Over the past three decades, Japan’s monetary policy has been characterized by near-zero interest rates and significant quantitative easing, aimed at countering persistent deflation and stimulating economic growth. The outcome of decades of accommodative policies has resulted in the accumulation by the Bank of Japan (BOJ) of a balance sheet equivalent to 125 percent of Japan’s GDP—a ratio that surpasses that of any other major central bank. Japanese government bonds (JGBs) dominate the balance sheet, accounting for more than three-quarters of the total; more than half of Japan’s outstanding government debt is held on the BOJ’s balance sheet.
That extraordinary accumulation has created an acute vulnerability. As interest rates rise, the value of JGBs could plummet because of heightened inflation and duration risks (bonds with longer maturities decline more sharply as rates rise). Moreover, the yen, a liability of the BOJ, is inherently tied to the proportion of “hard” assets on the bank’s balance sheet. A significant selloff in JGBs could erode the yen’s value, triggering broader financial instability. In consequence, the dual vulnerability of JGBs and the yen to a protracted selloff could have significant repercussions for global markets.
At its Jan. 24 meeting, the BOJ elected to raise interest rates to 0.5 percent, the highest level in 17 years. The current move comes as the BOJ has struggled for decades to normalize interest rates. Previous attempts have been derailed by both the sensitivity of the Japanese economy and the financial system’s sensitivities to higher borrowing costs. Current inflation pressures may force the BOJ to continue raising rates, despite the rising balance sheet risk. Recent data show inflation expectations rising among Japanese households and businesses, and the yen’s purchasing power has begun to decline after decades of relative stability.
This shift could lead global investors to reassess their exposure to yen-denominated fixed-income assets, sparking a portfolio reallocation away from domestic bonds. Japanese banks, which hold a quarter of all non-BOJ-owned JGBs, may also become sellers if losses on their bond portfolios—many of which are designated as hold-to-maturity—become untenable. The recent failure of SVB Financial Group in the United States provides a cautionary tale of the risks associated with unhedged bond portfolios, especially when market losses become too large to ignore.
Sharp declines in both JGB prices and the yen are likely to have far-reaching consequences on a global scale. Historically, financial stresses in Japan have prompted risk-off flows, as investors sell foreign assets to repatriate capital, driving up the value of the yen. If confidence in the financial stability of Japan falters, capital outflows could exceed repatriation inflows, further weakening the yen and exacerbating disruptions.
If either of those were to occur, the BOJ would adopt emergency measures to stabilize the market: new, more aggressive rounds of quantitative easing, yield curve control, capital controls, and other interventions. But the central bank’s ability to respond to crises is constrained by an already bloated balance sheet. A worst-case scenario could conceivably see the BOJ purchasing a substantial percentage of the JGBs it doesn’t already own to suppress rising yields, which would leave the yen as the single remaining adjustment mechanism. That would likely lead to a sharp, possibly prolonged bout of currency depreciation.
If capital were to flee Japan, global bond yields–and in particular U.S. Treasury yields–could decline as risk-averse investors rush into safe havens. Gold and crypto would likely surge. Equity markets, meanwhile, are likely to face downward pressure as both Japanese and foreign investors reduce exposure to most risk assets. A substantially weaker yen would further strengthen currencies including the dollar, pound, and euro. That could lead to trade tensions especially if the suddenly strengthened dollar weakens or neutralizes the potency of tariffs. The island nation’s well-documented susceptibility to earthquakes and tsunamis could also contribute to the unfolding of risks outlined here.
This is not a forecast, but a scenario that bears close monitoring. Japan’s current monetary dynamics reflect a precarious balance of inflationary pressures, rising interest rates, and a massively encumbered central bank balance sheet. Decades of the BOJ’s playing an outsized role in its government securities markets alongside deteriorating liquidity and growing risks associated with its balance sheet have generated the possibility for a destabilizing financial crisis. In addition to indirect risks posed to the United States, Japan’s increasingly precarious economic circumstances serve as a cautionary tale for U.S. policymakers leaning increasingly on central bank interventions.
