Japan and the World Interest Rate
By Arnold Kling
In Rudi Dornbusch’s international macro course, there was something called the world interest rate. If the interest rate in dollars is 5 percent, and the interest rate in yen is 2 percent, then to have a world interest rate the dollar has to be expected to decline at a 3 percent rate.
In the short run, the world interest rate can be locked in via what is known as covered interest parity. For example, suppose that the three-month interest rate in U.S. dollars is 2 percent, and the three-month interest rate in Japanese yen is 1 percent. If you borrow in yen and lend in dollars, your only risk is currency risk–if the dollar depreciates at a rate of more than 1 percent, then when you get back your dollars in three months and pay back in yen, you would actually lose money.
You can cover your currency risk by buying three-month yen futures and selling three-month dollar futures. To eliminate arbitrage opportunities, the three-month forward exchange rate has to incorporate (in this example) an expected decline of 1 percent in the value of the dollar. That is covered interest parity.
When we are talking about ten-year interest rates, there is no depth to the forward market in foreign exchange. So if there is a world interest rate, it rests on uncovered interest parity. So, right now ten-year Japanese government bonds yield less than 1.5 percent, while ten-year U.S. government bonds yield close to 4 percent, for a difference of 2.5 percentage points (money managers multiply by one hundred to call this 250 basis points). If there is a world interest rate, then investors expect the dollar to decline by 2.5 percent per year for 10 years, for a total decline of 25 percent.
I suspect that in fact there is not a world interest rate. I suspect that Japanese savers are willing to accept a lower rate of return on Japanese government bonds than on U.S. government bonds. I suspect that it is difficult for the private sector to try to arbitrage against this–the private sector cannot borrow and lend at government rates, the private sector pays a substantial premium to borrow for ten years, and the private sector cannot engage in ten-year forward foreign exchange contracts in any depth.
This all relates to the issue of Japan’s huge government debt. Under my suspicion, the willingness of Japanese savers to forego the returns that they could earn elsewhere is what is keeping the Japanese government going.
(Alternatively, if there is a world interest rate that is higher than the Japanese interest rate, then Japanese savers are earning it, and the Japanese government is paying it. That is, when Japanese savers are paid back, they will be paid back in yen that have appreciated strongly relative to the dollar, and the government will have to pay back in a currency that has appreciated relative to the dollar–not that the government should have a problem with that.)
I suspect that Japanese private firms pay something closer to the world interest rate. That is, private firms do not enjoy the benefits of the prodigious savings propensities of Japanese consumers. My guess is that new businesses in Japan are relatively starved for capital, and that helps account for a lack of dynamism and low rate of growth there. But those are just guesses.