The coming financial contagion

A global recession without a financial crisis means a decent chance that the coming economic downturn will be milder than expected.

Japan, where the central bank has kept interest rates at zero or negative for decades, might be the world’s most acutely vulnerable country. In addition to ultra-low rates, the Bank of Japan has also engaged in yield curve control, capping five-year and 10-year bonds at around zero. Given the increase in real interest rates around the world, the yen’s sharp depreciation, and high inflationary pressures, Japan may finally exit its near-zero era.

Higher interest rates would immediately put pressure on the Japanese government, as the country’s debt amounts to 260 percent of GDP. If one were to integrate the BoJ’s balance sheet, roughly half the government debt bought by the private sector is effectively in short-maturity bonds.

A 2 percent interest-rate increase would be manageable in a high-growth environment, but Japan’s growth prospects will most likely decline as long-term real interest rates continue to rise.

Japan’s enormous government debt almost certainly constrains policymakers’ options for managing long-term growth. Still, given the government’s taxation powers and the possibility of inflating away the debt, the problem should be manageable.

The real question is whether there are hidden vulnerabilities in the financial sector that could be unearthed if inflation continues creeping up and Japan’s real interest rates…