Almost three long decades ago, during the Asian financial crisis (remember that?) I found myself in the Bank of Japan for a media briefing.
At the end, a central banker pointed to some portraits of 20th-century BoJ governors and solemnly noted that two — Junnosuke Inoue and Korekiyo Takahashi — were assassinated after leaving office.
The reason? They were victims of the 1930s fascist turmoil. But they had also run different — controversial — monetary experiments: Inoue was hawkish, embracing the gold standard, while Takahashi was a diehard reflationist. “We don’t forget the risks [in our work],” my interlocutor quipped.
Investors should take note of this little-known historical twist, particularly given this week’s intervention by Washington and Tokyo to avert a collapse in the yen.
Thus far, most market chatter has focused on the motives of Scott Bessent, US Treasury secretary. No wonder: the action suggests Bessent fears 1997-style competitive devaluations in Asia, and is eager to deter Japan from dumping its Treasury holdings at a time when US yields are rising. It also underscores that we live in an era of geofinance: Washington will only offer financial support to friends-cum-vassals.
But the Japanese side of this equation matters too. The ghosts of the 1930s have made Japan’s financial mandarins desperate for stability — just as German leaders are fiscally and monetarily conservative because of their memories of Weimar hyperinflation.
And there is an irony here: the desperate desire to maintain stability may be creating long-term dangers. If so, currency intervention might not work.
The reason lies with Japan’s eye-popping debt burden. After the 1997 Asian shock, Japan implemented a zero-interest rate policy (Zirp). This eventually caused the BoJ’s holdings of Japanese government bonds to rise from 11.6 per cent of all outstanding JGBs (in 2013) to a peak of 53.9 per cent (in 2023).
BoJ officials have agonised about the long-term risks of this path, given those 1930s lessons. But as Japan’s economy has recovered in recent years, the BoJ has started to shrink its balance sheet, and now “only” holds 49 per cent of all JGBs. It has also raised policy rates from zero to 1 per cent.
The BoJ says this shows it is “normalising” policy. And it deserves applause for getting here without sparking a crisis — yet — since the JGB yield rise has mostly been fairly steady. But the yen has slid from ¥147 to the dollar to ¥163 last week, the lowest for four decades. That is because Japan’s economy is weak(ish), yen rates are below dollar ones, and foreign investors also seem to be playing complex hedging games.
But that debt burden is the biggest issue. On paper, the obvious route to strengthen the yen is with higher rates, since while the economy is weak, inflation is rising. Some investors think Bessent is pushing for a September rise.
But Sanae Takaichi, Japan’s prime minister, dislikes higher rates because she wants to reflate the economy, says Sayuri Shirai, a former member of the BoJ policy board.
She — and others — also fear rising debt-servicing costs. Until recently, the Zirp policy kept these servicing costs low, even as the total debt-to-GDP ratio exploded way above 200 per cent, the highest of any major economy (although net debt is nearer to 130 per cent, says the economist Robin Brooks).
But recent rate rises have already pushed servicing costs to ¥31tn in fiscal 2026, or a quarter of spending, and a recent Ministry of Finance memo projects they will be about a third of outlays in three years, according to Reuters.
This is horrifying — particularly since 10-year rates are already above the MoF models that produced these projections. And the BoJ has decided, amid fierce debate, to slow its balance-sheet reductions to prevent a disorderly rate rise.
However, the threat of a looming debt crunch now hovers in the air. And if that does ever materialise, it would not just hurt Japan but wider global markets too. After all, yen outflows have funded many investment strategies around the world in recent years, via the carry trade, and hedge funds own a swelling chunk of JGBs.
Is there any solution? The least bad one would be some fiscal austerity and further, slow, rate rises if inflation remains high. Some economists like Brooks also want the Japanese government to sell its vast pile of assets to cut gross debt; he argues this could finally stabilise the yen.
But Takaichi seems averse to austerity and higher rates, and may even prefer a weaker yen, notes Shirai. And she seems ready to bully the BoJ.
The good news is that Bessent — like the BoJ — is highly motivated to avoid a market shock. And if any country can weather a putative debt crunch, it is Japan: just 7 per cent of JGBs are foreign owned and there is a strong cultural tradition of shared sacrifice and social cohesion. This is notably not the case in the UK or US.
But the bad news is that there is no easy way out of this trap. The ghosts of Takahashi and Inoue hang in the air; or, more accurately, a fear of those ghosts is haunting policy, reinforcing the current dilemma around raising rates. All eyes on the yen — and a bedevilled BoJ.
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