Japan’s Consolidated Balance Sheet and Challenges for Monetary Policy

Most countries experienced higher levels of inflation following the height of the COVID-19 pandemic. Japan is no exception. Since April 2022, Japan’s inflation rate as measured by its consumer price index (CPI) has been consistently higher than the 2% target set by the country’s central bank, the Bank of Japan (BOJ). To combat higher inflation, the BOJ increased its policy rate in March 2024 for the first time in 17 years, from negative territory to between 0 and 0.1%. In July 2024, the BOJ further increased its policy rate to around 0.25%.

The July rate hike triggered a strong reaction from financial markets; the Japanese yen immediately appreciated, and the stock market tumbled soon after. In the four trading days following the July rate hike, the yen regained its value relative to the U.S. dollar by almost 8%, and the Nikkei 225 stock market index dropped by more than 18%. As a result, the BOJ received criticism for its decision to increase the policy rate.See, for example, the Aug. 5, 2024, Bloomberg article “BOJ Under Fire for Rate-Hike Timing after Market Meltdown.” These events suggest that if the BOJ continues to tighten monetary policy, Japanese stocks and foreign currency asset holders could see further losses.

The Dynamic of Fiscal Tension and Monetary Policy

Given the Japanese government’s balance sheet position, it’s likely the government would face large losses if the BOJ were to raise the policy rate further. Evidence from the consolidated balance sheet of Japan’s general government and the BOJ, which is shown in the table below,The general government includes Japan’s central government, local governments and public pension funds. Given that profits and losses incurred by the Bank of Japan are remitted back to the Japanese central government, a consolidated balance sheet reflects the overall indebtedness of the Japanese public sector more accurately. Our November 2023 On the Economy blog post explains why and how to consolidate balance sheets. appears to support this notion. The Japanese government and BOJ hold an amount equal to more than 100% of the nation’s gross domestic product (GDP) in risky assets, including domestic equities, foreign equities and foreign bonds. In contrast, a large fraction of their liabilities is in safer, short-term assets. More than 46% of the total value of liabilities on their consolidated balance sheet have no duration: The BOJ holds reserves equal to 90.9% of GDP and cash equal to another 21.6% of GDP.For more details, see the analysis in the July 2024 Federal Reserve Bank of St. Louis Working Paper “What About Japan?” (PDF).

Given this large and relatively risky asset position, the general government and the BOJ itself could suffer substantial losses on their balance sheet due to higher interest rates. Consider this example: The Japanese government and the BOJ hold foreign assets valued at 56.1% of GDP. A 10% appreciation of the Japanese yen would imply a 10% loss in their foreign assets, an amount equivalent to 5.6% of GDP. Alternatively, a 10% decline in the Japanese equity market, in conjunction with the government and BOJ’s 45.4% equity holdings, would incur a loss equal to 4.5% of GDP.

Therefore, there is a potential for tension between the Japanese government’s fiscal position and the BOJ’s policy of raising interest rates. As domestic interest rates rise, Japan’s fiscal situation could worsen rapidly, creating a strong incentive for the government to support low-rate policies to manage fiscal challenges. This fiscal pressure could complicate the BOJ’s efforts to raise rates. Similar tensions also exist in other countries, particularly where central banks have large balance sheets. However, in Japan, the issue is especially pronounced. The BOJ has the largest balance sheet relative to GDP among major central banks, and the government’s balance sheet is highly exposed to interest rate risk. The portfolio composition of the government and BOJ’s balance sheet make them particularly vulnerable to rate hikes.

Challenges for Monetary Policy

A primary aim of many, if not all, central banks is to achieve price stability. Generally, central banks increase their policy rates to help combat rising inflation. However, higher interest rates also increase the cost burden on governments of servicing debt. Thus, there is always the potential for fiscal tension. However, for central banks to effectively perform their role, they must be able to make monetary policy decisions without political interference. This concept is known as central bank independence.

At times, the idea of central bank independence has been challenged. In late September 2024, Japan’s ruling Liberal Democratic Party elected new leadership, with the winner set to become the next prime minister. Before the party election, Sanae Takaichi spoke against further policy rate hikes while her opponent, Shigeru Ishiba, voiced his support for them. When Ishiba won the election, financial markets reacted immediately. The yen strengthened, and stock futures sharply declined.The reaction from financial markets is described in the Sept. 27, 2024, Japan Times article “Yen Rallies as Ishiba Beats Takaichi in LDP Race” and the Sept. 27, 2024, Nikkei Asia article “Japan Stock Futures Fall 5% as Ishiba to Succeed PM Kishida.” Nevertheless, less than one week later, the new prime minister unexpectedly warned against a future rate hike. The yen weakened sharply. The strong reaction from the market in response to the election results could potentially be viewed as a lack of confidence in the BOJ’s independence; were that to be the case, it may hinder the BOJ’s ability to tame inflation. More recently, Ishiba has said he would not intervene in monetary policy affairs and that it is important to avoid the appearance of doing so.

In a scenario where inflation is persistently higher than the BOJ’s 2% target, raising interest rates could result in further losses on the government’s balance sheet. Political pressure associated with such a decision could be viewed as an obstacle for the BOJ and its inflation target.

Notes

1. See, for example, the Aug. 5, 2024, Bloomberg article “BOJ Under Fire for Rate-Hike Timing after Market Meltdown.”
2. The general government includes Japan’s central government, local governments and public pension funds. Given that profits and losses incurred by the Bank of Japan are remitted back to the Japanese central government, a consolidated balance sheet reflects the overall indebtedness of the Japanese public sector more accurately. Our November 2023 On the Economy blog post explains why and how to consolidate balance sheets.
3. For more details, see the analysis in the July 2024 Federal Reserve Bank of St. Louis Working Paper “What About Japan?” (PDF).
4. The reaction from financial markets is described in the Sept. 27, 2024, Japan Times article “Yen Rallies as Ishiba Beats Takaichi in LDP Race” and the Sept. 27, 2024, Nikkei Asia article “Japan Stock Futures Fall 5% as Ishiba to Succeed PM Kishida.”