The Japanese stock market experienced a significant crash last Monday, marking its worst day since 1987. The Nikkei 225 index plunged by 12.4 percent, driven by the Bank of Japan’s decision to raise interest rates to 0.25 percent from near-zero levels. This unprecedented move dealt a blow more severe than the economic disruptions caused by the COVID-19 pandemic, the 2008 financial crisis, or the dot-com bubble burst of the 1990s. The repercussions were felt globally, with U.S. markets also declining around 3 percent.
The recent rate hike stands in stark contrast to the Bank of Japan’s long-standing policy of maintaining low or negative interest rates. Historically, Japan has kept rates low to combat persistent deflation and stimulate economic growth. However, the recent shift aims to counter the yen’s depreciation against other major currencies, which has made imports more costly and affected Japan’s trade balance.
Additionally, similar market disruptions linked to interest rate changes have been observed in the past, but none had such a dramatic impact on the yen carry trade. Previously, investors capitalized on borrowing yen at low costs and investing in higher-yield assets like U.S. Treasury Bills. The stability of this trade largely depended on consistent exchange rates between the dollar and yen. The recent rate hike led to a sudden appreciation of the yen by 12 percent, increasing borrowing costs and triggering a global sell-off of shares.
Yen Carry Trade’s Role
A key factor contributing to the market crash was the yen carry trade, a strategy employed by financiers and institutional investors. This trade involves borrowing yen at low-interest rates and investing in higher-yielding assets such as U.S. Treasury Bills. The sudden rise in Japanese interest rates made borrowing more expensive, and the yen’s appreciation increased the cost of servicing yen-denominated debt. Consequently, investors rushed to sell off shares to cover these increased costs.
Prime Minister Fumio Kishida termed the rate hike a “once-in-a-lifetime opportunity to exit from deflation.” This shift indicates a strategic move by Japan to embrace inflation as a means to boost economic growth and increase wages. The Bank of Japan’s policy departure from negative interest rates aims not only to protect the yen’s value but also to navigate the economy out of a prolonged period of low growth and deflation.
Comparative Global Impacts
Unlike its U.S. counterpart, Japan’s central bank has taken a unique approach to interest rates. While the Federal Reserve raises rates to cool inflation, Japan aims to stabilize its currency and import costs. The different priorities highlight the varying economic conditions and challenges faced by each country. The yen’s depreciation against other major currencies has made Japanese goods more expensive, impacting trade and economic growth.
Japan’s economic struggles have been compounded by the shrinking of its economy in two of the last three quarters. The rate hikes are thus seen as a necessary measure to reinvigorate growth and protect the economy from further stagnation. By raising interest rates, Japan hopes to achieve a delicate balance between controlling inflation and encouraging economic activity, a challenge that will require careful navigation.
The current shift in Japan’s monetary policy marks a significant departure from its historical strategies. By raising interest rates, the Bank of Japan aims to curb the yen’s depreciation and mitigate the adverse effects of expensive imports on the economy. This strategic move also reflects Japan’s attempt to end a prolonged period of deflation and low growth. Investors and market analysts will be closely watching the long-term impacts of this policy change, particularly its influence on global financial markets and trade dynamics.
