The Japanese government's $20 trillion arbitrage trade has finally exploded

Original Title: “The $20 Trillion Arbitrage Trade Has Finally Exploded!”

Original Source: Jin10 Data

At the end of last year, when the latest cycle of yen arbitrage trading was still in a relatively early stage (with the USD/JPY dropping to around 140), some media explained why the Japanese economy was essentially dead, with only the announcement of the time of death missing. The reason is that the $20 trillion arbitrage trade that the Japanese government has been involved in for the past 40 years is a massive ticking time bomb that cannot be defused; once it explodes, the Bank of Japan will be finished. The collapse of these trades will require the central bank to coordinate rescue actions within days. It is no surprise that central banks around the world are unaware of what is happening, and usually fall into panic afterward, releasing historic waves of interest rate cuts within weeks to stabilize the situation.

For those who missed the previous analysis, this article revisits the topic, but this time the analysis suggests that this time the arbitrage trade has already broken down, and the Bank of Japan must either do nothing and watch the economy collapse, or panic and reverse last week's foolish rate hike, intensifying easing policies to curb the crash that has just pushed the Nikkei index into a bear market; however, in any case, unfortunately for Japan, the game is over.

The Japanese government is involved in an arbitrage trade worth up to $20 trillion: this is the toxic dilemma currently facing the Bank of Japan, as it has reached its limit: on one hand, if the Bank of Japan decides to intentionally tighten policy, these trades will need to be unwound. On the other hand, if the Bank of Japan delays to continue the arbitrage trades, it will require a higher level of financial repression, but ultimately may bring severe financial stability risks, including a potential collapse of the yen.

As Deutsche Bank's chief forex strategist Saravelos stated, "Whichever option is chosen will have a huge impact on the welfare and distribution of the Japanese population: if the arbitrage trade is unwound, wealthy and older households will pay the price of higher inflation through rising real interest rates; if the Bank of Japan delays action, younger and poorer households will pay the price through a decline in future real incomes."

The resolution of this political economy issue will be key to understanding Japan's policy outlook in the coming years. This will not only determine the trajectory of the yen but also establish Japan's new inflation equilibrium. However, ultimately, someone will have to bear the cost of inflation "success."

The consolidation of debt is crucial to understanding why Japan has not faced a debt crisis in the past few decades, despite a public debt-to-GDP ratio exceeding 200% and continuing to rise. This is also essential for understanding the impact of the Bank of Japan's tightening on the economy.

What does the Japanese government's consolidated balance sheet look like? Here are the results from a paper by the St. Louis Fed. On the liability side, the Japanese government primarily finances itself through low-yielding Japanese government bonds (JGBs) and cheaper bank reserves. Over the past decade, the Bank of Japan has successfully replaced half of the stock of Japanese government bonds with cheaper cash, which is now held by banks.

On the asset side, the Japanese government mainly holds loans, such as through the Fiscal Investment and Loan Program (FILP), as well as foreign assets, primarily through Japan's largest pension fund (GPIF). Considering all of this, the net debt of the Japanese government is 120% of GDP, which is one reason why the debt dynamics are not as bad as they might initially seem.

But more importantly is the structure of the debt's assets and liabilities. As Saravelos explained, with a total balance sheet value of about 500% of GDP or $20 trillion, the Japanese government's balance sheet is simply a massive arbitrage trade. This is precisely why it has been able to maintain a continuously growing nominal debt level. The government raises funds at very low real interest rates imposed on domestic depositors by the Bank of Japan while earning higher returns on domestic and foreign assets with higher interest rates.

As the return gap widens, this creates additional fiscal space for the Japanese government. Crucially, one-third of this funding is now effectively overnight cash: if the Bank of Japan raises interest rates, the government will have to start paying funds to all banks, and the profitability of the arbitrage trade will quickly begin to reverse.

Given the massive sell-off in the global fixed income market, why hasn’t this arbitrage trade exploded in recent years? Others have exited the arbitrage trade; why hasn’t Japan? The answer is simple: on the liability side, the Bank of Japan controls the government's financing costs, which have remained at zero (or even negative) despite rising inflation. On the asset side, the Japanese government has benefited from a significant depreciation of the yen, which has increased the value of its foreign assets. This is particularly evident in the GPIF, which has seen cumulative returns over the past few years exceed the total of the previous twenty years.

The Japanese government has gained returns from the arbitrage trade in both foreign exchange and fixed income. However, it is not just the Japanese government that benefits. The declining real interest rates have benefited every asset owner in Japan, primarily older wealthy households. It is often claimed that an aging population is less affected by low inflation. In fact, the opposite is true in Japan: through the factual reduction of real interest rates and the increase in the value of their assets, older households have proven to be the greater beneficiaries of rising inflation.

What would force this arbitrage trade to unwind? The simple answer is sustained inflation. Imagine what would happen if inflation required the Bank of Japan to raise interest rates: the liability side of the government’s balance sheet would take a huge hit as interest expenses on bank reserves increase and the value of Japanese government bonds declines. The asset side would also be affected, as rising real interest rates and yen appreciation lead to losses in net foreign assets and potential domestic assets. Wealthy older households would also face similar blows: their asset values would decline, and the government's ability to support pension entitlements would weaken. On the other hand, younger households would benefit. They would not only earn more on their deposits, but the real return rates on future savings flows would also increase.

Does the government have any way to prevent the pain and necessary fiscal adjustment brought about by higher inflation, especially for older households? In reality, there are only three options: tax younger households, prevent real interest rates from rising, or not pay interest to banks. None of these options are sustainable in the long term. All of these options would lead to significant social unrest and political instability.

In the past few years, the extremely loose monetary policy has been relatively straightforward from the perspective of Japanese political economy: real interest rates have fallen, fiscal space has improved, and income redistribution has favored wealthy older voters. However, if Japan is indeed entering a new phase of structurally higher inflation, future choices will become more difficult. Adjusting to a higher inflation equilibrium will require raising real interest rates and greater fiscal consolidation, which in turn will cause more harm to older and wealthier voters unless younger voters are taxed. While this adjustment can be delayed, the cost will be greater financial instability in the future and a weaker yen. The yen can only begin a sustained upward trend when the Japanese government is forced to unwind the last large-scale arbitrage trade in the world through interest rate hikes by the Bank of Japan, a trade that has allowed Japan to enjoy a bizarre period of social and political calm. However, those days are coming to an end.