Until recently the Japanese yen was a safe haven currency. When shocks like Brexit hit the global market, Japanese investors — the apocryphal Mrs Watanabe retail investors — brought their savings back to Japan. When there was global uncertainty, the yen strengthened, making Japanese exports less competitive. That was despite three decades of low economic growth and structural headwinds like a shrinking and ageing population. 

The yen is now the weakest it’s been against the US dollar since 1990. Even tourists from developing Asia find Japan a cheap destination and attracting foreign workers from Southeast Asia is harder as the purchasing power of their remittances has declined.   

Japanese capital flows are huge. Japan has been the world’s largest creditor for the past three decades and at the end of 2022 had external assets of 1.34 quadrillion yen (US$8.7 trillion). The net balance of external assets exceeded foreign assets held within Japan by 418.6 trillion yen (US$2.731 trillion).

What changed after the COVID pandemic was that inflation returned to much of the world and central banks, with the exception of the Bank of Japan, responded by lifting interest rates. The US Federal Reserve steadily lifted rates from 0.15 per cent in early 2022 to 5.4 per cent in July 2023, where it’s been hovering since. The European Central Bank went from 0 per cent in July 2022 to 4.5 per cent where it’s been since September 2023. 

The Bank of Japan, central bank of what was then the world’s third-largest economy, held interest rates sub-zero at -0.1 per cent until March 2024. It bet that the inflation from the pent-up demand, once people were out shopping and buying things again, and the constraints of global supplies because of Russia’s invasion of Ukraine, were transitory, or temporary. 

Japanese inflation peaked at 4.3 per cent in January 2023. 

Wages were not rising in Japan and there was no sign that inflationary expectations had significantly changed from the very low inflation and deflation the Japanese population had gotten used to for close to two decades. There was also the problem of the cost of servicing the record government debt at 263 per cent of GDP if interest rates were lifted. 

With low and stable interest rates domestically and rising rates abroad, Japanese capital earns higher returns in the United States where the interest rates are higher. So the Mrs Watanabes sold their yen to buy US dollars to invest abroad and the yen has weakened. The Bank of Japan’s decision to exit negative interest rates and lift rates for the first time in 17 years to between zero and 0.1 per cent has done nothing to change that, yet. 

Last month’s BoJ policy change of Governor Ueda signals a bigger shift in policy than just the 10 basis point increase so far.

As Masahiko Takeda writes in this week’s lead article, ‘After two decades of wishing to create inflation, the BoJ finally signalled that it might need to control it.’

With growing labour shortages, wages are rising in Japan and a healthy level of price inflation looks set to continue. The BoJ has also announced the end of yield curve control on bonds (targeting longer term interest rates) as well as the purchase of exchange-traded funds (ETFs), a key element of quantitative and qualitative easing (QQE). The Bank had been pushing more money into the economy by buying US$475 billion worth of shares through ETFs and had become a major non-voting shareholder in many of Japan’s largest corporations. 

The Japanese stock market is surging with the Nikkei 225 index recently surpassing its peak at the height of the 1989 bubble economy. The days of ultra-cheap money and BoJ ETF purchases are coming to an end but the Japanese corporate sector is strong with record cheap-yen fuelled profits, huge cash reserves and expanding investment abroad. 

Yet Japan is in a technical recession (with two consecutive quarters of negative growth). Combined with the weak yen, this has resulted in Germany — itself the sick man of continental Europe — overtaking Japan this year to become the world’s third-largest economy. 

Looking beyond this headline, what’s happening in the Japanese economy?

Japan’s GDP in yen has been growing slowly but in US dollars has taken a big hit because of the weakening yen. With a shrinking population, even a stagnant GDP means that per capita incomes are still growing. If inflation remains positive and interest rates continue to rise, the yen is likely to eventually strengthen. Living standards in Japan haven’t fallen, though they have relative to the rest of the world. 

The challenge for policymakers will be to grow living standards at the rate of the rest of the advanced world. GDP growth is not a relevant target. GDP per capita is more relevant as a single indicator of Japanese welfare though even that fails to capture the safety, longevity and wellbeing of people in Japan. 

There are certainly major challenges on the horizon — as Takeda points out, a credible fiscal strategy is needed now that the cost of government debt is no longer zero — but there are opportunities, too, if policymakers are ambitious enough to grasp them.

What seem to be contradictions in the Japanese economy — stagnation, per capita income growth, a weak yen and strong corporate sector — point more to a mature economy managing a massive demographic transition, an uncertain external environment and finding some kind of new normal economic prosperity. 

The EAF Editorial Board is located in the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University.