the “widow-maker trade” might actually pay off.

The BOJ’s reluctance to increase its short-term policy rates is understandable, given that Japan’s gross government debt currently stands at 260% of GDP, or 235% of GDP after netting out $1.25 trillion in foreign-exchange reserves. Should the Bank be compelled to raise its short-term policy interest rates by 3% – about half as much as the US Federal Reserve has – the government’s debt-servicing costs would explode.

Moreover, a sharp interest-rate increase would put enormous pressure on the Japanese banking sector, particularly if long-term rates were to rise as well. This is precisely what happened in the United States in March when the Fed’s monetary tightening triggered a chain reaction that led to the collapse of Silicon Valley Bank and several other financial institutions.

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