In 2015, Clyde Prestowitz published a book titled “Japan Restored,” which envisioned the rise of Japan during a turbulent era, including scenarios like an Israeli strike on Iran. While the Middle East is currently facing significant conflict, the transformative changes that Prestowitz predicted have yet to materialize. However, one aspect where Japan has indeed established prominence is through the yen’s status as a favored currency for global finance.
The Bank of Japan’s lenient monetary policy has positioned the yen as the most affordable and dependable funding currency worldwide. By maintaining low yields on government debt to support its domestic economy, the Bank of Japan has effectively developed a publicly funded channel for financial institutions. These institutions can profit from borrowing yen at low interest rates and investing in higher-yield assets, such as US stocks. The “yen carry trade” has seen substantial growth following the pandemic, with speculators investing approximately $435 billion in the two years leading up to 2024, out of an estimated total of $1.7 trillion yen available. This strategy has generated profits for global investors estimated in the tens of billions of dollars.
Japan experienced its first interest rate increase since 2007 in March 2024; however, this change had minimal impact on the carry trade’s appeal. There remains a significant concern that the Bank of Japan might unexpectedly implement aggressive rate hikes, which could trigger a global financial shock. This risk arises from two main factors: the potential reduction in profits from the difference between Japanese and US asset yields, and the likelihood that a stronger yen would require borrowers to secure more US dollars to settle yen-based debts. Given that many hedge funds engaged in this trade are heavily leveraged, it is understandable why even minor indications of policy shifts cause market fluctuations.
Nevertheless, Japan’s current strength also exposes its vulnerabilities. The reliance on the carry trade to navigate internal challenges reflects a dependency stemming from its economic success. Japan’s ascent was so significant that its Western allies urged Tokyo to significantly appreciate the yen in 1985. This led to an overcorrection by the authorities, resulting in loose credit policies that inflated asset values. At one point, the land beneath the emperor’s palace in Tokyo, covering less than a square mile, was valued similarly to all the land in California. This economic bubble eventually collapsed in 1992.
The subsequent prolonged recession prompted increasingly radical policy measures, a trend likely to continue under Japan’s new Prime Minister, Sanae Takaichi, a proponent of fiscal expansion. For over thirty years, Tokyo has worked to stabilize a private sector reluctant to engage in borrowing. While this stability has made the yen the most affordable currency in international finance, it has not translated into economic growth.
The insights of economist Luiz Carlos Bresser-Pereira provide a framework for understanding this situation. He posits that a nation’s success hinges on effectively managing five key macroeconomic variables: profit, exchange rates, interest rates, wages, and inflation. When applied to Japan, this framework highlights its economic constraints. Although there has been some recent growth in real wages, historical trends reveal that wages have often been stagnant or declining. The wage-setting system has not undergone any significant transformation. Without a competitive exchange rate and a sustainable profit margin, Japanese businesses struggle to tap into market demand. This lack of demand stifles reform initiatives. While Japan has addressed some of its issues, its current status represents a financial dominance rather than a productive economic one.
