What About Japan?
YiLi Chien, Hal Cole and Hanno Lustig
FRB St. Louis, University of Pennsylvania and Stanford University

May 29, 2024

Roadmap
Intro: Why Japan?
Looking Backwards: Debt Dynamics
Quantifying Financial Repression
Gov’t Duration Mismatch and Fiscal Capacity
HH Duration Mismatch and Welfare Losses
Conclusion

2 / 30Why Japan?

▶ Advanced economies experiencing demographictransition.
▶ Governments projected to run large deficits and run up
debt/output ratio as a result.
▶ Japan at leading edge of transition.
▶ Eurozone and China following.

3 / 30Traditional Macro View
▶ Advanced economies experiencing
1. Demographic transition (see, e.g., Auclert et al., 2021) and2. Secular stagnation (see, e.g., Eggertsson et al., 2016).
3. Increase in inequality (Mian et al., 2020)▶ Forces lead to lower equilibrium long-run real rates(neutral w.r.t. monetary and fiscal policy).
▶ Creates extra fiscal capacity (Blanchard, 2019; Mehrotra
and Sergeyev, 2021)▶ Economies bump into ZLB and CBs deploy large-scaleasset purchases to lower long-term nominal rates.
▶ Guided by r∗ estimates. (Laubach and Williams, 2003, 2016;
Holston et al., 2017)4 / 30This Paper: Alternative (Complementary) View
▶ Advanced economies experiencing:
1. Demographic transition
2. Secular stagnation▶ Forces lead to large governments deficits.
▶ Financial repression: Governments resort to measures tolower real rate on government debt in order to create extra
fiscal capacity.
▶ CBs deploy large-scale asset purchases just to lower
long-dated real rates (Bianchi et al., 2022).
▶ Government debt appears expensive (Jiang et al., 2019;
Di Tella et al., 2023).

▶ Heterogeneity in duration of HH fin. wealth =⇒ increased
wealth inequality (Auclert, 2019; Greenwald et al., 2022)▶ Not just paper gains and losses.
5 / 30Duration Mismatch on Japanese Gov’t Balance Sheet▶ Consolidate the Japanese government’s balance sheet(including BoJ).
▶ Carry trade: Government to earn an additional 3.4% of
GDP from its risky investments.
▶ Risky maturity transformation on a large scale byborrowing at floating rates and investing in long-duration
assets.

▶ Duration mismatch on JP’s consolidated government
balance sheet.
▶ A decrease in real rates increases government’s spending
possibility set, because
1. Net debt position has negative duration,
2. But its future surpluses have long duration.

▶ Lots of extra fiscal capacity created (destroyed) when rates
decline (increase).
6 / 30Duration Mismatch on Japanese HH Balance Sheet▶ Duration mismatch on JP stand-in HH balance sheet.
▶ Mismatch especially pronounced for young JP households
who hold mainly deposits.
▶ A decrease in real rates shrinks consumption possibility set,because
1. The young’s financial wealth has little duration,
2. But the young need to finance future consumption out ofsavings (excess consumption has high duration).
(Greenwald et al., 2022)▶ Large welfare losses for young non-participants.
▶ Financial Repression is a tax on young non-participants.

7 / 30Roadmap
Intro: Why Japan?
Looking Backwards: Debt Dynamics
Quantifying Financial Repression
Gov’t Duration Mismatch and Fiscal Capacity
HH Duration Mismatch and Welfare Losses
Conclusion

8 / 30Debt Dynamics Accounting▶ Let Gt denote nominal government spending before
interest, Tt denote nominal government tax revenue.
▶ Start from the static government budget constraint,
Gt − Tt + Dt−1 Rt = Dt ,where Rt denotes the gross return on the entire portfolio of
marketable debt Dt .

▶ By iterating backwards, we obtain the following expression
for the debt/output ratio.
t
Dt
=∑
Yt
j=0
j



Gt−j − Tt−j
Yt−j

Rt−j,tD+ R0,t −1 ,Xt−j,tY−1jwhere Rt−j,t = ∏k=1 Rt−j+k and Xt−j→t = ∏k=1 Xt−j+k .
9 / 30Central Government Budget▶ In the past three decades, Japan’s social security payments
have increased from 17 to 35% of government
expenditures.
▶ Japan running large deficits as a result
10 / 30

Debt Dynamics▶ Consider a deterministic environment.
D
Y

=

G−T
Y
x−r .
1+x

▶ When r < x, the government can roll over its debt inperpetuity and run steady-state deficits (G > T) with aconstant debt/GDP ratio. (see, e.g., Blanchard, 2019;
Mehrotra and Sergeyev, 2021).
▶ Japan not in the Blanchard goldilocks region.
1997-2023

x-0.03%

π
0.36%

r
1.30%

r−x
1.27%

BofA Ice Japan Government Bond Index Fund (excluding T-bills).

r minus x
11 / 30

Consolidated Government and BoJ Balance Sheet▶ Consolidated Balance Sheet
1. Central Government,
2. Local Government,
3. Pension Funds,
4. Government-owned Financial Institutions and BoJ.

12 / 30

BOJ Balance Sheet▶ BOJ launched QE in 2001
▶ BOJ adopted YCC in 2016
% of GDP, Year End
AssetsCurrency and Deposits
Domestic Loans
Bonds & T-Bills
Liabilities
Currency
Bank Reserves
Government Deposits

1997

2023

0.0%
4.2%
9.6%

0.5%
17.1%
99.3%

10.8%
0.6%
0.1%

21.6%
90.9%
2.8%

13 / 30

Consolidated Balance Sheet (BoJ + Gen Gov’t + PFIs)▶ Gov’t replaced FILF deposits with Bank Reserves.
% of GDP, Year End
AssetsCurrency and Deposits
Domestic Loans
Other Domestic Securities
Domestic Equities
Foreign Securities
Sum
Liabilities
Currency and Deposits
Bank Reserves
Bonds & T-Bills
Loans
Deposits FILF
Sum
Net Liabilities

1997

2023

Difference

6.0%
102.8%
11.2%
13.9%
6.8%
140.6%

20.8%
60.7%
14.4%
37.5%
56.1%
189.5%

14.8%-42.1%
3.2%
23.7%
49.3%
48.9%

10.9%
0.6%
50.4%
52.1%
75.4%
189.5%
48.9%

24.5%
90.9%
123.4%
35.2%
5.8%
279.8%
90.4%

13.6%
90.3%
73.0%
−16.9%-69.6%
90.4%
41.5%

14 / 30

Negative Duration of Net Debt
▶ Net debt D̃ of about 90% of GDP.
▶ Negative duration of 43 years for its net debt D̃.
1. The duration of its A is around 26 years.
2. The duration of its D is only 3.6 years.
Figure: Duration of Japanese Government’s Balance Sheet

The duration of equity is 75.66 years. The duration of bonds is 7.19 years. The durationof loans is 3 years. The duration of deposits (cash and bank reserves) is 1 year (0 years).
15 / 30

Net Debt Dynamics Accounting▶ Start from static budget constraint for consolidated
government.
▶ The net debt/output ratio can be stated:
t
D̃t
=∑
Yt
j=0



Gt−j − Tt−j
Yt − j

Rt−j,tD̃
R̃0,t − R0,t A−1+ R0,t −1 ,−Xt−j,t
X0,t
Y−1
Y−1

where R̃0,t = ∏tk=1 R̃t−j+k .

▶ When rf > x, the government can run steady-state deficits(G > T) with a constant D̃/Y provided that rx A
Y is large
enough:
D̃
Y

=

rx A
T −G
1+x Y
Y
+
.
rf −x
rf − x1+x
1+x

16 / 30

Carry Trade Returns▶ Japanese Gov’t earns an additional 3.4% of GDP on its
risky asset position.
▶ Japanese Gov’t earns rx of 2.46% per annum above thecost of its funding position.
▶ The spreads really started to increase after the GFC.
Returns
Periods
1997-2023
2000-20092010-20192020-2023

Liabilities
0.72%
0.88%
1.08%
−0.65%

Assets
3.18%
1.37%
4.84%
3.36%

Profits
Difference
2.46%
0.49%
3.76%
4.00%

% of GDP
3.41%
0.23%
4.72%
8.02%

International Returns

17 / 30

Japanese Government Bond Purchases.

18 / 30

Japanese Government Bond Holdings.

19 / 30

Roadmap
Intro: Why Japan?
Looking Backwards: Debt Dynamics
Quantifying Financial Repression
Gov’t Duration Mismatch and Fiscal Capacity
HH Duration Mismatch and Welfare Losses
Conclusion

20 / 30

Balance Sheet of Consolidated Government▶ No Arbitrage: EER on the government debt portfolio’s:
h
i A
h
i
h
i
At
f
f
f
t
S
A
)
E
R
−
R
+
E
R
−
R
Et RD
−
R
=
(
1
−
t
t
t+1
t+1
t+1
t
t
t .
Dt
Dt

▶ The implied spread on A minus D:
h
i
h
i
At
D
A
S
Et RA
−
R
=
(
1
−
)
E
R
−
R
t
t
t .
t+1
t+1
Dt

▶ Claim to S needs to be much safer than D.
h
i
h
i
1
2.46%
S
A
D
E RA
=
= 7.68%.
t+1 − Rt = E Rt+1 − Rt ×
1 − 0.68
0.32
▶ Realized ER on risky assets E RA
t+1 is 3.18%▶ Implied ER on the surplus claim E RSt is -4.5% .

▶ S needs β < 0, i.e. counter-cyclical. But surpluses arestrongly pro-cyclical.
21 / 30

Measuring the FR Wedge▶ Government debt is overpriced :hiEt Mt+1 RD
t+1 < 1.
▶ Simple case: T and G are constant fractions of Y:βD= (1 −t

At Y At A) β + βt .
Dt t
Dt▶ In 2023, the unlevered beta of equity βYt in Japan is 0.45.
At▶ The ratio of risky assets to debt D
is 0.68.
t▶ The FR wedge between realized and implied ER:hfαt = Et RD
t + 1 − Rt

i



At
At
− (1 − ) βYt + βAt
Dt
Dt




vart Mt+1 , Rit+1.
Et (Mt+1 )αt denotes the Euler equation wedge: 223 bps.
22 / 30

Roadmap
Intro: Why Japan?
Looking Backwards: Debt Dynamics
Quantifying Financial Repression
Gov’t Duration Mismatch and Fiscal Capacity
HH Duration Mismatch and Welfare Losses
Conclusion

23 / 30

Government IBC▶ Iterate forward on the government’s budget constraint toobtain debt valuation expression:∞

NetDebt = E0 ∑ R−t (Tt − Gt ).
t=0▶ Gauge the effect of real rate declines on the government’s
spending possibilities:(a) If DNetDebt < DT−G then the government’s spending
possibilities expand when the interest rate falls,(b) if DNetDebt > DT−G the government’s spending possibilities
contract.

▶ Negative DNetDebt of 43 yrs because DA >> DD and DT−Gof 53 yrs.
∞

Debt ↘<< E0 ∑ R′,−t (Tt − Gt ) ↗
t=0▶ Rate decrease generates lots of extra fiscal capacity:
24 / 30

Roadmap
Intro: Why Japan?
Looking Backwards: Debt Dynamics
Quantifying Financial Repression
Gov’t Duration Mismatch and Fiscal Capacity
HH Duration Mismatch and Welfare Losses
Conclusion

25 / 30

Household IBC▶ Iterate forward on the HH budget constraint to obtain
expression for financial wealth:∞θ0 = E0 ∑ R−t (Ct − Yt ).
t=0▶ Gauge the effect of real rate declines on the household’s
consumption possibilities (Greenwald et al., 2022):(a) If Dθ > Dc−y then the HH’s consumption possibilities
expand when the interest rate falls,(b) if Dθ < Dc−y the HH’s consumption possibilities contract.

▶ in case (b), when rates fall:∞θ0 ↗<< E0 ∑ R′,−t (Ct − Yt ) ↗↗ .
t=0

▶ Lower Real Rates → Young Japanese households,
especially those saving in deposits, are worse off.
▶ Lower Real Rates → Older Japanese households, especiallythose with savings in bonds, equities are better off.
26 / 30

Japanese HH Balance Sheet: Trapped in Deposits.

% of GDP, Year End
AssetsCurrency and Deposits
Other Securities
Equities
Insurance & Pension
Liabilities
Loans

Japan
1997
2023

1997

U.S.
2023

128%
16%
16%
63%

189%
5%
46%
90%

42%
30%
125%
110%

61%
22%
199%
118%

65%

62%

62%

69%

27 / 30

The Welfare Impact of a 1% decline in Interest Rate
▶ Define a money-metric measure of the welfare effect:dV
Uc0= E0 ∑ βt

Uct
dct .
Uc0

▶ The welfare gain: (Greenwald et al., 2022; Fagereng et al.,2022):

Welfare gainj (θ, z) ≈ Dc−y − Dθ θ0 × d log R.
▶ Assumption: Euler equation holds.
▶ We compute Dc−y for X-section of Japanese households.
▶ Large Welfare losses for young non-participants.

28 / 30

Roadmap
Intro: Why Japan?
Looking Backwards: Debt Dynamics
Quantifying Financial Repression
Gov’t Duration Mismatch and Fiscal Capacity
HH Duration Mismatch and Welfare Losses
Conclusion

29 / 30

Conclusion▶ Japan is engaged in massive financial repression.
▶ Japanese government engaged in risky maturity
transformation.
▶ Japanese government has engineered large maturity
mismatch between surpluses and debt.
▶ Duration mismatch on government balance sheet: fiscal
capacity boost from lower real rates▶ Duration mismatch on HH balance sheet: large welfare
losses (gains) for young non-participants (older
participants)

30 / 30

Financial Repression▶ Financial repression
occurs when governments implement policies to channel tothemselves funds that in a deregulated market environment
would go elsewhere.
(Reinhart et al., 2011)▶ Directed lending by national pension funds, banks, central
banks etc.
▶ Caps on interest rates.
▶ Government ownership of banks.
▶ Macroprudential regulation.
▶ Commonly used to finance wars, even in U.S (WW-I,
WW-II, pandemic) .
▶ See Hall and Sargent (2022) for a comparison of thepandemic and two World Wars.
▶ See Sargent et al. (2019) for detailed discussions of the U.K.,
U.S. French and Italian experiences during the interbellum.
1 / 12

Japanese Financial Repression▶ Prior to 2001: Cheap funding for government.
▶ Participation by HH in capital markets was expensive(Hoshi and Kashyap, 1999).
▶ HH Trapped in deposits:▶ Interest rate ceilings on deposits.
▶ HH Deposits at Japan Post and pension fund reserves
required to fund FILF (Fiscal Investment and Loan
Program).

▶ Post-2001 liberalization: Alternative sources of cheap
funding.
▶ HH participation rates still low.
▶ Replacing FILF deposits with bank reserves at BoJ: BoJ
starts large scale asset purchases (2001)▶ BoJ starts YCC (2016).
▶ Domestic market segmented by large CIP deviations.
2 / 12

Consolidated Government▶ Consolidated Japanese General Gov’t Balance Sheet
1. Central Government,
2. Local Government,
3. Pension Funds.

3 / 12

Japanese General Gov’t Balance Sheet% of GDP, Year End
AssetsCurrency and Deposits
Domestic Loans
Other Domestic Securities
Domestic Equities
Foreign Securities
Sum
Liabilities
Loans
Bonds & T-Bills
Sum

1997

2023

5.7%
6.5%
5.7%
11.7%
6.8%
36.3%

18.7%
3.4%
14.1%
34.7%
56.1%
126.9%

25.2%
67.8%
93.0%

25.7%
201.1%
226.8%

4 / 12

Consolidated Japanese Government Balance Sheet

5 / 12

Japanese T-bill Purchases.

6 / 12

Bond Returns, Inflation and Growth; r > x

1997-2023
2000-20092010-20192020-2023

x
0.03%-0.33%
0.56%
0.75%

π
0.20%
-0.26%
0.48%
1.38%

r
1.30%
1.96%
1.41%
-1.85%

r−x
1.27%
2.29%
0.84%
-2.60%

Source: Bond Returns from BofA Ice Japan Government Bond Index Fund (excluding
T-bills)

7 / 12

International Equity and Bond Returns
CountryJP

ROW

ROW-JP

1997-2023
2000-20092010-20192020-2023

Nominal Equity Returns
5.4%
10.5%
5.2%
-2.4%
3.3%
5.6%
10.0% 12.5%
2.5%
12.1% 17.4%
5.4%

1997-2023
2000-20092010-20192020-2023

Nominal Bond Returns
1.6%
4.9%
3.2%
1.9%
7.3%
5.5%
2.0%
4.3%
2.3%
-1.5%
4.5%
6.0%

Source: Equity Returns computed using MSCI Equity Index for World ex Japan(ROW) and Japan. Quarterly Returns (annualized). Table reports returns on ROW
index in JPY. ROW Bond Returns computed using FTSE ex Japan Bond Index (BofA Ice
Japan Government Bond Index Fund).

8 / 12Foreign Investment▶ Why don’t Japanese financial intermediaries invest
abroad? they have to hedge currency risk.
▶ CIP deviations.
▶ Let St denote Yen per dollar.
▶ The Libor basis USD/Yen basis is defined as :$,LiborLibor
xt,t+n = rt,t+n − (rt,t+n − ρt,t+n ),where ρt,t+n = (1/n)(ftn − st ) denotes the forward
premium (in logs) obtained from the forward ftn and spotst .

9 / 12

LIBOR CIP Deviations$,Libor
Libor
The Libor USD/Yen basis: xt,t+n = rt,t+n − (rt,t+n − ρt,t+n ), wherenρt,t+n = (1/n)(ft − st ) denotes the forward premium (in logs) obtained fromthe forward ftn and spot st exchange rates.

10 / 12

Hedging Demand Pressure▶ Since the GFC, large negative bases have opened up in the
USD/Yen market and these bases have not decreased.
▶ Financial intermediaries in Japan have to intermediate
about 3× GDP in bank deposits, insurance and pensions.
▶ Financial intermediaries cannot replicate the government’s
strategy of foreign investments.
▶ When they invest abroad, the Japanese banks have tohedge at least part of the currency risk.
▶ To hedge the currency risk exposure, the banks will
demand synthetic dollars, creating upward pressure on thesynthetic USD LIBOR rate.
▶ This creates downward pressure on the basis.
$,LiborLibor
xt,t+n = rt,t+n − (rt,t+n − ρt,t+n ).

11 / 12CIP Deviations as Footprint of Financial Repression▶ Low interest rate currencies (of surplus countries) tend tohave more negative bases against the USD, as investors
seek higher returns abroad ( Du, Tepper and Verdelhan,2018) .
▶ connection with financial repression:▶ The BoJ’s Quantitative and Qualitative Monetary Easing(QQE) announcements, starting in 2014, as well as its moveto negative policy rates causes a widening of the USD/JPY
basis (Borio, McCauley, McGuire and Susho, 2016).
▶ As the BoJ further depresses the term premium in Japan,
this induces financial intermediaries to seek higher bondreturns abroad, thus causing the CIP basis to widen.

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