It is important to remember that Japan’s central government has typically run very large deficits, mostly driven by a secular increase in social security spending as a result of Japan’s ageing population. Some economists have argued that governments may be able to run deficits indefinitely provided that the real growth rate of their economy always exceeds the real return on government debt. In spite of its low interest rates, Japan is not in the fiscal Goldilocks position. In fact, since 1997, the real return on Japanese government debt has exceeded the growth rate by 1.2%. By consolidating the government with the Bank of Japan, we can see that Japan’s government has engineered a sizable duration mismatch on its consolidated balance sheet. The government borrows from Japanese households through the banking sector mostly at floating rates and then invests in longer duration, risky assets to harvest risk premia, leading to a duration mismatch on the government balance sheet.
As a result of this mismatch, the government’s fiscal space expands significantly as real rates decline. All else equal, the government can increase spending as rates decline, but a typical household will have to cut spending because it does not have enough duration in its portfolio. Conversely, when rates increase, the Japanese government’s spending fiscal capacity is quickly eroded.
Now to manage this fiscal challenge, you are seeing public pension funds take on larger quantities of unhedged duration risk and currency risk. For those who are not aware, the government implements a sizable carry trade, and it earns high realised asset returns while its borrowing rate declines! They have managed to realise an ex post excess return of about 2.3% per annum above its funding cost by going long in long-duration risky assets, financed with mostly short duration funding in the form of bank reserves, T-bills, and bonds. This “risky” investment strategy has allowed the government to earn more than 3% of GDP from its risky investments.
First, we can discuss the interest rate risk exposure on the government balance sheet. With this mismatch and the engagement of risky maturity transformation on a large scale by borrowing floating rates and investing in long-duration assets, just go back to the end of 2021, when liabilities were three times GDP. Almost half have no duration: 101% GDP in reserves held at BoJ, another 23% GDP cash. QE has added a floating-for-fixed interest rate swap of 1 GDP to the balance sheet, further shortening the duration of Japanese liabilities. Now to be fully hedged against rates, the duration of its net debt would have to equal the duration of its primary surplus. Think of the government issuing zero coupon bonds that match the expected surpluses period by period. Instead, the duration of its debt is shortened, as a result of QE, and further reinforced by its long position in high-duration risky assets. As a result of this duration mismatch on its consolidated balance sheet, a decrease in real rates creates extra fiscal capacity because its net debt position has negative duration, but its future surpluses have long duration.