Japan's Economic Pivot: Implications for Global Markets and Carry Trade
Following the recent market selloff, global equities are beginning to show signs of recovery. On Tuesday, US markets closed up by nearly 1%, while the Nifty rose by approximately 1.3% today, and the mid-cap index surged by over 2%. This rebound can be partially attributed to the Japanese government's announcement of a more measured approach to raising interest rates.
In response to the crash in Japanese markets, which saw the Nikkei plummet by more than 12% on Monday (its worst single-day loss since 1987), Japanese officials have signaled a more cautious stance on further rate hikes. The Bank of Japan stated that the central bank would not increase interest rates when financial markets are unstable. On Monday, financial and export stocks in Japan were particularly impacted - institutions that enable lending for carry-trade were affected, while exporters were affected due to a stronger yen. However, following this change in stance, the Nikkei rebounded, reversing these losses and recovering most of its losses from Monday.
A reduction in carry trade positions can potentially pull value out of major global markets, including India.
The concept of carry trade has played a significant role in these market movements. Carry trade involves borrowing in a low-interest currency (like the Japanese yen) and investing in higher-yielding assets elsewhere, such as US and Indian equity markets. A reduction in carry trade positions can potentially pull value out of major global markets, including India. Over the years, carry trade has become attractive even for retail investors in Japan, with the government deliberately encouraging this strategy. While the exact quantum of global carry trade positions from Japan is unknown, many believe it runs into trillions of dollars.
Despite its ultra-loose monetary policy, Japan has been adeptly managing the quality of life of its citizens. The country's PPP-adjusted Gross National Income (GNI) has grown steadily over the past 12 years, since the zero-interest rate regime began. For instance, it increased from $4.9 trillion in 2012 to $6.5 trillion in 2023, representing a 33% growth. This growth occurred even as the yen weakened considerably against the dollar, falling from around 80 yen per dollar in 2012 to recent levels of 160 yen per dollar, which has reversed a bit to 140-levels after last month's first rate hike.
Interestingly, Japan's population has been decreasing during this period, peaking at 128 million in 2008 and declining to about 125 million at present. The country is also grappling with an aging population, with the median age increasing from approximately 43 in 2008 to 50 at present. Despite this demographic challenge, the improvements in GNI-PPP have been significant, indicating substantial quality of life enhancements for the Japanese people.
This shift in Japan's economic strategy is a crucial factor to watch in the coming years, as it could offset some of the equity market gains expected during the current global interest rate downcycle, including in the Indian markets.
However, Japan's GDP has stagnated during this period, declining from $6.2 trillion in 2012 to $4.2 trillion in 2023. In response, the Japanese government has initiated measures to boost domestic growth by gradually discouraging carry trade strategies and encouraging local investment. These efforts have begun to impact inflation rates, reversing Japan's long-term deflationary state. In 2022, Japan's inflation rate reached 2% levels, aligning with other developed countries.
The next logical step is for Japan to further increase interest rates to 1% and beyond, aligning more with global standards. As the yen strengthens and global interest rates (in other countries) decrease in parallel, arbitrage opportunities will diminish and further reduce the attractiveness of carry trade.
This shift in Japan's economic strategy is a crucial factor to watch in the coming years, as it could offset some of the equity market gains expected during the current global interest rate downcycle, including in the Indian markets. The situation underscores the importance of international coordination to ensure that the effects of this withdrawal are smoothened out over time.