Japan’s Influence in Global Capital Markets

Thomas Ciha
Sep 7, 2018 · 8 min read

I read an interesting article the other day pertaining to Japan’s economy and its influence on world markets. However, I was feeling a little emptyhanded at the end. Why have Japan’s interest rates gone through the floor in the first place? What is the relationship between interest rates in North America and the rates in Japan? The article mentions Japan has been battling low inflation. The adverse effects of hyperinflation are straightforward and intuitive, but why would low inflation be a bad thing? I will paraphrase these aspects of the article and disclose some of the additional research I did to gain a better understanding of the material.

With that being said, I hope you’re ready for some charts.

Source: Author

What is the relationship between Japanese and North American interest rates?

The history of bond yields, interest rates and other economic metrics is very different in North America than Japan. We must gain a historical understanding of the differences in the Japanese and North American economies to understand the relationship between their interest rates. Although many factors influence the economy, the people that comprise it are the most significant input variable. In fact, the relationship between the Japanese and North American economies can largely be explained by demography.

In 1945, World War Two came to a halt. Over 12 million U.S. military personnel were demobilized within the next year. With the war in the rear-view mirror, many of them got married, developed careers and raised families — big ones. The North American population proliferated. So many people were born that we have dubbed this segment of the population, “The Baby Boomers.” The Baby Boomers continue to profoundly influence the US and Canadian economies. For example, medical care is now the largest component of the consumer price index with the Baby Boomers approaching their 70s & 80s.

Source: Thomson Reuters

In the 1970s, the Baby Boomers were starting to buy houses, most of the time on credit. This influx of mortgages and credit demand drove interest rates to an all-time high. In the mid-to-late 1980s, the majority of the Baby Boomers were earning a sizeable salary and living in homes they had already mortgaged. Many of them were raising kids and saving for their education. They didn’t demand nearly as much credit as they did in the 70s. This is illustrated in the precipitous drop in interest rates around the year 1985, albeit, the recessions in 1980–82 may have played a role in this as well.

Note: Long-term government bond yields are displayed because they reflect the demand for credit. Short-term rates are unduly influenced by central bank monetary policy.

Japan was booming in the late 1970s and throughout the 1980s; partially because of the skyscraping interest rates in North America. Corporations in the U.S. didn’t want to borrow capital at high interest rates when they could obtain a significantly lower cost of capital from Japan. Bond yields were notably lower in Japan throughout this period for a few reasons.

First, the BoJ did not issue long-term bonds until 1978. The low supply and lack of liquidity in this market made bond prices sensitive to changes in demand. The increase in demand for these bonds increased prices, which in turn, drove down yields.

Secondly, inflation in North America was through the roof throughout this period; in Japan, this was not the case. Inflation forecasts influence long-term interest rates because inflation erodes the return on a bond. For example, if inflation rates are 10%, the value for one dollar is decreasing at an annual rate of 10% because the price of goods are increasing by 10%. This necessitates a 10% return to retain the purchasing power of your capital. So the higher inflation rates are, the higher nominal interest rates need to be to realize the same real rate of return. Thus, investors demand higher yields when inflation expectations are high. This coupled with the demand for credit from the Baby Boomers was the primary cause of the extreme interest rates in North America.

Comparing Inflation Rates

Although Japan had a ridiculous inflation rate of 24% in the midst of the 1970s, it fell aggressively by 20% over the next four years. As illustrated in the chart above, Japan’s inflation has been lower than North America’s since 1978. What does this have to do with long-term interest rates?

Bonds are particularly susceptible to interest rate fluctuations because of their fixed coupons. Low inflation — and at times, deflation — in Japan eradicated most of the inflationary risk associated with government debt. This decrease in risk contributed to lower interest rates.

Another reason for the lower interest rates in Japan may lie in the timing of their Baby Boom. The atomic bombs dropped on Hiroshima and Nagasaki left Japan in shambles. It took several years for Japan to redevelop infrastructure and recover economically. The difference in timing and magnitude between the Baby Booms of Japan and North America may have been large enough that the Japanese population didn’t demand as much credit as people did in North America.

Real Long-term Bond Yields

Japan’s economic boom throughout the 80’s was so immense that it fueled an asset bubble. At one point, the grounds of the Tokyo Imperial Palace were purportedly worth more than the state of California! The bubble burst in the early 1990’s and hindered economic output for several years thereafter. Many economists refer to this era as the “lost decade”. The BoJ decreased short-term rates as part of their expansionary monetary policy as a result.

Japan’s role in global markets

Extremely low interest rates have driven the Japanese to invest abroad in pursuit of reasonable returns. This outflow of capital has induced a decrease in the value of the Yen and inflated financial security prices around the globe. According to the Economist’s Big Mac Index, the Yen is currently the world’s most undervalued currency.

If you’re already familiar with purchasing power parity (PPP) and the Big Mac index, feel free to jump to the next paragraph. PPP is a theory that states exchange rates should move to equalize the cost of goods and services given the difference in underlying value of currencies. The Big Mac index is a lighthearted demonstration of PPP and was conjured up in the 1980s by The Economist. Instead of using a basket of countless goods, they use a singular good — the Big Mac. The idea is simple. For example, if the price of a Big Mac is 200 rupees in India and $3 in the United States, PPP implies the exchange rate should be 66.67 rupees for each greenback. However, suppose the current exchange rate is 70 rupees to 1 USD. This implies the rupee is undervalued by about 5%. This makes sense because if you are traveling from Mumbai to Atlanta, it’s better for you to get 1 USD for every 66.67 rupees than every 70. The exchange rate is currently 70:1, but should be 66.67:1; the rupee should be worth more, but it’s not. Thus, it’s undervalued.

The Japanese currently own around 15% of Sweden’s and Australia’s government debt and their holdings of foreign assets have increased from 111% of GDP in 2010 to 185% in 2017. Japan’s monetary policy has the potential to disrupt international markets if an interest rate increase is abrupt and significant. In theory, raising rates would cause capital to flow into Japan from the Japanese and possibly foreign investors. The Yen would also appreciate since more people would demand Yen to invest in Japanese markets.

Why are Japan’s interest rates so low in the first place?

The research I conducted suggests the answer to this is moot. There are a myriad of variables that influence interest rates. This often precludes simple explanations such as: the rate is low because of X, Y and Z. However, we can use what we know to draw inferences.

We know low interest rates signify a low demand for capital. We also know demographics help to elucidate many economic phenomena. The figures below illustrate how the populations of Japan, Canada and the U.S have changed over the last 50 years:

Over 25% of Japan’s diminishing population is now above the age of 65. Fewer people are working and demand has decreased dramatically across the board. The lack of demand and depleted labor force contributed to deflation in Japan. That deflation incentivizes people to save money because they can buy more goods and services with tomorrow’s dollar than today’s.

Some economists say the BoJ has decreased interest rates to combat this tendency to save. From the bank’s perspective, lowering the interest rate incentivizes corporations to undertake projects that require debt financing because the cost of borrowing is lower. These projects should foster economic activity and create jobs, which should eventually increase demand. From the saver’s viewpoint, it incentivizes spending because the interest gain from saving has been diminished.

The BoJ is injecting ¥80 trillion ($715 billion) into the money supply each year via open market operations to achieve a target yield on 10 year bonds of around 0%. This makes sense in theory because the impact purchasing government debt has on the economy is similar to a decrease in interest rates. Purchasing government bonds increases the money supply. This renders money less scarce, thus less expensive to borrow.

Despite all of these efforts to stimulate the economy and disincentivize saving, a significant portion of Japan’s population requires reasonable returns. Japanese pension funds are supporting an unprecedented quantity of people and they, as well as other institutions and individuals, have turned to international markets to realize a return that will suffice. The BoJ meets again September 18–19 to discuss monetary policy. I’m excited see the implications of BoJ’s policy decisions going forward.

Conclusion:

Thank you for reading! Constructive criticism is appreciated. I am neither an economist nor an expert in demography, so please let me know if I’m missing details or if you disagree with the analysis.


Thomas Ciha

Written by

I’m an avid traveler with an insatiable desire to learn. Deep learning research intern.

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