Japan: Historic turning point?

The rise of inflation, which after the pandemic and the outbreak of the Russian-Ukrainian conflict put all advanced economies in trouble, finally reached Japan as well.
Thus, on 19 March 2024, while the West anxiously awaits an interest rate cut by central banks, Bank of Japan Governor Kazuo Ueda announces a historic benchmark rate hike from -0.1% to a range of 0 to 0.1%, after 8 years in negative territory and 17 years since the last hike.
To understand the Japanese central bank's moves, which are bucking the trend of other developed countries, we need to rewind the tape and step back into the past.

Let's go back to 1989. While Europe was celebrating the collapse of the Berlin Wall and the Milan team of immortals was winning the Champions League Cup, Japan was in the midst of its economic miracle, boasting a GDP per capita higher than that of the USA, and a Nikkei 225 that tripled its capitalisation of three years earlier and touched its all-time high (only surpassed this year). The rapid economic growth had been fuelled by an oversupply of money (10-12% against real income growth of around 6%) caused by an increase in low-interest loans from banks. The large amount of available liquidity, however, was mostly invested in speculative activities in the real estate and stock market, causing a bubble to form. When the Japanese Central Bank started to raise interest rates from 2% to 6% in just 2 years, the resulting increase in the cost of debt triggered an increase in insolvency, resulting in the bursting of the speculative bubble and a crisis in the real estate and financial market (a film revisited in Western terms by the US in 2008). The initial inadequate response of the government and central bank, added to the external effects of the Asian financial crisis of 1997 and the great recession of 2007, which occurred precisely at the time of Japan's partial recovery, prolonged the economic stagnation for more than two decades, referred to as the 'lost twenty years'.

Since 1992, Japan's GDP per capita (at current prices) has risen from ,000 to about ,000. To put it in context, during the same period, the US GDP per capita has grown from ,000 to about ,000. As a matter of fact, from 2000 until 2012, the economy of the rising sun almost always lived in a deflationary environment, forcing the central bank to keep interest rates constantly around zero, at what, according to Keynesian theories, was considered the natural limit below which rates could not fall (Zero Lower Bound), imprisoning the country in a liquidity trap that makes monetary policy ineffective. With Abenomics, the series of reforms aimed at revitalising the economy implemented between 2012 and 2020 by then-Prime Minister Shinzo Abe, rates were brought below the Zero Lower Bound through unconventional monetary policies such as Quantitative and Qualitative easing (buying not only government bonds but also stock market funds and real estate-related securities) and Yield Curve Control, making the central bank once again able to influence the economy. This, combined with the depreciation of the yen and increased government spending, allowed the transition from a state of deflation to slight inflation and gave an initial boost to the Japanese economy, which, however, maintained GDP growth rates below the average of other advanced economies.

The BoJ's announcement a few days ago thus represents the beginning of a 'normalisation' of monetary policy, in which Quantitative and qualitative easing and yield curve control will once again give way to conventional policies, applicable only with rates above 0. In its decision, the central bank emphasises the strengthening of the prospect that, thanks to wage growth and domestic demand, 'the price stability target of 2 per cent will be achieved in a sustainable and stable manner', although it admits the presence of 'extremely high uncertainties regarding Japan's economic activity and prices' arising mainly from developments in foreign economies.
Meanwhile, with the Japanese central bank signalling its intentions well, markets experienced no particular shocks in the week of the announcement. The Nikkei 225 continued its positive trend since the beginning of the year, accruing +22% since January 2024, making it the best-performing index among advanced economies, while the Yen remained fairly stable. The appreciation of the Japanese currency at the beginning of the current week, which led to a downward market correction, had nothing to do with the BoJ's decision, but, rather, was attributable to the words of Deputy Finance Minister Masato Kanda, who drew attention to the yen's weakness relative to its fundamentals, in his view due to speculative movements.

The consequences, however, could be much deeper if the normalisation process succeeds in bringing interest rates to a level further away from 0%.
One potential implication, for example, could be greater volatility of the yen.  Since Japan has always kept rates at or below 0% for the past 30 years, the currency has been fairly stable. This has made it the preferred currency of carry trade investors, a strategy in which one borrows in a low-yielding currency to finance investments in high-yielding currencies and assets, and the currency used by companies and governments in times of crisis, issuing samurai bonds in the Japanese market. A substantial rise in rates, perhaps coinciding with a cut by other advanced countries, could lead to an appreciation of the yen and an end to the dynamics described above.
Moreover, a rise in rates could be of great benefit to local banks, which would see their profitability increase and, consequently, their attractiveness to foreign investors. As a matter of fact, in the face of rate hike expectations, the price of Japan's main financial stocks has shot up. In the past year, Mitsubishi UFJ Financial Group recorded +90%, Mizuho Financial Group +65% and Sumitomo Mitsui +74%.

In any case, it currently seems unlikely that there will be a lasting shift towards higher rates, as confirmed by the BoJ, which 'anticipates that accommodative financial conditions will be maintained for the time being'.
Indeed, Japan is still grappling with the major structural challenges that have characterised its recent history.
Firstly, it holds the record as the most indebted state in the world in terms of debt-to-GDP ratio, which stands at 250%. The country has been able to sustain such a high level of debt mainly due to the special nature of its holders, as a large part of the bonds are held by domestic investors and the Bank of Japan. Thus, a reduction in government bonds held by the central bank and a substantial increase in rates could increase the portion of debt held by international investors, risking breaking the balance of Japanese debt.
Another major problem is the ageing population. In terms of records, in fact, the Japanese population is the oldest in the world, with 10% over 80 and almost 30% over 65 (in the second oldest country, Italy, they are 23%). In addition, the fertility rate of 1.2 is well below the rate of 2.1 considered necessary to keep the population stable. This implies increasing pressure on the welfare system, an increase in the propensity to save and a decrease in the propensity to consume and invest. All ingredients that could push prices down again.

In conclusion, it is still too early to define the new monetary policy as 'historic' or rather as 'episodic'. At the moment, in fact, we cannot establish whether we are facing the beginning of a new economic cycle, finally freed from the liquidity trap in which it has been stagnating for too long, or before the eve of a new long phase of stagnation in rates and thus in the country's own growth.
What is certain is that this is in any case a good starting point that bodes well, and one that leads us, in fact, to reconsider exposure to Japanese equities, long absent from our portfolios.