Economic Letter from Asia: Japan Musings

In this week’s letter, we focus on Japan. Investor interest is acute because of the impact of a potential normalization of Japan’s monetary policy, the timing of which is still uncertain. Specifically, we look at recent trends in Japan’s business climate, inflation, and wage growth. We find that while business climate has improved in Japan, wage growth continues to lag inflation, inherently dragging on the Bank of Japan’s (BoJ) desire to see income-led consumption. We also examine Japan’s extensive overseas asset holdings and explore the potential impact on these holdings brought about by tighter monetary policy by the BoJ. We find that while Japan’s investors have been rebuilding their foreign bond holdings over the past year, much of these holdings stand to be unwound should yields at home climb.

Business sentiment in Japan Business sentiment in Japan seems to have turned a corner lately, with recently released Q3 Tankan results indicating an improved view of present conditions by firms. The improvement was especially evident for large firms, as manufacturers posted an unexpected confidence upgrade, while non-manufacturer sentiment rose to a multi-decade high (chart 1). Small and medium-sized manufacturers, however, retained a more downbeat view, while similarly-sized non-manufacturers expressed only a modest improvement in their outlook.

Japan inflation and wages All eyes are on the BoJ for any cues on imminent policy normalization, following that “largely” positive Q3 Tankan development. The BoJ remains the only major central bank that has yet to raise its policy rate, in divergence from peers who already seem close to completing their tightening cycles (chart 2). The BoJ continues to seek “virtuous cycles” in the economy, from income to spending, and between wages and prices.

However, while headline CPI inflation has held above 2% since April 2022, wage growth has failed to keep pace, resulting in diminished real wages (chart 3). With that said, the deterioration of real wages has slowed in recent months, given accelerated nominal wage growth while inflation has kept at elevated levels. Additionally, the year’s “Shunto” wage negotiations, which saw an average wage increase of 3.6%, spur hopes that Japan may finally be deviating from an age of subdued wage growth. Regardless, and given current conditions, market watchers are expecting the BoJ’s hiking cycle to only start next year at the earliest.

Japan’s portfolio investment holdings The BoJ’s rate hike cycle is likely to have far-reaching impacts when materialized, partially due to Japan’s outsized overseas holdings. In fact, the market-moving potential of Japanese investors is so great that the European Central Bank warned in May that BoJ normalization could exert a “sizable effect” on global bond markets. Japan remains the world’s largest creditor, with its net assets having exceeded $3 trillion, and portfolio investment assets totaling about $4 trillion in 2022 (chart 4). Further, about 53% of Japan’s portfolio investment assets are dollar-denominated, while 12% are euro-denominated. A BoJ rate normalization cycle is likely to induce some repatriation of Japanese funds currently vested in overseas assets, as yield differentials become less unfavorable for Japan, weighing on currencies of other economies. Concurrent rate cuts by other major central banks – currently seen to commence about mid-next year – could catalyze the aforementioned.

Japan’s yield differentials with peers Japan has nevertheless continued to reel from deeply unfavorable yield differentials in recent months. Japanese yields have become increasingly unattractive compared to those of other developed economies, as the world moved to return rates to normal while Japan stood back (chart 5). As such, many investors have borrowed in yen to buy higher-yielding currencies such as the dollar to profit from yield differentials – a move known as the carry trade. The increasing allure of such carry trades – barring underlying currency volatility – is among many drivers weighing on the yen, reflected in Japan’s chronically worsened nominal effective exchange rate since 2021.

Japan’s portfolio flows In response to unattractive domestic yields and a faltering yen, Japanese investors have been rebuilding their foreign debt holdings, while tightening cycles abroad looked set to end. Cumulatively, resident investors have made net portfolio outflows of about 15.8 trillion yen ($110 billion) this year, driven mostly by purchases of foreign debt. Non-resident investors were cumulative net buyers of Japanese portfolio assets in Q2 this year but soon became net sellers as their divestments of Japanese debt accelerated. Zooming out, Japanese investors have bought a cumulative 133.8 trillion yen’s worth ($900 billion) of foreign debt since the BoJ started to lower rates in late 2009 (chart 6). At least some of the investors’ significant post-crisis accumulations stand to be unwound if prospects – whether from improved yields or a reversal of yen weakness – turn more favorable at home.