The Liquidity Trap and Portfolio Instability

Japanese banks, insurance companies, trust funds, and even some individuals hold dollar assets over a wide spectrum of maturities. But interest rate adjustment for currency risk is more difficult at the shorter end of the maturity structure than for the 10-year bonds shown in Figure 13. First, governments in industrial countries tend to target some short-term interbank rate -federal funds in the U.S., gensaki in Japan-as an instrument of monetary control, thus leaving it rigid for extended periods. Consequently, these rates cannot change to counteract short-term shifts in currency risk. Second, if the currency risk is sufficiently great, nominal interest rates on yen assets -particularly those at short term- are eventually forced toward zero. Figure 14 [ PDF 128.3KB | 1 page ] shows the near-zero interest rate on short-term yen assets, the so- called liquidity trap, that has persisted since early 1995.

The liquidity trap has major implications for economic policy.

(1) During Japan's lost decade and even today, the central bank has not been able to stimulate domestic demand by the traditional technique of lowering short-term interest rates when they are bounded from below by zero. Once deflation was set in motion by the greatly overvalued yen in the early 1990s, within the liquidity trap there was (is) nothing the central bank could do to stop it. Engineering a major devaluation of the yen against the dollar in nominal terms, if technically possible, was and is out of the question after the previous episodes of Japan bashing to get the yen up.

(2) Having short-term interest rates compressed toward zero greatly reduced(s) the profit margins, the spread between loan and deposit rates, of Japanese commercial banks. After the real estate and stock market bubbles burst in 1990-91, numerous defaults on bank loans led to a rash of non-performing loans (NPLs) on bank balance sheets. No surprise there. What is surprising, however, is that the banks had not grown out of their NPL problem more than a decade later—even after several subsidized re-capitalizations. Goyal and McKinnon (2003) attributed this anomaly to the artificially reduced bank profit margins arising out of the persistent liquidity trap.

(3) Once yen interest rates fall near zero, greater portfolio instability in the holding of dollar versus yen assets within Japan is generated. Because yen interest rates cannot be forced below zero, the condition for portfolio stability -equation (1) above- is violated at shorter terms to maturity, with echo effects at longer terms. With private Japanese financial institutions fearful of another big yen appreciation, episodic runs out of dollars into yen become more likely. And, to prevent the yen from appreciating sharply, the BoJ becomes the residual buyer of the surplus dollars -resulting in a substantial build up of official exchange reserves.

Points (1) and (2) are obviously important for understanding Japan's past economic malaise and deflationary hangover into the present, but point (3) is less obvious. For any given interest rate on a dollar asset, in the low-interest liquidity trap the rate on the same-maturity yen asset cannot be forced low enough for Japanese financial institutions to hold the riskier dollar asset at the margin. But where the margin is depends on how large the existing stocks of dollar assets are in Japan's private sector. If, from the ongoing current account surplus, private holdings of dollar assets become large relative to the net worth of Japanese financial institutions, then the system becomes very vulnerable to a run.

On the other hand, once there is a run, during which the BoJ buys dollar assets from the private sector on a large scale, Japanese insurance companies, banks, and so forth, eventually become happy holding their remaining smaller stocks of dollar assets if and when they finally decide that the BoJ can hang on without letting the yen appreciate (further). After a run, these institutions may even be willing to rebuild their depleted stocks of higher-yield dollar assets for many months or years -thus providing finance for the ongoing current account surplus without the BoJ's intervening at all.

Figure 15 [ PDF 88.2KB | 1 page ] captures the remarkably episodic nature of (internal) runs from dollars into yen since 1980 by simply plotting the monthly percentage changes in the BoJ's official foreign exchange reserves -which we know to be mainly dollars, although the authorities don't reveal the exact currency composition of the reserves. The episodes of concentrated upward spikes in official reserves clearly indicate the presence of runs- often followed by quiescent periods, sometimes with some reserve decumulation. However, a single satisfactory metric for measuring runs is not easy to find. Indeed, the absolute scale of the official intervention from late 2002 to early 2004 of $330 billion was much greater than previous interventions (Table 2). But it was not particularly large in monthly percentage terms, as reflected in the spike in reserves for 2003-04 (Figure 15).

With Japanese short-term interest rates mired close to zero and without overt Japan bashing to appreciate the yen, the behavior of U.S. interest rates becomes the biggest determinant of whether or not there will be a run. After the collapse of the high-tech bubble in 2001, U.S. short-term interest rates came down very sharply, with the rate on federal funds touching the unprecedented low level of 1% in January 2004 (Figure 14). Because Japanese short-term interest rates were bounded from below by zero, the differential of American over Japanese rates narrowed sharply. Consequently, net dishoarding of dollar assets by Japan's private sector led to a sharp jump in official exchange reserves. From the end of 2002 through early 2004, official reserves almost doubled (Table 2). These episodic runs into official reserves, followed by quiescent periods, were also part of Japan's earlier experience (McKinnon, 2005, chapter 3).

In their letter to Secretary Paulson in 2007, American lawmakers and Michigan automobile executives in particular were harking back to this three-year-old intervention episode as evidence that Japan has been unfairly manipulating its currency. On March 9, 2007, the Bloomberg Press reported "Democrats say a book, Global Financial Warriors (January 2007) by former U.S. Treasury Undersecretary John Taylor proves that the Bush Administration went along as Japan tried to hold down the foreign exchange value of the yen, hurting American manufactures. Taylor writes that he acquiesced as Japan sold yen to buy dollars in 2003-04 to help the world's second largest economy pull out of a decade of anemic growth."

However, after March 2004, U.S. interest rates started increasing back to "normal" levels so as to increase the interest differential at shorter maturities with yen assets. Japan’s private financial institutions have returned to acquiring most of the dollar assets generated by Japan's current account surpluses and the BoJ has hardly intervened at all-Figure 15. But this is only a lull. Because dollar assets continue to accumulate in private Japanese portfolios, the currency mismatch will again cumulate to a point where the risk premium on yen assets can't be sufficiently negative (because yen interest rates are bounded from below by zero) for Japanese private investors to keep adding to their stocks of dollar assets. Then any mere rumor of currency appreciation will prompt another run out of private portfolios into official exchange reserves.

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