Arnold Kling  

Japan and the World Interest Rate

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In Rudi Dornbusch's international macro course, there was something called the world interest rate. If the interest rate in dollars is 5 percent, and the interest rate in yen is 2 percent, then to have a world interest rate the dollar has to be expected to decline at a 3 percent rate.

In the short run, the world interest rate can be locked in via what is known as covered interest parity. For example, suppose that the three-month interest rate in U.S. dollars is 2 percent, and the three-month interest rate in Japanese yen is 1 percent. If you borrow in yen and lend in dollars, your only risk is currency risk--if the dollar depreciates at a rate of more than 1 percent, then when you get back your dollars in three months and pay back in yen, you would actually lose money.

You can cover your currency risk by buying three-month yen futures and selling three-month dollar futures. To eliminate arbitrage opportunities, the three-month forward exchange rate has to incorporate (in this example) an expected decline of 1 percent in the value of the dollar. That is covered interest parity.

When we are talking about ten-year interest rates, there is no depth to the forward market in foreign exchange. So if there is a world interest rate, it rests on uncovered interest parity. So, right now ten-year Japanese government bonds yield less than 1.5 percent, while ten-year U.S. government bonds yield close to 4 percent, for a difference of 2.5 percentage points (money managers multiply by one hundred to call this 250 basis points). If there is a world interest rate, then investors expect the dollar to decline by 2.5 percent per year for 10 years, for a total decline of 25 percent.

I suspect that in fact there is not a world interest rate. I suspect that Japanese savers are willing to accept a lower rate of return on Japanese government bonds than on U.S. government bonds. I suspect that it is difficult for the private sector to try to arbitrage against this--the private sector cannot borrow and lend at government rates, the private sector pays a substantial premium to borrow for ten years, and the private sector cannot engage in ten-year forward foreign exchange contracts in any depth.

This all relates to the issue of Japan's huge government debt. Under my suspicion, the willingness of Japanese savers to forego the returns that they could earn elsewhere is what is keeping the Japanese government going.

(Alternatively, if there is a world interest rate that is higher than the Japanese interest rate, then Japanese savers are earning it, and the Japanese government is paying it. That is, when Japanese savers are paid back, they will be paid back in yen that have appreciated strongly relative to the dollar, and the government will have to pay back in a currency that has appreciated relative to the dollar--not that the government should have a problem with that.)

I suspect that Japanese private firms pay something closer to the world interest rate. That is, private firms do not enjoy the benefits of the prodigious savings propensities of Japanese consumers. My guess is that new businesses in Japan are relatively starved for capital, and that helps account for a lack of dynamism and low rate of growth there. But those are just guesses.



COMMENTS (5 to date)
Les Cargill writes:

Peter Drucker writes at some length about his instillation of the Japanese with a mania for saving. There are still echos of the medieval Japanese class structure in play there. I would imagine that Hansonian near/far plays a significant role in Japan.

Based on my reading of Drucker, I was always skeptical of Western pronouncements of how dynamic Japan was. I think there were windows of opportunity where a Toyoda or Masaru Ibuka could found a "dynasty". Once that was in place, there's a natural resistance to overturning it. Schumpeterian forces find hard soil in Japan.

Said window really was in the uncomfortable periods of imperial and later industrial expansion. Toyoda founded Toyota in 1937; Sony sort of came of age post-or-peri-Drucker in the late '50s.

Boonton writes:

Say the Japanese people did have a 'mania for saving' and they also have a bit of a racist tinge, not trusting any countries other than their own. They would seek out Japanese savings vehicles (i.e. Japanese bonds).

Of course this flies in the face of what we saw in the 80's when wealthy Japanese firms and investors had no problems buying up expensive US real estate, golf courses, and trophy buildings. I'd feel a lot safer spending $1B on some US bonds than buying anything Donald Trump is trying to offload to me. But anyway....

At the end of that savings wouldn't there be money managers of some type and they would see they could park the money in US Treasuries, earn 4% or whatnot and then pay the savers 1.5% leaving a nice margin for themselves?

As Arnold said, this doesn't work if Japan's currency is going to suddenly appreciate leaving the money manager with US dollars that won't be worth the Yen he needs to pay back the savers....and there's no serious market out there allowing one to hedge currencies ten years out.

But what about Japan's 170% debt to GDP level which only a few days ago Arnold was hinting was going to cause a problem sooner or later? Since when is it plausible to think that a country getting into debt problems is going to suddenly have its currency *increase* in value? Even if Japanese savers are irrationally patriotic the country does have clearly sophisticated money managers.

If Arnold's 'fiscal singularity' is true, then Japan will hit there first making the intelligent bet to short Japan and go long on the US. In other words, borrow in Yen, buy dollars, buy bonds, use the bonds from the US to pay off your Yen as time goes by. When the collapse hits Japan, your US dollars will generate even more profit.

Les Cargill writes:

Boonton:

Yes, but when? Japan successfully went through an extremely long medieval period. Had Admiral Perry not floated into the harbor, they might be there still. It's a simply remarkable culture. Island cultures seem to tend towards rather an iron discipline - Britain significantly tailored its culture to producing people who could stand at post during wooden ship warfare. That's some real nickel anthropology there, but ...

I am no real Japanologist, just another bag of Internet opinions. Still, it seems that said discipline is still there bubbling under. The apparent principle high-status hobbies in Japan involve reinvigorating medieval arts - katana makers are still highly esteemed, executives study martial arts to a high degree, bowplay is back.

And Japan does buy a considerable quantity of treasuries. I think they're in the top ten in holdings. I just don't think they're organized around the principle of optimizing returns for the sake or returns.

Amaturus writes:

When I studied this phenomenon in my International Financial Management class, we called it the International Fisher Effect (IFE). The textbook (by Jeff Madura) explains that the IFE does not hold consistently, much like Purchasing Power Parity. I think there's simply a lot of noise in the system that make these economic theories not hold consistently, but there is an underlying truth to them. In the early days of the financial crisis, the yen-carry trade started unwinding and incentivized the Japanese to get out of foreign capital markets (foreign interest rates were falling and less desirable to the Japanese). They sold off assets denominated in the other currencies and returned their holdings to yen, leading to a cycle of yen appreciation that devastated stock markets. There is a strong correlation between the appreciating yen and the fall of the DJI in Fall 2008.

Elvin writes:

Arnold,

I don't think this is right. I just looked up the option-adjusted spread for Japanese investment grade corporate bonds: it's 43 basis points, while the US OAS is 139 basis points.

Some thoughts: Japanese savers are rewarding corporate buyers as well; aren't JGBs rated Aa+, not Aaa?; Japanese companies are more conservatively managed than US companies. (This last one is definately true, as the largest corp sector in Japan was the Aa, while in the US it is Baa.) Maybe lending is harder in non-price terms.

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