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And because of this persistent trade surplus, Japan has built up a large portfolio of foreign currencies.These foreign currencies are then invested in foreign assets (e.g., U. Treasuries) earning Japan a steady stream of income.Why aren’t investors demanding higher rates of return? The answers to these questions have proven so elusive over the years that I figure it’s time to try to get to the heart of the matter.
Because this portfolio is large, Japan — as a country — regularly earns more income on its foreign currency holdings than they pay out to foreign investors.
In combination, the trade surplus and the income surplus brings new money into corporate Japan.
Corporate Japan places that money into the banking system, which then gets levered up and dramatically expands its purchasing power.
Then the banks, life insurance companies, and pension funds turn around and buy lots of JGBs (accompanied with much pressure/regulation by the Bank of Japan).
Here’s how it works: on the trade side, Japan exports more than it imports bringing more capital into Japan than leaving.
Japan has maintained a trade surplus for about 30 years.While this monetization of debt creates inflationary pressures, it has thus far been offset by the deflationary pressures of a declining workforce and declining population.There are short-term fluctuations from year to year, but it is clear when looking at averages decade by decade that funding pressures in Japan have been growing over time.As you can see in Table 1, this is the answer to the original question.This cash flow cycle is how Japan has funded itself over the past 22 years. The Japanese debt crisis is being spawned by a burgeoning fiscal deficit.Therefore, Japan’s ability to finance its federal government will be determined by the health of its GDP growth (which grows tax revenues, all else equal), its ability to grow federal tax revenues, its ability to control its budget, its ability and willingness to use its substantial foreign exchange reserves, and perhaps most importantly, its ability to continue selling bonds to the public.The secret of Japan’s ability to finance itself over the past 22 years is that it has used its current account surplus to create a closed loop — more money flows into Japan than flows out, and that net inflow is largely invested in JGBs (Japanese government bonds).By mid-1986, the rising yen had forced Japan into a recession (because the stronger yen harmed the country’s exports).As illustrated by the dotted line in Figure 1, the Bank of Japan (BOJ) responded by reducing the official discount rate five times between January 1986 and February 1987, leaving it finally at 2.5% — which remained in effect until May 1989.But when GDP stops growing and exports slow, the model fails.The point of failure for Japan was when its easy monetary policy stimulated a real estate and stock market bubble instead of fueling exports.