There is little correlation between the weak yen, rising long-term interest rates, and increased government bond issuance!

Hirokazu Kobayashi

CEO, Green Insight Japan Co., Ltd.

Professor Emeritus and Visiting Professor, University of Shizuoka

However, the media reports daily that these phenomena are attributable to a decline in international creditworthiness stemming from increased government bond issuance. This misconception is not limited to the media; even AI systems that collect this information provide similar responses. While this theory appeals to household-level intuition, it is a misconception. As of today, Japan's credit default swap (CDS) rates remain at approximately "20 bps," which is among the lowest globally. A CDS is a financial derivative that trades the credit risk (risk of default) of companies or countries, with "bps" (basis points) indicating the credit risk of the subject entity. One bps equals 0.01%. A higher number indicates greater risk and functions like a "credit insurance premium" for government or corporate bonds. In other words, bps fluctuate constantly based on the seller (the party offering insurance) and the buyer (the party purchasing insurance). A low bps value means the market judges the risk to be low; that is, the entity is considered creditworthy. Japan's level is slightly above 20 bps, comparable to EU countries but lower than the U.S. (about 30 bps) and China (about 40 bps). Russia averaged 13,800 bps over five years, while Greece's rose to 25,000 bps in 2012. Therefore, the argument that increased government bond issuance leads to a decline in creditworthiness, causing yen depreciation and rising long-term interest rates, is flawed. On the other hand, "country credit ratings" serve as a measure of an economy's international creditworthiness. While ratings from the three major agencies are well known, some question their objectivity.

How is it that Japan can maintain "low CDS = high creditworthiness" despite increased bond issuance? According to the modern monetary theory (MMT), Japanese government bonds will not default. This theory is rooted in "chartalism," which was first proposed in 1905. It states that sovereign currency-issuing nations with "high creditworthiness" will not default on their bonds. However, this theory does not apply when a country's currency has low creditworthiness, as seen in Argentina's debt crisis from the 1980s to the 1990s and Zimbabwe's hyperinflation and currency collapse in the 2000s. In other words, a currency's creditworthiness is key. Japan's yen is one of the world's three major reserve currencies. Therefore, MMT holds that a large size of the national debt does not determine the risk of fiscal collapse.

So, what causes yen depreciation? Primarily: First, the U.S. has repeatedly raised interest rates, pushing its Treasury rates to 4.25–4.5%. Meanwhile, Japan's policy rate remains low at 0.5%, and other interest rates (long-term and market rates) are also relatively low. Investors buy the high-yielding dollar and sell the low-yielding yen (see figure). This theory is known in economics as the uncovered interest parity (UIP) condition. Additional factors include: (2) Rising energy import costs. Japanese companies need more dollars to pay for imports, so they sell yen to buy dollars. This reduces demand for the yen, weakening it. A minor factor is (3) stock prices and investor sentiment.

Figure: Relationship between increased JGB Issuance and yen weakness / rising long-term interest rates

JGB, Japanese government bond; MMT, modern monetary theory; CDS, credit default swap; UIP, uncovered interest parity; and EPS, earnings per share

Meanwhile, long-term interest rates rose to just over 1.9% this month. Here, the term 'long-term interest rate' refers to the yield on long-term government bonds. The coupon rate of long-term government bonds is set at the time of issuance and remains fixed thereafter. However, government bonds are traded daily on the open market, and their prices fluctuate. If the market price falls below the purchase price, investors can receive the same coupon amount for a lower price, so the yield rises. Conversely, if the market price rises, the yield falls. An increase in long-term interest rates implies a decline in the market price of government bonds. While some investors view increased government bond issuance as a contributing factor, long-term interest rates are actually determined by various factors, including monetary policy, inflation expectations, domestic and international interest rate differentials, and investors' asset allocation. In other words, government bonds whose market prices have fallen are attractive to new investors. For example, if you purchase a government bond with a face value of 1 million yen for 900,000 yen, you will be repaid the face value at maturity, plus interest based on the coupon rate. Furthermore, if the market price recovers, you can sell the bond and realize a capital gain. However, the media argues that increased government bond issuance leads to a decline in creditworthiness, implying that the government cannot attract buyers for long-term bonds without paying higher interest rates. If this were household debt rather than government debt, a loss of creditworthiness would indeed occur. However, since the Bank of Japan has the authority to issue currency, which prevents default (see MMT), interest rates reflect monetary policy, supply and demand, and inflation expectations (see figure). Here, the constraint for households is 'repayment capacity', while the constraint for the state is 'tolerance for inflation'. Furthermore, an increase in the policy interest rate encourages yen buying and leads to yen appreciation. In other words, the Bank of Japan can actively steer the yen towards appreciation or depreciation by manipulating the policy interest rate. In contrast, a rise in long-term interest rates is a passive response to market movements.