Summary of Key Points
The Bank of Japan raised interest rates to 1% in June (the highest level since 1995), but the yen has not stopped falling and has depreciated to around 164, reaching its lowest purchasing power since the introduction of the floating exchange rate system in 1973. There is a high likelihood that interest rates will be raised again at tomorrow's meeting. However, due to constraints such as debt pressure and zombie companies (companies that have been operating for over 10 years without generating enough profit to cover interest expenses), the maximum potential increase is around 1.5%. The root cause of the yen's depreciation is the large amount of yen being borrowed overseas for arbitrage purposes (such as investing in tech stocks and high-yield bonds). Even if interest rates are raised, the short-term inflow of yen may offset the appreciation effect, and it will still be difficult to stabilize the currency in the long term, which could potentially cause fluctuations in global markets.
Detailed Analysis
1. High likelihood of another rate hike tomorrow, but only up to 1.5%?
Theoretically, interest rates would need to be raised above the "neutral rate" (the level that keeps the economy neither too hot nor too cold) to curb inflation. Japan's current neutral rate is between 1.1% and 2.5%, so a 1% interest rate is still considered extremely accommodative, and a raise to above 1.5% would be more appropriate. However, this is not feasible in reality for the following reasons:
- Debt pressure on the government: For every 1% increase in the yield on government bonds, the government has to pay an additional 8.7-10 trillion yen annually (accounting for more than 10% of tax revenue). The central bank also incurs significant losses on its holdings of government bonds when interest rates rise; the yield on 10-year government bonds has already reached 2.8%, just one step away from the "fiscal death line" of 3%. If it exceeds this level, no one will believe that Japan can afford to repay its debts.
- Zombie companies: 17% of Japanese companies are considered "zombies" (operating for over 10 years without generating enough profit to cover interest expenses) and rely on low interest rates to survive. A 0.25% increase in interest rates would result in an additional annual cost of 640,000 yen for each company, which could lead to bankruptcy, causing bad debts for banks and increased unemployment—a political risk that the government cannot afford.
Therefore, market forecasts suggest that the maximum rate hike in Japan would be 1.5%, possibly not until 2027.
2. Where has all the money gone due to the yen's sharp depreciation?
The money printed by the Japanese central bank is not circulating domestically but has been borrowed overseas for quick profits:
- Ordinary households: 63% of household funds are invested in foreign currencies, with households borrowing cheap yen to buy high-yield currencies (such as the US dollar) to profit from the exchange rate difference. Japan accounts for 35%-40% of global retail foreign exchange transactions.
- Multinational corporations/investment banks: They borrow yen and use leverage of 3-5 times to purchase high-return assets around the world. At its peak in 2024, there were over 180,000 short yen contracts held by hedge funds.
- Local institutions: The world's largest pension fund (worth 293 trillion yen) has invested nearly half of its assets overseas, and companies also prefer higher returns abroad due to lower domestic yields.
Where is all this money going? It is being invested in tech stocks (such as Nvidia and Microsoft), high-yield bonds (in countries like the US and Mexico), and various industries (for example, lending to Chinese real estate companies at interest rates of 5%-10%). Japan's overseas net assets have reached 561 trillion yen, effectively creating a "second Japan" abroad.
3. Why can't raising interest rates save the yen?
A rate hike in August 2024 to 0.25% triggered the "Black Monday," with the Nikkei index plummeting by 12.4% and global risk assets crashing. However, the yen soon depreciated again after a short-term increase. The reason is simple: higher interest rates increase borrowing costs, forcing arbitrage funds to convert their overseas assets back into yen for repayment. But the large amount of yen flowing back offsets the appreciation effect. Moreover, since everyone knows that Japan's room for rate hikes is limited, there is continued pessimism about the yen, meaning that any hike will only cause short-term fluctuations and cannot reverse the long-term depreciation trend.
4. What if interest rates continue to rise?
If interest rates continue to be raised:
- Global interest rates will increase: Japanese funds flowing back overseas will lead to a sell-off of US and European bonds, raising global borrowing costs and making it more expensive for companies to borrow money.
- Tech stocks will be under pressure: Many arbitrage funds have invested in AI-related tech stocks, and the withdrawal of these funds could cause their valuations to fall.
The result would be detrimental for both Japan and the rest of the world (a lose-lose situation), but not raising interest rates would only accelerate the yen's depreciation. Therefore, the government has no choice but to proceed with the hikes.
In one sentence:
Raising interest rates in Japan is like "drinking poison to quench thirst": if rates are not raised, the yen will continue to depreciate; if they are raised, there is a risk of debt crises and company bankruptcies, and it still won't stop the long-term depreciation. Ultimately, it could drag down global markets as well.
(End of analysis)