Interest Rates and Japan's Currency Mismatch

Like wage setting in labor markets, interest rates in financial markets are also forward- looking and sensitive to currency risk -perhaps more immediately so. When future changes in exchange rates are well signaled from some easily identifiable source, such as continual foreign mercantile pressure, interest rates begin to adjust.

After the yen first appreciated, about 17% from the "Nixon Shock¡¯ of 1971, most analysts felt that this was a one-time devaluation of the dollar against the currencies of all the major industrial countries. However, by the late 1970s, the United States began to single out Japan, its foremost mercantile competitor, for applying overt political pressure to appreciate the yen. In 1977, in the midst of trade disputes and the threat of U.S. trade sanctions on imports from Japan, U.S. Secretary of the Treasury Michael Blumenthal stated that the yen should be appreciated. This contributed to a run on the "Carter dollar" in 1978 with a sharp yen appreciation. At this point, the financial markets began to behave as if the yen would continually appreciate into the indefinite future.

Long-term interest rest rates on 10-year Japanese government bonds (JGBs), which are not directly controlled by the government, best reflect this big change in exchange rate expectations. Figure 13 [ PDF 147.6KB | 1 page ] shows the interest rate on JGBs before 1978 to be about the same as that on 10-year U.S. Treasuries- and if extended back into the 1950s and 1960s, interest rates on JGBs were typically one to two percentage points higher than those on U.S. Treasuries. But by 1978, the relationship turned around. Since then, JGB rates have averaged 3 to 4 percentage points less than on U.S Treasuries. In July 2007, the interest rate on U.S Treasuries was about 5.04% and that on JGBs was 1.97%.

From 1978 to 1995-96, this interest differential can be readily explained by the principle of open-interest parity. Figure 13 also shows logarithmically the trend of the appreciating yen against the dollar from 1971 to 1995, about 3 to 4 percentage points per year. Since 1995, however, the yen has not appreciated on net balance- although it has fluctuated widely against the dollar. But the large interest differential remains. To explain this apparent anomaly, the growing currency mismatch within Japan generates a growing negative risk premium in interest rates on yen assets. To make this concept clearer, consider the following equation linking interest rates in American and Japanese financial markets in the absence of capital controls:

i = i* +E(¨º) + ¦Õ

where i is the interest rate on yen bonds, and i* that on dollar bonds at the same term to maturity. The interest differential, i - i*, between yen and dollar bonds is partitioned into two components: E(¨º) is the expected change in the yen/dollar rate (negative if appreciation is expected), and ¦Õ is the risk premium (negative in the Japanese case). Because both these components are negative, i < i*.

In the Japan bashing period before April 1995, one could reasonably expect that the yen would continue to appreciate so that the E(¨º) term was dominant. Similarly, today¡¯s PRC bashing to appreciate the renminbi is forcing down nominal interest rates on renminbi assets within the PRC (McKinnon, 2007). Because entrenched expectations often change with a lag, after 1995 the expectation of a secular appreciation of the yen may have decayed only gradually so that E(¨º) remained important while slowly losing its dominance.

However, for the interest rate differential to remain so large today, one must appeal to the value of the negative risk premium, ¦Õ. Although Japan is the world¡¯s largest creditor country, it does not lend much in yen because of the currency asymmetry associated with the dollar standard. Instead, the country¡¯s large current account (saving) surpluses are partially financed by outward foreign direct investment but mainly by building up foreign currency claims (mainly dollars) on foreigners (Table 2 [ PDF 88.5KB | 1 page ]). This leads to a currency mismatch within Japan¡¯s economy.

In the private sector in particular, financial institutions such as insurance companies or banks acquire higher-yield dollar assets even though their liabilities are mainly in yen -as are their annuity obligations to policyholders or to depositors. Although these financial institutions have come to depend on the higher yield on dollar over yen assets, they fear any fluctuation in the yen/dollar exchange rate that would change the yen value of their dollar assets relative their yen liabilities. Even a random upward blip (appreciation) in the yen could wipe out their net worth. So, they will hold dollar assets only if they are given a substantial risk premium for doing so.

Because American interest rates are mainly determined in world markets, portfolio equilibrium within Japan¡¯s economy requires that interest rates on yen assets be bid down (as in equation 1) by the amount of the negative risk premium to make Japanese investors at the margin willing to hold dollar assets. Because of the currency mismatch, this negative risk premium will be higher (more negative) the greater the fluctuations in the yen/dollar rate and the larger are Japan¡¯s private holdings of dollar assets. Figure 13 shows that, in the absence of secular appreciation of the yen since 1995, the yen/dollar rate has still fluctuated very substantially.

Japan¡¯s current account (saving) surpluses only became significant in the early 1980s. But more than 20 years later, the cumulative total of liquid dollar claims held by the economy is now much greater relative to GNP than it was back in the 1980s -and it is continually growing (Table 2). Private sector finance for acquiring counterpart dollar claims is always chancy because of ongoing high volatility in the yen/dollar exchange rate- the risk that offsets the higher yield on dollar assets relative to yen assets. For the private sector to keep acquiring dollar claims, the interest rate differential may have to increase -i.e., the risk premium becomes more negative so as to depress yields on yen assets (equation 1). But what happens when Japanese short rates approach zero?

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