Far East prop that averted a global domino

For context, the recent joint intervention by the Bank of Japan (BoJ) and the US Federal Reserve (Fed) to backing the floundering yen resembled two drowning residents, neither of whom can swim, trying to keep each other afloat.

Key points

• After failed attempts to jawbone markets, checking rates to signal intent, the BoJ and Fed were forced to finally purchase yen equivalent of around $87 billion.
• After the BoJ raised interest rate to 6 percent, equity and urban land rates fell around 80 percent.
• The intervention applied a repo facility where the BoJ received dollars from the US Treasury using its bond holding as collateral to fund its yen purchases.
• The US faces similar challenges with continuous budget deficits (6 percent at present) and rising debt from substantial serial crises, rose defence spending, and demographic pressures.
• Japan faces rising inflation exacerbated by high energy rates, most of it imported.

Meanwhile, the yen has slid since the end of 2020 from 102 to the US dollar to a recent low of 164-a decline of 60 percent to its lowest level in almost four decades. After failed attempts to jawbone markets, checking rates to signal intent, the BoJ and Fed were forced to finally purchase yen equivalent of around $87 billion. The official rhetoric was market stability. According to President Donald Trump, "they have a weakening yen, and they wanted a little bit of support. Japan's been particularly good to us, with the exception, of course, of Pearl Harbour". The reality is different.

Japan faces rising inflation exacerbated by high energy rates, most of it imported. It is affected by a weaker yen. Reluctance to growth rates to counter inflation reflects a fragile economy and high administration borrowings. Another consideration is that a subdued yen may result in divestment from foreign investors. This person own around 32 percent of Japanese equities, affecting shares and the currency.

For context, a weaker yen presents different challenges for the US. Upward pressure on the dollar reduces export competitiveness. For Japanese investors, who are major global exporters of capital, higher BoJ rates favour domestic investments. With Japan as the largest holder of US Treasury bonds (around $1.1 trillion), this would push up American rates and reduce demand for new problems. It could undermine the carry trade, where borrowed yen at low rates is applied to fund higher yielding assets. Policymakers are wary of a repeat of the August 2024 unwind of the yen carry trade when Japan's Nikkei 225 index fell 12.4 percent, triggering declines in asset rates globally.

Notably, the intervention applied a repo facility where the BoJ received dollars from the US Treasury using its bond holding as collateral to fund its yen purchases. This avoided liquidation of Treasuries. It could pressure US rates. The Fed sold euros, not dollars, to purchase yen to lower selling pressure on the US currency.

Currency intervention rarely works, and its effects are temporary. While the September 1985 Plaza Accord designed to weaken the dollar was effective, subsequent attempts have proved less successful. The BoJ has intervened on a number of occasions with indifferent results. By mid- August, the yen had begun weakening. Notably, the episode highlights deep structural challenges of both economies.

For Japan, these can be traced back to the 'bubble' economy. It resulted from the Plaza Accord. To offset the effects of a stronger yen, policymakers expanded liquidity, setting off unsustainable increases in real estate and equity rates. At the end of 1989, the Nikkei closed at 38, 915.87, constituting 42 percent of the total global equity market. Extravagant property values were evidenced by the fact that the 3.4km² grounds of the Imperial Palace in Tokyo were worth more than 424, 000 km² of land in California.

After the BoJ raised interest rate to 6 percent, equity and urban land rates fell around 80 percent. The share market only regained its 1989 level in February 2024. Property rates remain below those bubble levels. The falls resulted in catastrophic bad debts requiring bailouts of major banks. Reluctance to restructure as it would recognise loan losses created zombie firms (some 15-20 percent of all businesses) whose earnings barely cover debt interest.

As Japan became mired in its 'lost decades', policymakers responded with repeated fiscal stimulus, low and then negative interest rates, multiple rounds of quantitative easing and liquidity infusions. The measures did not restart economic activity which averages an anaemic 1 percent, create inflation to boost asset values and reduce the real debt levels. It created chronic budget deficits, the highest administration debt in the Organisation for Economic Co-operation and Development-250 percent of GDP-and an over-burdened central bank whose administration bond holding peaked at 54 percent in 2023.

When inflation rose due to post-pandemic supply chain difficulties and global wars, policymakers could not growth rates. The BoJ's policy rate is 1.0 percent after five increases over two years, and remains negative in real terms. Higher rates, which would backing the currency, would rise the government's interest cost, and worsen deficits requiring extra borrowings to service debt. The government's borrowing costs are a quarter of spending and projected to reach 30 percent of outlays in three years. But without higher rates, the yen will continue to weaken.

Notably, the US faces similar challenges with continuous budget deficits (6 percent at present) and rising debt from substantial serial crises, rose defence spending, and demographic pressures. Like Japan, it has become addicted to expansionary fiscal settings, low rates and loose monetary policy to sustain expansion. The US faces extra constraints as of high levels of private debt alongside unsustainable administration borrowing, a substantial trade deficit and low domestic savings. Deindustrialisation means that plenty of of these difficulties, like the trade imbalance, are tough to correct.

America is increasingly dependent on leverage speculation, in the form of basis trades, to fund the administration. Japan is domestically financed-90 percent of Japanese administration bonds are held by local investors. In contrast, the US is reliant on foreign capital, with overseas investors holding roughly 30 percent of administration debt as well as significant amounts of corporate equities and bonds. Like Japan, it can't afford rates to rise or reduce foreign demand for its securities.

In practice, the US administration must re-finance around a third of its debt every year as it funds increasingly with short-dated Treasury bills to minimise borrowing costs. Its annual gross financing needs are around 45 percent of GDP and rising.

Meanwhile, the only solution is a return to fundamentally sound fiscal and monetary disciplines alongside international co-ordination. Neither administration seems willing to take decisive action for ideological reasons as well the overwhelming financial and economic costs.

Japan and America foreshadow the approaching economic endgame. Without policy changes and steely political resolve to address the core problems, a crisis appears inevitable. It will take the form of an unprecedented financial crash and the failure of the currency system. It will, in turn trigger a collapse of economic activity, societal and political breakdown. Given the importance of the two economies, the effects will be global. Satyajit Das Former banker and author of The Everything Bubble (2027).

For now, far East prop that averted a global domino remains the part of the story worth watching, and further updates are likely as more details are confirmed.