Japanese Rates and Sub Prime Crisis

Japanese Rates and Sub Prime Crisis

In a bid to keep its economy chugging after the great real-estate-and-stock-market boom and bust of the late 80s, Japan kept lowering its interest rates.

This continued until 1997, when rates hit rock bottom at 0.25%, and could not be lowered any more. The low Yen favored Japan-based exporters, which was OK from Japan’s point of view, given that their domestic economy was so well developed that it could no longer be a growth engine for Japanese companies.

However, Wall Street did not fully realize the potential for arbitrage (more commonly called Yen-carry trade) until around January 2006.

This presentation titled “The Broad Yen Carry Trade” (url: http://www.princeton.edu/~hsshin/www/yenliquidityslides.pdf) discusses how the Yen-carry trade affected the Western financial markets. The slide on page 5 titled “Interbank Liabilities of Foreign Banks in Japan” shows how borrowings by foreign banks really picked up around the beginning of 2006.

The Yen-carry trade made possible the low mortgage rates in the US. This is important when you consider that the sub-prime crisis started in full earnest in March 2007, just succeeding February 22 when the Bank of Japan raised its interest rates from 0.25% to 0.50%.

This is, of course, not to suggest that BoJ deliberately or consciously caused the crisis. However, circumstances do suggest that the rate hike caused problems in the sub-prime sector to become a full blown crisis – by removing liquidity at a time when it became crucial to sustain the sector.