Financial Stability and Monetary Policy Autonomy in Japan. Should Japan Peg the Yen to the Dollar?

1 Introduction

With the rise in consumer price inflation from 2021, the US Federal Reserve (Fed) and the European Central Bank (ECB) have raised interest rates sharply and shortened their balance sheets. In contrast, the Bank of Japan (BoJ) ^[1] has only lifted its key interest rate slightly from minus 0.1 per cent to 0.25 per cent during March 2024 and has lagged far behind the Fed and ECB in terms of quantitative tightening (see Figure 1). The delayed monetary tightening has revelaed a high degree of vulnerability of Japan in the face of monetary tightening.

Figure 1:

Fed, ECB and Bank of Japan: Balance sheets as percentage of GDP. Source: Bloomberg, Federal Reserve of St. Louis. GDP = gross domestic product.

Research on the Bank of Japan’s monetary policy has so far focussed on the effectiveness of unconventional monetary easing since 2001.^[2] Ikeda et al. (2024) find that the Bank of Japan’s unconventional monetary policy has been effective (with delays). In contrast, Ouliaris and Rochon (2024) argue that the effectiveness of quantitative easing was low and has decreased since 2013 with the so-called Abenomics.^[3] Basu and Wada (2023) identify an influence of quantitative and qualitative easing on bond yields, Harada and Okimoto (2021) on the Nikkei 225 stock index.

In contrast, the consequences of the Bank of Japan’s interest rate increases are comparatively under-researched. This is particularly the case after the Bank of Japan’s balance sheet has strongly expanded following an extensive quantitative easing. Therefore, the paper explores the impact of interest rate increases on the sustainability of public finances, the impact on the capital of the Bank of Japan itself and the stability of the private financial sector. It finds that – after previously sharp fluctuation of the yen against the dollar have destabilized Japan’s small neighbouring countries (McKinnon and Schnabl 2003) – fluctuations in the yen/dollar exchange have increasingly become a threat for domestic financial and macroeconomic stability of Japan itself. We therefore recommend pegging the yen to the dollar.

2 Japan’s Government: Debt and Interest Burdens

Rising interest rates pose a risk for the Japanese government, as government debt has risen from 63 per cent of gross domestic product (1990) to over 250 per cent since the Japanese bubble economy burst at the end of the 1980s (Figure 2).^[4] The outstanding debt of the Japanese central government stood at 1,310 trillion yen (8,733 billion dollars) at the end of September 2024^[5] (Japan Ministry of Finance 2024a). This suggests fiscal or financial dominance, i.e. significant influence of the government and/or the financial sector on the central bank to ensure government financing via the central bank and/or financial stabilization measures of the central bank (Hayek 1976, Sargent and Wallace 1981).

Figure 2:

Japan, USA, Germany: Government debt as a percentage of GDP. Source: Bloomberg, International Monetary Fund. Forecasts from 2024 onwards.

For a long time, the share of interest payments in the Japanese central government’s budget remained moderate despite the steep rise in government debt because the Bank of Japan kept interest rates low with the help of extensive purchases of government bonds (Schnabl 2015). The Bank of Japan currently holds 53.2 per cent of the Japanese government’s outstanding longer-term bonds (JGBs) and continues to purchase government bonds. It has kept interest rates on ten-year government bonds at zero since September 2016 with the so-called yield curve control. During 2024, it has allowed interest rates on ten-year government bonds to rise to around one per cent, with long-term interest rate increases in the USA further putting upward pressure on Japanese government bond yields. Yet, Japan’s long-term interest rate level has stayed substantially below the USA (Figure 3).

Figure 3:

Japan and USA: Ten-year government bond yield. Source: Bloomberg, ECB.

If the Bank of Japan push ahead with a reduction in the amount of government bonds on its balance sheet, the Japanese government’s interest burden is likely increase for three reasons. Firstly, a major buyer would withdraw from the market for Japanese government bonds, which is why private investors would only purchase at higher interest rates. Secondly, the Japanese government has the highest level of public debt as a proportion of gross domestic product among industrialised countries. The risk premium would rise sharply, especially as long as the structural budget deficit remains high.^[6] Thirdly, an increase in long-term interest rates in Japan would slow down the already weak economy, which would further dampen tax revenues that continued to be sluggish during three decades of economic stagnation.

The Japanese central government’s debt stood at 1,310 trillion yen (8,733 billion dollars) at the end of 2024. The expected interest expenditure in the 2024 fiscal year is estimated at 9.7 trillion yen, or 8.6 per cent of the total budget (Japan Ministry of Finance 2024a). According to an estimate by the Cabinet Office of the Japanese government, average long-term interest rates will rise from 0.6 per cent in the 2023 fiscal year to 1.5 per cent in 2028 and 3.4 per cent by the 2033 fiscal year. In a high growth scenario, this would triple the Japanese government’s interest payments from 7.6 trillion yen (2023) to 11.5 trillion yen (2028) and finally to 22.6 trillion yen (2033) (Arai 2024).

Due to the persistently weak economy, there is great uncertainty regarding the expected tax revenue. In addition, the Japanese government’s expenditure obligations in the social sector are likely to continue to increase significantly due to the rapidly ageing society (Japan Ministry of Finance 2024a). The probability of a default of the Japanese government and a debt crisis in one of the largest industrialised countries would increase significantly.

However, the Japanese government not only has a high level of debt, but also considerable financial assets. These include high foreign exchange reserves (Japan Ministry of Finance 2024b), which the Japanese Ministry of Finance has accumulated particularly in the course of recurring foreign exchange market interventions against yen appreciation (dollar purchases and yen sales) (Hillebrand and Schnabl 2008, Ito 2003).^[7] It can therefore be assumed that a large proportion of the foreign exchange reserves are in dollars. The Ministry of Finance’s foreign exchange reserves totalled just under 1,232 billion dollars at the end of May 2024.

As the currency reserves are held by the Japanese Ministry of Finance, i.e. the Japanese government^[8] this has an impact on its net interest liabilities. The outstanding government bonds of the Japanese government are much higher in total than the dollar assets of the Japanese government. However, the interest rate on ten-year US government bonds has risen to 4.6 per cent (15 January 2025), while ten-year Japanese government bonds only yielded 1.2 percent (Figure 3). With a national debt of 1,310 trillion yen, the Japanese central government has an estimated interest burden of 9.75 trillion yen (65 billion dollars) in 2024 (current fiscal year).

According to the Japanese Ministry of Finance, the Japanese government held almost USD 918 billion of its foreign exchange reserves in bonds at the end of December 2024. Over the past 10 years, a ten-year US government bond has yielded an average annual return of 2.39 per cent. Using this as a benchmark, Japan earned interest income on its current bond holdings in the USA totalling 21.9 billion dollars, which is equivalent to 3.3 trillion yen at an exchange rate of 150 yen per dollar. The net interest burden thus falls to 6.4 trillion yen (42.7 billion dollars).^[9] If the yen were to depreciate further against the dollar, the significance of dollar interest income relative to interest liabilities in yen would increase, whereas it would decrease if the yen were to appreciate.

The interest burden for the central government is even lower if the government and central bank are seen as a single entity.^[10] The Bank of Japan holds just under half of all government bonds (Figure 5). The interest burden on the Japanese government including the central bank is thus arithmetically reduced to approximately half, i.e. to 4.85 trillion yen (and to 1.55 trillion yen if interest income on foreign exchange reserves is taken into account). However, the Bank of Japan’s profit in the 2023/2024 fiscal year was only 2.29 trillion yen, which is significantly less than the Bank of Japan’s calculated interest income on the government bonds it holds.^[11]

Figure 4:

Japan’s gross and net debt as a percentage of gross domestic product. Source: IMF, World Economic Outlook.

As the Japanese Ministry of Finance holds large foreign currency reserves and public pension funds have built up high reserves, Japan’s net debt is significantly lower than its gross debt. After deducting financial assets such as Japanese government bonds, currency reserves, loans granted and assets of public pension funds, the IMF puts the net debt of the Japanese state (excluding the central bank) at 158 per cent of gross domestic product (Figure 4). According to the IMF calculation, the net debt of the USA was 98 per cent.

Figure 5:

Holders of Japanese government bonds* as at 31 December 2023. Source: Bank of Japan. * long-term government bonds (JGBs) and T-bills.

Koshima (2019) points out that a considerable proportion of outstanding Japanese government bonds are held by the Japanese government itself – for example by the central bank or public pension funds. Chien and Stewart (2023) put the net debt of the public sector in Japan at around 119 per cent of gross domestic product, as the Bank of Japan (amounting to 100 per cent of gross domestic product) and the social security funds (amounting to 14 per cent) hold large amounts of government bonds. However, it should be borne in mind that the Bank of Japan’s large holdings of government bonds are offset by corresponding liabilities in the form of commercial bank deposits at the Bank of Japan (Figure 6).

Figure 6:

Important balance sheet items of the Bank of Japan. Source: Bloomberg, Bank of Japan.

Net debt can be considered more meaningful in terms of the sustainability of government debt because high assets can help to cushion a debt crisis. The counterargument is that only a small proportion of assets such as cash reserves are liquid, whereas in a debt crisis, tangible assets such as roads and buildings cannot be liquidated promptly. In addition, government assets in Japan, such as outstanding loans from the Fiscal Loan Fund and assets of pension funds, are offset by corresponding liabilities.^[12] This is why the OECD (2015) considers gross debt to be the best measure of public debt (and the associated risks).

A balance of payments or exchange rate-related debt crisis such as that experienced in Southeast Asia in 1997/98 is unlikely for Japan. In the course of the 1990s, Southeast Asian banks borrowed abroad in foreign currencies, including from Japanese banks. When the Southeast Asian currencies depreciated sharply against the dollar and yen after the outbreak of the Asian crisis, external debt rose sharply in terms of domestic currency, destabilizing the domestic banks (Krugman 1999). Such a devaluation-driven foreign currency risk does not exist for Japan, because – due to the persistent current account surpluses since the early 1980s – Japan has no net foreign debt, but rather large net foreign assets (see Section 4). Only 13.5 per cent of Japanese government bonds are held abroad (see Figure 5).^[13]

3 The Bank of Japan as the Central Financier

Like the central banks of other industrialised countries, the Bank of Japan has been buying assets on a large scale since the turn of the millennium to stabilise the financial sector and the whole economy. Compared to other major central banks, the Bank of Japan’s balance sheet volume has grown significantly faster (Figure 1). On the asset side of the balance sheet, government bonds (78 per cent of total assets at 10 January 2025) and other loans and discounted bills (14 per cent) are the most important items. The liability side is dominated by commercial bank’s deposits and other deposits (around 80 per cent), which together with banknotes in circulation (16 per cent of the balance sheet volume) form the monetary base (see also Figure 6).

As the central banks have increased the deposits of commercial banks far above the minimum reserves through quantitative easing, there is a risk of losses originating from interest rate hikes. In contrast to other major central banks, the Bank of Japan’s profits are still positive because it still does not pay interest on commercial bank deposits. By contrast, the average weighted interest rate on government bonds held by the Bank of Japan was 0.77 per cent as of 31 December 2023, according to the Japanese Ministry of Finance. Thus, the Bank of Japan generated net interest gains of 1.7 trillion yen from this positive interest rate differential in the 2023/24 fiscal year.

On the other hand, the central banks of the Eurosystem have realised losses after the European Central Bank raised the key interest rates and thus also the interest rate on the Eurosystem’s deposit facility from −0.5 per cent in June 2022 to 4.0 per cent in September 2023. As the Eurosystem has been slow to reduce its asset holdings the euro central banks had to make considerable interest payments to the commercial banks due to key interest rate hikes. As rising interest rates on the ECB’s deposit facility take effect immediately, but the average interest rate on the government bonds held changes only slowly, due to this maturity mismatch net interest income of the Eurosystem has become strongly negative, resulting in considerable losses.^[14]

The larger the volume of bond holdings, the greater the increase in key interest rates and the longer the remaining maturities of the bonds held, the greater the losses (Giles 2024). The deposits of commercial banks at the Bank of Japan are particularly high by international standards and have reached 524 trillion yen (3,493 billion dollars) (Figure 6). At a deposit interest rate of – say – 4.0 per cent the Bank of Japan would have to pay interest totalling 20.96 trillion yen (140 billion dollars) to the commercial banks. By comparison, the profit transferred to the government by the Bank of Japan in 2023 was 2.17 trillion yen (14.5 billion dollars).^[15] The central bank must not necessarily pay interest rates on the deposits of commercial banks, if they are transformed into required reserves. Yet, this would constitute financial repression, which would be equivalent to a tax on banks.

In addition, there are possible valuation losses on the assets held by the central banks. The central banks of many emerging economies, developing countries and smaller industrialised countries hold large foreign currency reserves on their balance sheets, resulting in valuation losses if the domestic currency appreciates. This was the case for the Swiss National Bank (Schweizer Nationalbank 2024) in the 2023 financial year and the Czech National Bank in the 2021 financial year (Czech National Bank 2022), among others. The Deutsche Bundesbank suffered major valuation losses as a result of the appreciation of the German mark against the dollar following the collapse of the Bretton Woods system in the 1970s (von Hagen 1998).^[16] As the foreign currency reserves of the Bank of Japan are less than 1.5 per cent of total assets, this risk is low. The risk is borne instead by the Ministry of Finance, which holds the majority of Japan’s foreign currency reserves.

However, the recent interest rate hikes by the Fed and the ECB have led to significant valuation losses on outstanding low-yielding government bonds (Anderson et al. 2022, Buiter 2024, Sonnenberg 2023). In 2022, Gros and Shamsfakhr (2022) estimated the valuation risks on the government bonds held by the Eurosystem at EUR 700 billion over the next 10 years, with higher losses for countries with a lower interest rate level (such as Germany).^[17] As the Bank of Japan has purchased far more government bonds as part of its quantitative easing programme than the Federal Reserve System and the Eurosystem as a share of gross domestic product, significantly higher valuation risks can be assumed.

How changes in the value of securities held de jure affect the balance sheet depends on the accounting rules of the respective central bank (Bell et al. 2023).^[18] The Bank of Japan uses the amortised cost method to account for valuation chances of securities (Nishizawa and Okajima 2024): It recognises the face value of long-term Japanese government bonds held to maturity on the asset side of the balance sheet and amortises the difference between the acquisition cost and the face value evenly until maturity. If the Bank of Japan changes the status from “held-to-maturity” to “investment”, the Bank of Japan must change the valuation to mark-to-market. In the event of a fall in the value of long-term government bonds due to rising interest rates, it must devalue them with corresponding book losses.

The Bank of Japan currently accounts for Japanese government bonds at amortised cost, which is why there are no realised losses. The unrealised losses are estimated at around 9.4 trillion yen (63 billion dollars) if long-term interest rates rise by around one percentage point (Jiji Press 2024). By comparison, the Bank of Japan’s equity in 2023 was 100 million yen (667,000 dollars); reserves and provisions were 12.1 trillion yen (81 billion dollars) (Bank of Japan 2024b).

The Bank of Japan also holds equities in the form of ETFs^[19] whose prices could fall in the event of interest rate hikes. The same applies to real estate investment trusts, where the valuation risk is likely to increase in the event of interest rate hikes. However, at 4.9 per cent (ETFs) and 0.9 per cent (real estate investment trusts) of the balance sheet, the relevance of both asset classes is low compared to government bonds. The greatest risk therefore results from the interest payed on the deposits of Japanese commercial banks at the Bank of Japan, although the Bank of Japan itself can determine this interest rate.

4 Pension Funds, Banks and Insurers as Large and Risky Agents

Japan’s pension system consists of the flat-rate national pension system and employment-related pensions for public and private sector employees. Japan therefore has several public pension funds that have built up reserves for old-age provision in a rapidly ageing society. The largest is the Government Pension Investment Fund (GPIF) with assets totalling about 246 trillion yen (1,640 billion dollars). It finances around 10 per cent of Japanese people’s basic pensions.^[20] In addition to the GPIF, there are numerous other public funds that pay pensions to public employees and civil servants. The Federation of National Public Service Personnel Mutual Aid Associations manages assets totaling around 10 trillion yen, the Pension Fund Association for Local Government Officials 30 trillion yen and the Promotion and Mutual Aid Corporation for Private Schools of Japan five trillion yen.

Due to the very long period of zero interest rates on Japanese government bonds, Japanese social security funds have reallocated their investments in favour of riskier asset classes such as equities and foreign currency bonds (Figure 7). At the end of 2023, the foreign investments of Japanese social security funds, including pension funds, totalled 161 trillion yen (1,073 billion dollars). The pension funds are not completely flexible in their investment behaviour because this is coordinated with the Japanese government (GPIF 2020). As a result, they cannot react quickly to new developments on the international financial markets, which can result in additional currency risks. There are also foreign investments by private pension funds and occupational pension funds.^[21]

Figure 7:

Investment structure of Japanese social security funds (incl. Pension funds). Source: Japan, Cabinet Office, flow of funds.

Since 1 April 2020, the Government Pension Investment Fund has invested around 50 percent of its deposits in Japan and 50 percent abroad, with half of the investments being made in securities and half in equities (see Figure 8).^[22] Assets such as real estate and infrastructure are limited to five per cent and are classified as either securities or equities according to their risk and returns. Foreign securities whose currency risk is hedged are categorised as domestic securities. Deviations from the target values due to price fluctuations are allowed up to a certain limit.

Figure 8:

Investment structure of the government pension investment fund (GPIF). Source: GPIF, total investments: 246 trillion yen (approx. 1,640 billion dollars).

Public pension administrators currently hold 4.4 per cent and other pension funds 2.5 per cent of outstanding Japanese government bonds (Figure 5). Interest-related valuation losses are only a threat if the government bonds have to be sold prematurely, which is unlikely given the pension funds’ calculable payout liabilities. On the other hand, there are risks associated with foreign investments, as the GPIF and other pension funds do not hedge some of their exchange rate risks (see also below).

Japan’s banks have long suffered from the persistently low and negative interest rate environment because the Bank of Japan has squeezed interest margins – credit margins, transformation margins, liability margins – through its highly expansionary conventional and unconventional monetary policy (Schnabl 2020). In addition, following the bursting of the Japanese bubble economy, the demand for credit from companies and households fell from the early 1990s until 2013, meaning that deposits at banks have risen far in excess of lending.^[23] As a result, the share of foreign assets in total assets has risen (Figure 9).^[24] While the banks initially offset the decline in domestic demand for credit by purchasing Japanese government bonds, the Abenomics replaced the government bonds with rapidly growing reserves held by Japanese commercial banks at the Bank of Japan from 2013 onwards.

Figure 9:

Structure of the aggregated balance sheet of Japanese commercial banks. Source: Bank of Japan.

In Germany and Europe, the European Central Bank’s interest rate hikes had a positive impact on credit margins. As the rising interest rates on the ECB’s deposit facility took immediate effect for all commercial bank’s deposits with the Eurosystem, interest income from deposits with the Eurosystem rose sharply. From this perspective, the banking sector has profited from the interest rate increases – despite possible valuation and credit default risks. A similar development can be expected for Japan. Commercial banks would benefit greatly if the Bank of Japan were to pay interest on the deposits of commercial banks. On the other hand, the risks of valuation losses on government bonds are comparatively low because the holdings on the banks’ balance sheets have fallen as a result of quantitative easing.

However, the foreign currency risks of the Japanese banking sector have increased since the 1980s. Today, assets totalling 1,390 billion dollars are held abroad, which corresponds to 8.5 percent of total assets (Figure 9). As foreign assets are mostly denominated in foreign currencies, risks arise from an appreciation of the yen against the dollar. In addition, rising interest rates abroad can lead to valuation risks, as in 2024 the case of Norinchukin Bank showed. Norinchukin Bank, which specialises in agricultural businesses, had invested an unusually large amount in foreign government bonds because domestic deposits are high (not least due to generous government subsidies for the agricultural sector) and demand for credit in the Japanese agricultural sector is low (Nihon Keizai Shinbun 2024).^[25]

At the end of March 2024, Norinchukin Bank had the equivalent of around 23 trillion yen worth of foreign bonds on its books, which equated to around 42 per cent of its assets. The rise in interest rates in the US sharply reduced the prices of these bonds. As the bank had to assume that interest rates in the US (and Europe) would not fall as much as expected, it decided to sell around half of the foreign bonds, from which it expected losses totalling 1.5 trillion yen (10 billion dollars) (Kitagawa 2024). The resulting losses in the income statement are (partially) compensated by yen depreciation or amplified by yen appreciation. A yen appreciation occurs, when many Japanese financial institutions were to liquidate foreign investments and repatriate the corresponding before Norinchukin Bank.

Credit default risks are a risk that is difficult to calculate for Japanese banks. The loans to companies and households stood at 960 trillion yen (6,4 billion dollars) at the end of May 2024. Due to the prolonged period of low interest rates, some authors assume that many companies are “zombified”, i.e. can only survive if interest rates remain low (Caballero et al. 2008; Peek and Rosengreen 2005; Sekine et al. 2003). The number of insolvencies has declined to a historic low and has only increased slightly recently. However, if interest rates rise sharply, this could result in more corporate insolvencies. Yet, a large volume of loans from private banks to private companies is already secured by government loan guarantees (Schnabl 2020), meaning that the losses would not necessarily be incurred by the banks but by the state.

Japan has very high net foreign assets totalling 3,339 billion dollars, most of which are held by the private sector (Figure 11).^[26] Out of the gross foreign assets, the government holds 14.4 per cent, banks 19.7 per cent and other financial institutions 39.3 per cent.^[27] The foreign positions are only partially hedged against currency fluctuations,^[28] because this is expensive.^[29] This results in a currency mismatch: liabilities and balance sheets are denominated in yen, while large holdings of assets are held in dollars. If the yen-dollar exchange rate fluctuates freely, risks arise for the institutions listed in yen (McKinnon and Schnabl 2004). As they hold securities quoted in dollars (and euros), an appreciation of the yen against the dollar and the euro has a negative impact on equity. Conversely, a depreciation has a positive impact.^[30] High net foreign assets constitute a persistent inherent upward pressure on the yen (Latsos and Schnabl 2018), as they can be exchanged back into yen at any time.

Figure 10:

Exchange rate of the Japanese yen against the dollar. Source: Bloomberg.

Life insurance companies, banks and other financial institutions benefited from the yen’s continued depreciation against the dollar from 2012 until the end of June 2024 (see Figure 10). The appreciation of the yen from July 2024, on the other hand, triggered turbulence and ultimately a sharp fall in prices on the Tokyo Stock Exchange because it affected not only export corporations but also banks and insurance companies negatively. A strong, sustained yen appreciation is therefore likely to be the greatest risk for the Japanese economy.

Figure 11:

Net foreign assets of Japan. Source: Ministry of Finance of Japan.

For example, Japanese life insurance companies have a double risk if the Bank of Japan raises interest rates. On the one hand, the value of domestic shares and securities falls. On the other hand, an appreciation of the yen reduces the value of foreign investments calculated in yen. To minimise the exchange rate risk of Japanese life insurance companies (or other financial institutions), the Bank of Japan has in the past kept interest rates in Japan sufficiently low below interest rates in the USA (Figure 3), also to prevent a run on the yen (McKinnon and Schnabl 2004).

If appreciation expectations for the Japanese yen were to materialise, Japanese banks, insurance companies and pension funds would have to repatriate their foreign investments in a timely manner to anticipate appreciation-related losses.^[31] Figure 12 shows the structure of the securities portfolios of Japanese life insurance companies. They hold foreign securities worth 97 trillion yen (approx. 650 billion dollars), which corresponds to around 25 per cent of their assets.^[32]

Figure 12:

Structure of bond holdings of Japanese life insurances. Source: The Life Insurance Association of Japan 2023.

The currency risks for the Japanese financial sector could increase if inflation control comes into conflict with upward pressure on the yen. As inflation in Japan has been low to date, the Bank of Japan has been able to cut interest rates or expand its balance sheet when the yen came under upward pressure. Recently, however, inflation has risen to 2.9 per cent (November 2024), partly because the trade unions have made greater efforts to compensate for the long-term loss of purchasing power by demanding higher wages. In addition, the US Federal Reserve has cut interest rate, which implies an appreciation pressure on the yen. A small interest rate hike by the Bank of Japan of 15 basis points to 0.25 per cent and increased expectations of interest rate cuts in the US led to a shock-like unwinding of yen carry trades and sharp price losses on the global equity markets at the beginning of August 2024 (Flossbach von Storch 2024). The loss on the Tokyo Stock Exchange was particularly severe, where the prices of export companies, banks and life insurance companies fell.

The volume of global yen-based carry trades is difficult to estimate.^[33] According to George Saravelos, Head of Currency Analysis at Deutsche Bank, Japan and its public sector (government, Bank of Japan, pension funds and public banks) are engaged in a gigantic carry trade worth the equivalent of 20 trillion dollars, which has been favoured by the persistent low interest rate phase (Business Standard 2024). Yen loans to foreign investors are said to have risen by a further 460 billion dollars to 1,800 billion dollars. In the same period, the weakness of the yen has increased the value of foreign investment income of Japanese investors in terms of yen. In contrast, an uncontrolled appreciation of the Japanese yen is likely to pose a considerable risk not only for export companies, but also for insurance companies, banks and pension funds.

5 Policy Implication: Peg the Yen to the Dollar

In Japan, raising the interest rate causes a valuation risk on domestic government bonds as wells as a currency risk for the export industry and the financial sector linked to an appreciation of the yen against the dollar. In contrast, monetary expansion by keeping the interest rate low combined with further quantitative easing constitutes a risk for Japanese consumers in form of rising inflation, particularly via depreciation-induced price increases. This implies that the room for manoeuvre for the Bank of Japan has become very small, as reflected by increasingly miniscule moves in monetary policy making.

As yen-dollar exchange rate fluctuations have caused a high degree of uncertainty in the past (McKinnon and Ohno 2003, McKinnon and Schnabl 2003) and are even more likely to increase more uncertainty and risk in the future, Japan could peg the yen to the dollar. This would on the one side eliminate uncertainty for the Japanese financial system and on global financial markets caused by sudden yen appreciation. On the other side the probability would be minimized that influential lobby groups push towards a deprecation of the yen at the cost of Japanese consumers.

Pegging the yen against the dollar would imply a loss in monetary policy independence. This is however already small, as the discretionary power of the Bank of Japan has become minuscule as shown above. While exchange rate pegs tend to suffer under a limited credibility, a dollar peg can be maintained, if the Bank of Japan is willing to follow credibly the monetary policy decisions of the Federal Reserve System. This would include expansionary and restrictive monetary policy of the Fed, which would also rule out the temptation for the Bank of Japan to remain inactive in the face of monetary tightening in the US.

The resulting interest rate convergence between Japan and the United States would eliminate the pressure on the Bank of Japan to keep interest rates artificially low and would also discourage the risky carry trades. The resulting limited upward shift in the Japanese interest rate level would put a pressure on Japanese companies to increase efficiency and on the Japanese government to reduce government debt. Both effects can be expected to have a positive growth effect on the Japanese economy.

The resulting upward pressure on the interest level in Japan would remain limited, as the high level of government debt in the United States puts a constraint on monetary tightening in the US. If fiscal consolidation and deregulation in the US create a leeway for the Fed to keep interest rates higher, the reform pressure would be extended to Japan. This can be seen as a change to escape from the long-lasting stagnation.