Japan's $20 trn 'carry trade' poses risks amid central bank's policy shift

Japan's government is engaged in a massive $20 trillion "carry trade" - the funding of loans and foreign assets by borrowing low-cost yen - that could bring unexpected risks if the central bank tightens policy, Deutsche Bank analysts warn.
 

Using research by the San Francisco Federal Reserve and International Monetary Fund, Deutsche's head of currency research George Saravelos analysed a consolidated balance sheet of the Japanese government including the government-run pension fund GPIF, the Bank of Japan (BOJ), and state-owned banks, showing the asset-liability mix of its $20 trillion debt.
 

That debt, Deutsche Bank found, amounts to an enormous "trade" invested abroad at high interest rates and funded by low-rate, short-term borrowing in yen.
 

 

As expectations grow for the Bank of Japan to exit its ultra-loose monetary stance, Deutsche Bank's report says it is crucial to understand the potential consequences of this huge trade, not only on the government's balance sheet but on savings and assets held by households.
 

The yen has traditionally been a favourite funding currency for carry trades because of Japan's low interest rates, and market participants expect investors globally to unwind hundreds of billions of dollars of such trades if and when the BOJ exits its ultra-easy monetary policy.
 

Deutsche Bank's report extends that scenario to include the Japanese government and its balance sheet.
 

With real rates kept low via the central bank's negative rates policy, the government has found fiscal space, enabling it to run public debt above 200% of GDP while financing one-third in overnight cash, the report said.
 

Deutsche also said it was no surprise the heavy selloff in bonds this year had not hurt Japan.
 

"Everyone else has stopped out of carry trades, why hasn't Japan? The answer is simple: On the liability side the BOJ controls the government's cost of funding and this has been kept at zero (or indeed negative) despite rising inflation," it said.

Sustained inflation, however, could bring an end to this enormous carry trade, with pressure already mounting on the BOJ to normalise its monetary policy.
 

"If the central bank raises rates the government will have to start paying money to all the banks and the carry trade's profitability will quickly start unwinding," Deutsche analysts said.
 

That would mean higher interest payments on bank reserves and a fall in government bond values, as well as a decline in the government's asset values in a higher interest rate environment.
 

The analysts also expect that an appreciation of the yen as domestic interest rates rise could potentially trigger a drop in the value of both foreign and domestic assets.
 

The effects would not be limited to the government, they said, with older and wealthier households in Japan suffering a fall in their assets' values and a hit to their pension entitlements if the government's finances are impaired.
 

Young households, on the other hand, would benefit from more earnings on bank deposits and greater return on future savings, they said.