This article first appeared in Forum, The Edge Malaysia Weekly on January 30, 2023 - February 5, 2023

In 2002, a Big Mac burger could be bought in Japan for ¥262, compared with US$2.35 in the US, which suggests that one US dollar then was worth ¥111. Instead, the dollar-yen rate was significantly weaker at 130. By 2012, one would pay ¥320 for the same burger, 22% higher in nominal terms, though in the US it would cost 68% more, at US$3.96. The implied Big Mac exchange rate of ¥81 to the dollar was very close to the then market rate of 78, the strongest in history.

Ever since the bursting of the twin asset bubbles in real estate and the stock market after 1990, cutting interest rates to near zero was the preferred strategy of getting rid of bad assets held by corporations and banks. Demand was austere after households and businesses were left nursing a serious financial hangover from the mountains of debt from failed investments, creating the conditions for what is known as Japan’s “Lost Decades”.

During this period, the Bank of Japan (BoJ) led the world in rolling out quantitative easing (QE), using its balance sheet to purchase Japanese government bonds (JGBs) and other securities, thus increasing the money supply. This action allowed the government to become a major borrower, filling in for the private sector that was busy deleveraging. Public debt-to-GDP ballooned to over 100% by the late-1990s. Unaccustomed to seeing governments behave this way, traders began short-selling JGBs, expecting a crash to follow such recklessness.

This bear trade gained notoriety as the “widow maker”, because it consistently lost money for traders who bet against the capacity of BoJ to keep on buying government bonds. But the Japanese government came up short, too. Through the 2000s, the yen appreciated despite loose monetary policy, while growth stagnated and deflation persisted.

Enter 2013. Newly elected prime minister Shinzo Abe decided to radically lead Japan out of deflation. He placed Haruhiko Kuroda in charge of the BoJ. Kuroda then launched the centrepiece strategy of “Abenomics”, which was to drive inflation upward to a target of 2% per annum by aggressively expanding money supply. At that time, domestic banks and insurers owned about 57% of all JGBs, whereas the BoJ held 12%. In a groundbreaking move, the BoJ announced two-year plans to increase bond purchases from ¥89 trillion to ¥190 trillion, forcing domestic holders out of JGBs into other assets. Capital flowed outward to purchase US dollar Treasuries, which garnered a higher yield than domestically, which helped devalue the yen.

For a period, the economy enjoyed an export stimulus and headline inflation reached above 2% while the dollar-yen rate rose to 120. The BoJ balance sheet almost doubled by the second year of Abenomics. Then, inflation began to cool. This prompted the BoJ to double down on QE by launching the Yield Curve Control programme to actively manage long-term interest rates as well. Short-term interest rates were set below zero, a seemingly impossible position for conventional economists.

By the end of 2022, assets held by the BoJ swelled to more than ¥700 trillion, equivalent to 1.3 times the size of Japan’s economy. Prior to Abenomics that ratio had been 32%. The BoJ’s relentless bond buying succeeded in crowding out other investors and it became the largest creditor to the Japanese government, holding over half of all JGBs. But the results of Abenomics have been mixed at best: while Japan mostly avoided deflation, the 2% target had not been convincingly met; the yen weakened while Japanese trade as a percentage of GDP rose from roughly 20% to 30% in the last decade.

Today, a Japanese Big Mac is priced at ¥390 and an American one costs US$5.15, implying each dollar should be exchangeable for ¥76. Instead, the actual dollar-yen rate was 131 at the end of 2022, influenced by the US Federal Reserve decision to hike interest rates to 4.5% per annum. Meanwhile, the BoJ has held fast to its ultra-loose monetary policy and kept to its near-negative rates stance.

This month, the central bank surprised financial markets by maintaining its yield curve control, pledging to keep 10-year JGB yields to a ceiling of 0.5%. Can we expect the reversal of nearly a decade of uber QE? Clearly, monetary policy faced a crossroads, as domestic consumer inflation reached 4%. Producer prices jumped nearly 10% last year, straining corporate profits.

Kuroda, the last of Abenomics’ chief stewards, will step down from the BoJ in April. The next governor will face an immediate trial by fire. Japan’s public debt-to-GDP ratio has grown to 260%, the highest among developed countries. But the government’s fiscal burden is minimised by zero-bound interest rates. The central bank will have to consider the government’s interest servicing ability in any monetary policy adjustment. A loss of control would risk a balance sheet recession on the government’s books. But doing nothing risks letting inflation eat away at profits and savings, undoing decades of efforts to revive a moribund economy. Foreign investors, responsible for about 14% of JGB holdings, are understandably nervous and were net sellers of JGBs last year, reducing their exposure by almost ¥11 trillion.

The disconnect between monetary policy and economic reality has turned attention back to the “widow maker” trade, as short sellers position for a rise in JGB yields in anticipation of a pivot by the BoJ towards fighting inflation. The stakes are very high, because if domestic interest rates rise, Japanese domestic investors may pull out of their foreign assets.

At the end of 2021, Japanese gross foreign assets amounted to ¥1,250 trillion or US$10.9 trillion, equivalent to 11.6% of world GDP, whereas net assets were ¥411 trillion or US$3.6 trillion. The Japanese market tends to move in herd-like fashion, and large collective action could build into a financial tsunami. Watch this space.

Tan Sri Andrew Sheng writes on global issues that affect investors. Tan Yi Kai is a Malaysian multi-asset trader based in Hong Kong.

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