Chapter 10. Japan’s Role in the Global Economy and Spillover Effects of Abenomics

Dennis Botman, Stephan Danninger, and Jerald Schiff
Published Date:
March 2015
  • ShareShare

Related Material

Show Summary Details
Dennis Botman and Joong Shik Kang 

The previous chapters have shown that successful Abenomics could help Japan achieve higher growth, lower government debt, and stronger financial sector stability. But what would be the implications of this for key trading partners and the rest of the world? Abenomics can affect other countries through higher import demand if growth increases, through competitiveness changes following exchange rate moves, through capital flows amid portfolio rebalancing in light of the quantitative and qualitative monetary easing framework, and by affecting global risk sentiment in case the policy package is incomplete.

Concerns at the start of Abenomics, especially in Asia, focused on potential spillovers on trade and capital flows. Specifically, trading partners worried that the depreciation of the yen would lower their price competitiveness, while capital inflows from Japan could create additional exchange rate pressure. These did not materialize in the first two years of Abenomics, showing that the domestic private sector response was not fully forthcoming.

In this chapter, we summarize special features of Japan’s integration with the global economy and discuss how these will affect the potential spillover effects of Abenomics, including:

  • Outsourcing production. Japan’s overseas production increased steadily since the asset bubble burst. Labor cost differentials (vertical integration) and the host country’s market size (to tap into local demand) have been important determinants of Japan’s outward foreign direct investment (FDI). As a result, sales by overseas subsidiaries now exceed exports by firms in Japan. This phenomenon matters for possible spillover effects as the response of exports to changes in the yen may be more tempered than used to be the case in the past.

  • High-tech inputs in the global supply chain. Although firms based in Japan have lost some of their global market share, partly owing to the rising role of emerging market economies and increased overseas production, Japan still remains an important player in global trade by providing high-tech inputs to the Asian and global supply chain. These supply-chain linkages matter for potential spillover effects from Abenomics as they tend to mute the effects of exchange rate changes on competitiveness.

  • Rising cross-border credit exposures. Japan’s households are prolific savers, funding not only most of the government’s very large financing requirements (see Chapters 5 and 8), but also a stream of capital to the rest of the world, as evidenced by the country being the largest international creditor. Banks and major life insurers have actively started to expand abroad again after the global financial crisis. The factors that have driven these cross-border activities include limited domestic opportunities, a capacity to take on more foreign exposures, large financing needs in emerging Asia, and the deleveraging of European banks. Despite greater opportunities at home, as noted in Chapter 8, this trend is likely to continue under Abenomics, creating a source of benign spillover effects (Lam 2013).

  • Safe-haven effects. Japan is a major safe haven. When risk-off episodes occur, policymakers in safe-haven countries may have to deal with sharp real appreciations or surges in capital flows.1 Transitory real appreciation may create hefty adjustment costs to the economy and, subsequently, economic dislocation when exchange rates eventually revert back. These safe-haven effects arise in Japan without noticeable changes in capital flows. Instead they transpire through complex financial transactions such as derivatives positions. Persistently low interest rates and historically low volatility made the yen a favored funding currency for carry trades and rendered it a significant driver of cross-currency positioning. These considerations matter for evaluating the depreciation of the yen that has occurred so far during Abenomics, and the inward spillovers to Japan from global economic conditions and the resulting spillbacks to other countries.

Next, we discuss how these factors have contributed to relatively mild spillover effects in the first two years of Abenomics notwithstanding the sharp depreciation of the yen. Japan’s exports have been subdued, imports have been relatively strong, and portfolio rebalancing by financial institutions toward foreign assets has been more than offset by greater inflows by foreign investors into Japan. However, several factors behind these slow responses are expected to wane, suggesting the possibility of greater spillover effects going forward. At the same time, the global context has also changed. With the beginning of the Federal Reserve’s tapering, neighboring countries have experienced tightening financing conditions, leading them to be less concerned about possible capital inflows from Japan.

We then assess the future potential spillover effects from Abenomics. First, we discuss potential effects based on the IMF’s G20MOD model.2 The simulations suggest that, if all three arrows of Abenomics are successfully deployed and succeed in raising growth and inflation and bringing down public debt, spillover effects to the Group of Twenty economies are positive, albeit small (about 0–0.1 percent of GDP) in the short term, before rising over the medium term once the effects of structural reforms translate into higher growth in Japan. Second, we argue that, in practice, overall spillover effects as well as the impact on individual countries would be more complex because of the unique features already mentioned that are not fully captured in general equilibrium models. Finally, we discuss how Abenomics may affect the probability of a medium-term tail risk. Specifically, the combination of high government debt and large net foreign assets implies that the materialization of fiscal risks and tail events could have important spillovers on other countries if heightened risk aversion in Japan spreads progressively to bond and stock markets in other economies. Insofar as Abenomics succeeds in putting the debt path on a downward trajectory over the medium term (Chapter 5) and thus enhances financial sector stability (Chapter 8), these potential adverse spillover effects might be prevented.

Unique Features of Japan’s Global Role

Firms’ Overseas Production

Intraregional trade has expanded rapidly since 1990, largely owing to dynamic economies such as China. Nonetheless, Japan’s intraregional exports as a share of global GDP have remained remarkably stable—even during the global financial crisis—and account for more than two-thirds of industrial countries’ intraregional trade. Japan’s deepening regional integration has largely been driven by the outsourcing of production by Japanese firms to neighboring countries, especially China, Hong Kong SAR, and Singapore. This integration affects the interpretation of changes in Japan’s export structure. Its increased outsourcing and upstream position has facilitated the shift in technology content to other Asian countries, adding to the apparent convergence in export structures. Rising similarity could thus reflect increased complementarities, as well as competition.

Japan’s stock of outward FDI is concentrated mainly in the United States, followed closely by Asia, reflecting the increased presence of Japanese corporations in the region. The euro area has continued to attract around one-fourth of Japan’s outward FDI. IMF (2011) models its outward FDI flows by employing a gravity-model framework. The analysis suggests that labor cost differentials—vertical integration—have been a main driver of FDI. Host- country market size has recently become another important determinant of outward FDI. This is also consistent with the expansion of the country’s multinational operations, especially in Asia, to tap into local demand. Originally, Japan’s outward FDI complemented its trade pattern (for example, exporting parts and capital goods to factories and subsidiaries financed by FDI). But since 2000 it has become increasingly aimed at servicing local markets, substituting for its exports (Figure 10.1).

Figure 10.1Exports versus Sales of Overseas Subsidiaries

(Trillion Yen)

Sources: Japan Ministry of Economy, Trade and Industry; and IMF staff estimates.

Supply Chain

The importance of supply-chain linkages, both domestically and in relation to other countries, came to the fore during the March 11, 2011 earthquake, which struck a wide area in the northeast, including Tokyo.3

Assessing the economic ramifications was highly difficult, partly because of uncertainty about the duration of widespread electricity shortages and increasing uncertainty about global economic conditions in light of the escalating euro area crisis. Supply-chain factors also complicated this assessment. Just-in-time production, in combination with more extensive supply chains, created additional uncertainty about supply disruptions and their transmission to other sectors and regions in Japan as well as internationally. Japan is a key source of demand for final goods and an important producer of intermediate components and capital goods in the regional supply chain, especially in electronics. The earthquake highlighted the fragility of tightly integrated global production networks.

The country’s contribution to “foreign value added” is especially high in economies engaged in assembly or processing activities, such as Taiwan Province of China, Thailand, and China, particularly for high-tech exports, such as electronic equipment and motor vehicles. Nonetheless, Japanese exports have the lowest share of foreign value added in the region, underscoring the country’s upstream position in the regional production chain (IMF 2011). For example, it accounts for one-fifth of the world’s semiconductor production and in the machinery and reactors sector it accounts for more than a third of global exports of machinery and wafers, providing more than 50 and 35 percent of U.S. and Chinese imports, respectively. As Japan has increased the sophistication of its export basket, it maintains a lead in specialized core components. This has enabled it to maintain a bilateral trade surplus with most countries in Asia and capture a significant share of value added in other Asian countries’ exports. For example, Japanese companies account for about 10 percent of value added in Chinese exports of electrical equipment.

With the vertical integration of global production processing, a significant amount of imported intermediate inputs are embodied in final exports, mitigating the impact of currency movements on export prices and limiting the deterioration of price competitiveness of neighboring countries in response to yen depreciation (Figure 10.2). This also affects price competitiveness in third markets compared to competitors who rely less on Japan for intermediate inputs. The substitution of intermediate inputs for Japanese inputs in trading partners would further mitigate the negative effects from currency appreciation, but at the cost of lower domestic production (IMF 2013).

Figure 10.2Import Content from Japan for Gross Exports


Source: IMF staff estimates.

Global Financial Role

Because of its large external surpluses, Japan has accumulated one of the world’s largest net foreign asset positions. The approximately $3.3 trillion net international investment position at the end of 2013 reflects both official reserves (mostly held in the form of U.S. Treasury securities) and a large net private position in bonds. The private position (more than 80 percent of the net international investment position) primarily consists of the outward investments of banks, life insurers, and corporate pension funds in U.S. Treasuries and both U.S. dollar and yen-denominated corporate bonds.

In terms of financial linkages, the expansion of Japanese financial institutions abroad in the 1980s and 1990s was partly successful (Lam 2013). During the mid to late 1980s, these institutions rapidly raised overseas exposures in tandem with the outward FDI of real estate and construction companies, though that ended abruptly with losses incurred after the domestic asset bubble burst. Subsequently, in the years leading up to the Asian financial crisis (1997–98), banks funded overseas loans to developing Asia mostly through foreign exchange financing. Banks incurred sizable valuation losses and higher nonperforming loans after the Asian financial crisis, forcing them to recede from overseas lending. Losses abroad added to financial vulnerabilities at home (for example, credit risks in small and medium-sized enterprises and declining interest rates), and contributed to Japan’s subsequent banking crises in the early 2000s.

As noted in Lam (2013), the cross-border activities of Japanese financial institutions have risen again over the past few years, particularly to Asia. Overseas loans by major banks are growing and major Japanese banks have attained an important global and regional presence, particularly in the areas of syndicated lending and project finance. Foreign claims on Asia have recouped the decline at the height of the global financial crisis. As noted in Chapter 8, several regional and domestic factors have contributed to overseas expansions since the crisis. Stagnant growth and limited domestic credit demand have added incentives for financial institutions to seek opportunities abroad. Modest global uncertainty, large growth differentials, and the resilience of domestic banking systems are key drivers for cross-border claims. Outside Japan, growth in Asia and deleveraging of European banks in the region contributed to a rise of cross-border lending. The yen’s appreciation in the past years might have added incentives for expanding abroad.

The trend of expanding abroad is not limited to banks. Major life insurers have begun to strengthen their overseas business, especially in Asia, by acquiring or affiliating with local insurers for long-term profitability. They usually expand via incremental capital and building alliances typically involve minority stakes rather than aggressive acquisitions.

Japan’s debt and equity markets are among the top five international markets in size, but are primarily geared toward domestic investors. Foreign investors hold less than 5 percent of Japanese government bonds (JGBs), of which about one-fifth are in Asia. By comparison, more than 30 percent of U.S. Treasuries and about 55 percent of German bunds are held abroad. However, foreign investors account for about 15 percent of the cash turnover in JGBs and 65 percent of futures markets transactions. Participation in the equity market is larger, with one-fourth of market capitalization held abroad, but less than one-half of a percent accounted for by investors in Asia.

Given its domestic focus, Tokyo as a financial marketplace is not a major intermediary of global capital flows. Foreign issuance of equity and debt in Japan has been negligible in recent years, and bonds placed by Japanese issuers abroad amount to only 1½ percent of global outstanding cross-border debt securities. At 14 percent of GDP, the sum of gross capital inflows and outflows in Japan’s balance of payments—a crude measure of financial market turnover—is considerably smaller than in other systemic economies.

Safe-Haven and Carry-Trade Effects

The yen remains an important global currency, although its share in global reserve holdings has declined in the past decade. Yen holdings currently account for 2 percent of reported foreign exchange reserves as measured by turnover. The foreign exchange market in Tokyo remains the third largest in the world, albeit well behind London and New York. In recent years, the yen has not only been a funding currency for foreign-exchange carry trades but a preferred investment currency during global turmoil. This has contributed at times to relatively abrupt currency movements in response to shifts in sentiment.

As such, the yen is widely considered a safe-haven currency, which appreciates when global investors’ behavior becomes more risk-averse or economic fundamentals are more uncertain. Since 2008, the yen appreciated steadily against the U.S. dollar in effective terms in the aftermath of various shocks. First, the global financial crisis was associated with a large real exchange rate appreciation by over 20 percent. Second, in May 2010, higher market distress about peripheral European sovereigns led to a large jump in the VIX (a volatility index), followed by a 10 percent yen appreciation against the euro within a matter of weeks. Third, following the March 2011 earthquake, the yen appreciated further on expectations of sizable repatriation of foreign assets by insurance companies, which in fact did not occur. Fourth, on February 25, 2013, uncertainty surrounding the outcome of the Italian elections led to a whopping intraday appreciation of the yen against the euro of 5¼ percent and about 4 percent against the U.S. dollar. These examples illustrate that appreciation of the yen during episodes of increased global risk aversion is recurrent. Indeed, since the mid-1990s, there have been 12 episodes during which the yen has appreciated in nominal effective terms by 6 percent or more within one quarter and these often coincided with events outside Japan.4

Safe-haven currencies tend to have low interest rates, a strong net foreign asset position, and deep and liquid financial markets. Japan meets all these criteria. After controlling for the carry trade, Habib and Stracca (2012) find that safe-haven status is robustly associated with stronger net foreign asset positions (an indicator of external vulnerability) and, to a lesser extent, with the absolute size of the stock market (an indicator of market size and financial development). For advanced economies, in addition to the net financial asset position, the public debt-to-GDP ratio and some measures of financial development and the liquidity of foreign exchange markets (measured by the bid-ask spread) are associated with safe-haven status.

Although being a safe-haven country may appear enviable when risk-off episodes recur, policymakers in safe-haven countries face the challenge of dealing with sharp real appreciations or surges in capital flows. Transitory real appreciation may create hefty adjustment costs to the economy, and subsequently, economic dislocation when exchange rates eventually revert back (for example, Bussière, Lopez, and Tille 2013). The longer lasting the real appreciation and surge in capital flows, the greater the potential for vulnerabilities to build up in either private or public sector balance sheets.5 Moreover, in economies with already low inflation and interest rates close to the zero bound, real appreciations driven by risk-off episodes could feed deflation risks and place downward pressures on aggregate demand (IMF 2012a, de Carvalho Filho 2013).

Although the yen’s safe-haven status has been well documented (for example, Ranaldo and Söderlind 2010, de Bock and de Carvalho Filho 2013), the mechanisms through which risk-off appreciations occur have received considerably less attention. In this regard, a casual glance at the data reveals a curious feature: large movements in the yen during risk-off episodes occur without any detectable movements in net capital in- or outflows. A similar observation holds for the large depreciation that has occurred since late 2012, which coincided with the emergence of Abenomics as well as waning safe-haven effects and widening trade deficits. As such, a forensic investigation of what drives large movements in the yen fills a void in the literature, with potential important implications for spillover analysis and the role of macroeconomic policies to address excessive exchange rate volatility.

Botman, de Carvalho Filho, and Lam (2013) use the risk-off indicator proposed by de Bock and de Carvalho Filho (2013), which identifies the onset of risk-off episodes with large increases in the VIX relative to its 60-day historical moving average.6Botman, de Carvalho Filho, and Lam (2013) find that safe-haven effects in Japan work differently than in other countries. Specifically and in contrast to the experience of the Swiss franc, there is little evidence that yen risk-off appreciations are driven by capital inflows. Neither do expectations about the relative stance of monetary policies appear to be an important factor. Instead, the authors present supporting evidence that portfolio rebalancing through offshore derivative transactions appears to be a key factor behind risk-off appreciations (Figure 10.3). This could possibly reflect self-fulfilling expectations of currency appreciation. In addition, risk-off appreciations could be driven by transactions between residents or among nonresidents. Alternatively, portfolio rebalancing could be achieved with little or no transaction as prices adjust to changes in beliefs that are common to market participants.

Figure 10.3Chicago Mercantile Exchange Yen Trading Position

Source: Bloomberg, L.P.

Prior to the global financial crisis, persistently low interest rates and historically low volatility made the yen a favored funding currency for carry trades. Moreover, the strong appetite for risk that characterized 2003–07 led to a steady buildup in these positions, and rendered the carry trade a significant driver of cross-currency positioning.7

Quantifying the size and destination of these positions is challenging as the range of instruments has grown over the years, including complex off balance sheet transactions that are less easily detected in balance of payments and capital-flow statistics. The trade has also come to encompass a range of different investor classes, from Japanese retail investors (so-called Mrs. Watanabe) to more sophisticated global brokerage houses and hedge funds. In 2007, near the peak, estimates of the yen-funded carry trade ranged from $100 billion to $2 trillion. IMF (2011) estimates the sensitivity of the carry trade to fundamentals following the methodology of Hattori and Shin (2009), using the net interoffice assets of foreign banks operating in Japan as an indicator of the scale of the yen-funded carry trade. These net interoffice assets are then modeled as a function of international policy-rate differentials (yen versus average of the Australian dollar, U.S. dollar, and euro) and the VIX. The results suggest that an average widening of the interest differential by about 220 basis points would prompt an increase in the carry trade of about ¥4.3 trillion.

Spillover Effects from Abenomics

Trade and Financial Spillovers during Abenomics’ First Year

Contrary to initial concerns, spillover effects through trade from the sharp depreciation of the yen were not substantial during Abenomics’ first year. Real export growth has been subdued, while that of trading partners has remained robust, including to Japan. These features of Japan’s role in the global economy have an important bearing on spillover effects seen so far.

Specifically, during previous episodes of depreciations by more than 20 percent, it took about six to eight quarters for the trade balance to improve, with both exports recovering and imports moderating (Figure 10.4). These J-curve effects appeared to have been more drawn out this time considering the faster pace of yen depreciation, which could reflect capacity constraints caused by rush demand ahead of the consumption tax hike as well as the need for exporters to replenish profit buffers following years of yen strength during the postcrisis period. Furthermore, as noted, firms have increasingly relied on overseas production as a substitute for exports and supply chain interactions have muted the effect of yen depreciation on competitiveness. Elevated import demand for mineral fuels has also contributed to the weaker trade balance after all nuclear power plants were closed after the earthquake in March 2011.

Figure 10.4Sharp Yen Depreciations and the Trade Balance

(Percentage points of GDP)

Source: IMF staff estimates.

Likewise, despite the sharp yen depreciation and creation of liquidity, capital outflows from Japan have so far been limited. Weekly portfolio flows show that foreign investors continued to pour into Japanese equity markets (cumulative about ¥18 trillion from November 2012 to the end of 2013), more than offsetting net sales of domestic bonds and notes (cumulative about ¥4.4 trillion) during the same period. Domestic investors scaled down foreign bond holdings significantly during the first half of 2013 (cumulative about ¥11.2 trillion) before net purchases rose again in the second half (cumulative about ¥8.7 trillion). They sold foreign equities steadily from November 2012 throughout 2013 (cumulative about ¥6.8 trillion). Net assets held in the retail investment trusts (toshin funds)—particularly on equity funds—increased in early 2013 after net declines in 2012. The increase, however, was mostly driven by valuation effects rather than increasing outflows.

Potential Spillover Effects over the Medium Term: A Model-Based Evaluation

Spillovers from Abenomics are complex and conditional on the new macroeconomic policies being fully completed (the three arrows). Spillover channels of a successful effort to revitalize the Japanese economy are likely to operate through the exchange rate, higher growth in Japan, and financial interlinkages. IMF (2013) use the IMF’s G20MOD for illustrative simulations and considers each arrow of Abenomics in separate scenarios to quantify their contribution to key macroeconomic indicators and spillover effects. As such, it is similar in spirit to the analysis in Chapter 3 on the domestic effects of Abenomics and in Chapter 8 on the financial stability implications of complete and incomplete reforms.

Simulation results show that, while varying across countries and regions, the net spillover effects are generally positive, though small. Successful reflation in Japan would affect other countries through (1) yen depreciation and a corresponding appreciation of trading partner currencies, (2) higher growth in Japan as well as the global economy, and (3) lower interest rates in trading partners owing to capital inflows and higher global savings from falling debt in Japan. In sum, the negative spillovers arising from yen depreciation would be offset by positive spillovers through the other two channels. Japan’s rising current account surplus implies capital inflows into trading partners, reducing interest rates and stimulating investment and growth. Higher growth in Japan increases import demand. From the simulations, structural reforms in Japan appear to exert particularly important positive spillover effects.

To understand the impact of a sharper depreciation of the yen (relative to the more gradual depreciation in these simulations), IMF (2013) also considers a case in which the yen real effective exchange rate depreciates by an additional 10 percent in the near term and is sustained at this level. This broadly corresponds to the estimated contribution of quantitative and qualitative monetary easing to the depreciation of the yen, with the rest accounted for by the widening of the trade deficit, the larger interest rate differential with the United States, and waning safe-haven effects. The simulation shows smaller net growth spillovers in this case, with some economies including China, Germany, and Korea slowing in the near to medium term before benefiting in the long term. As such, credible structural and fiscal policies are essential in Japan to generate positive spillovers, while in their absence monetary policy would become overburdened and the exchange rate would be the main transmission channel with adverse effects on trading partners.

Beyond Model Simulations

However, in the near term, overall spillover effects, as well as the impact on individual countries, will likely be more complex because of the unique features of the Japanese economy that are not fully captured in the model simulation just described.

  • Portfolio rebalancing. Regarding the financial channel, the Bank of Japan’s JGB purchases could cause a substantial rebalancing of financial institutions’ portfolios, potentially leading to large financial spillovers to other countries. The effects of capital inflows on recipient countries would not be uniform, but would depend on their cyclical conditions. While easier financing conditions can support growth in economies with slack and little inflation, they could raise overheating risks for those with already rapid credit growth and rising asset prices, although this concern may have been reduced since the U.S. tapering started.

  • Foreign direct investment. Financial spillover effects could also occur through FDI. It has been observed that a rise of 1 percent of GDP in Japanese FDI boosts growth by 0.5–0.7 percentage point in recipient countries. Empirical analysis also suggests that overseas production and outward FDI are sensitive to real effective exchange rate movements. For instance, a 10 percentage point depreciation in the real effective exchange rate would slow the overseas production ratio by 1.3 percentage points. Nonetheless, outward FDI is a long-term trend since firms aim to locate where the demand is growing and take advantage of cost differentials. It is unlikely that increasing overseas production or FDI abroad would be reversed given the relatively high rate of return on these investments.

  • Supply chain. For the trade channel, increased vertical integration of the production network implies that a significant amount of imported intermediate inputs from Japan would somewhat offset the effect of yen depreciation on trading partners’ export prices while higher growth and exports would benefit other countries through the supply-chain structure.

  • Interest rate differential. A sustained different stance in monetary policies between the Bank of Japan and other major central banks, in particular the Federal Reserve, would increase the incentive for Japanese investors to rebalance their portfolios toward foreign assets. An illustrative scenario analysis (IMF 2014) that takes into account increasing pressure on bank profits from large excess reserves, higher domestic credit growth, governance reforms at the Government Pension Investment Fund, and rising interest rate differentials with the United States, estimates that potential capital outflows could rise significantly as Abenomics proceeds. While the vast majority of these funds are expected to flow to advanced economies, emerging market economies would also benefit, not only from direct regional flows that could moderate the expected tightening of financing conditions but also indirectly as outflows from Japan to advanced economies would lessen the tightening of financial conditions there.

  • Overseas expansion. In terms of banks’ expanding abroad, as noted in Chapter 8, Lam (2013) argues that the trend of expanding overseas is likely to continue, but its pace will depend on a supportive domestic economy and careful risk supervision. Although stronger domestic growth might slow the expansion pace, it is not expected to reverse the trend unless incomplete policies under Abenomics elevate domestic financial stability risks. Increasing cross-border activity could add to funding risks while exacerbating supervisory challenges that require continued close monitoring.

Spillovers from Tail Risks8

Financial stress in Japan has measureable spillovers on global financial markets, including those in Asia. Specifically, given Japan’s role as a global lender and its large domestic needs for funding as a result of the government’s high financial requirement, a key risk for Japan and the rest of the world stems from a spike in JGB yields. IMF (2011) simulated a range of fiscal crisis scenarios originating in Japan featuring different assumptions regarding the impact of the crisis on worldwide market confidence.9

The first scenario features a fiscal crisis contained within Japan. A sudden loss of confidence in fiscal sustainability raises long-term nominal interest rates, while heightened risk aversion also hits the stock market and reduced confidence leads households and firms to postpone their consumption and investment. Combined with fiscal consolidation and yen depreciation, such a scenario would have major implications for Japan, but the spillover effects would be relatively modest on other countries: a weighted-average peak output loss of 4.4 percent in Japan, 0.1 percent in euro area periphery countries, 0.2 percent in other advanced economies, and 0.4 percent in emerging market economies.

As such, spillovers will only be material if heightened risk aversion in Japan spreads progressively to bond and stock markets in other economies, including emerging markets. Although Japanese financial markets are relatively isolated, during periods of uncertainty global financial markets face elevated risks of falling market confidence and herd behavior. Depending on the extent of spillovers to market confidence, the costs to other countries can reach as high as 3 percent of GDP.

In addition, spillovers could be amplified as most JGBs are held by Japanese financial institutions. This suggests that a shock to JGB yields might have a direct spillover to other markets, by impacting Japan’s financial sector balance sheets and prompting a withdrawal by financial firms from foreign markets. However, even under the most severe scenario, the regional impact of a reduction in foreign loans is limited. Assuming that banks reduce their foreign loans in proportion to their share of loans to each jurisdiction, the impact on local banking systems is relatively minor, ranging from 0 to 2 percent expressed as a fraction of total domestic credit. The key exceptions are the offshore financial centers, Hong Kong SAR and Singapore, where the impact ranges from 3 to 6 percent. As these centers are effectively cross-border intermediaries, the effect on the local economy will quite likely be limited.10

In essence, successful Abenomics that put debt on a downward path will prevent such a medium-term tail risk from emerging and therefore avoid the possibility of sharp negative spillovers through financial stress in the future.


Japan’s share in global growth started to wane as firms and the financial sector grappled with the Lost Decade. However, during that period, secular shifts took place that simultaneously strengthened Japan’s footprint in the world economy in general and Asia in particular. For example, firms’ FDI increased markedly, particularly to countries with strong domestic demand, and Japan became a key upstream player in the global and regional supply chain. Banks, too, have actively expanded abroad in recent years. With low interest rates in Japan, financial linkages also manifested themselves as a result of the yen carry-trade, while the country remained among the largest providers of global liquidity each year owing to its stable current account surplus, which also continued to cement its status as a safe-haven country.

These factors are not only spillover channels themselves, they also tend to mitigate the transmission of Abenomics to other countries. Overall, model-based simulations suggest that a complete package of reforms that achieves the Bank of Japan’s inflation target puts the debt-to-GDP ratio on a declining trajectory, and raising potential growth through structural reforms would create positive, albeit modest, spillovers to other countries, even though direct competitors may be affected adversely in the short run as a result of the weaker yen. The trend of banks and firms expanding overseas may slow in this case as demand for credit, competitiveness, and consumer confidence increase in Japan, but it is unlikely to change in a material way. Capital outflows could be more substantial in the period ahead compared to Abenomics’ first two years, which would contribute to keeping financial conditions in recipient countries accommodative amid tapering in the United States. Finally, a complete package of reforms would help to avoid negative spillovers from a potential tail risk in light of Japan’s rapidly rising debt under the pre-Abenomics baseline.


    BekaertG.M.Hoerova and M.L.Duca. 2010. “Risk, Uncertainty, and Monetary Policy.NBER Working Paper No. 16397. Cambridge, Massachusetts: National Bureau of Economic Research. Carvalho Filho and R.W.Lam. 2013. “The Curious Case of the Yen as a Safe Haven Currency: A Forensic Analysis.IMF Working Paper No. 13/228. International Monetary FundWashington, DC.

    BussièreM.C.Lopez and C.Tille. 2013. “Currency Crises in Reverse: Do Large Real Exchange Rate Appreciations Matter for Growth?MPRA Paper No. 44096. Munich: Munich Personal RePEc Archive.

    de BockR. and Carvalho Filho. 2013. “The Behavior of Currencies during Risk-off Episodes.IMF Working Paper No. 13/08. International Monetary FundWashington, DC.

    de Carvalho FilhoI.2013. “Risk-off Episodes and Swiss Franc Appreciation: the Role of Capital Flows.” Unpublished. International Monetary FundWashington, DC.

    HabibM.M. and L.Stracca. 2012. “Getting Beyond Carry Trade: What Makes a Safe Haven Currency?Journal of International Economics87(1): 5064.

    HattoriM. and H.S.Shin2009Yen Carry Trade and the Subprime Crisis.IMF Staff Papers56(2): 384409.

    International Monetary Fund. 2004. “Debt-Related Vulnerabilities and Financial Crises—An Application of the Balance Sheet Approach to Emerging Market Countries.

    International Monetary Fund. 2011. “Japan: Spillover Report.IMF Country Report No. 11/183Washington.

    International Monetary Fund. 2012a. “Switzerland: Selected Issues Paper.IMF Country Report No. 12/107Washington.

    International Monetary Fund. 2012b. “Iceland: Ex Post Evaluation of Exceptional Access under the 2008 Stand-by Arrangement. IMF Country Report No. 12/91Washington.

    International Monetary Fund. 2013. “IMF Multilateral Policy Issues Report.2013 Spillover Report—Analytical Underpinnings and other Background PapersWashington.

    LamR.W.2013. “Cross-Border Activity of Japanese Banks.IMF Working Paper No. 13/235. International Monetary FundWashington, DC.

    RanaldoA. and P.Söderlind. 2010. “Safe Haven Currencies.Review of Finance14(3): 385407.

    SorsaP.B.B.BakkerC.DuenwaldA.M.Maechler and A.Tiffin. 2007. “Vulnerabilities in Emerging Southeastern Europe—How Much Cause for Concern?IMF Working Paper No. 07/236. International Monetary FundWashington, DC.

    VitekF.2010. “Policy Analysis and Forecasting in the World Economy: A Panel Unobserved Components Approach.IMF Working Paper No. 12/149. International Monetary FundWashington, DC.

Risk-off episodes in this chapter refer to large swings in global risk aversion as proxied by the VIX (a volatility index). During such periods, investors reallocate resources toward lower yielding investments which are perceived to have lower risk.

G20MOD is the IMF’s global macroeconomic model developed to support the G20’s Mutual Assessment Process. The model has 23 blocks, comprising all G20 countries and three aggregate country groups (other non-euro-area European Union countries, other industrial countries, and the rest of the world), and treats each G20 member separately to allow policies to be considered and tailored to every member’s individual circumstances.

Japan’s strongest earthquake on record unleashed a vast tsunami and subsequent nuclear accidents and a radiation crisis. The Cabinet Office estimated the direct economic cost of the disaster at 16.9 trillion yen ($210 billion or 3.6 percent of 2011 GDP).

These include the Asian financial crisis, the 2008 Lehman shock, the 2010–11 escalation of the euro area crisis, and uncertainty surrounding the debt ceiling debate in the United States.

Sorsa and others (2007) identified expectations of appreciation spurred in part by capital inflows as a driver of liability dollarization in Southeastern European countries. A similar phenomenon appears to have occurred in Turkey during the buildup to the crisis of 2000–01 (IMF 2004) and in Iceland before the global financial crisis (IMF 2012b).

Bekaert, Hoerova, and Duca (2010) show the VIX can be decomposed into risk aversion and uncertainty. However that decomposition is not very informative because risk aversion and uncertainty are highly correlated.

The discussion on carry trade is based on IMF (2011), Chapter IX.

This section is based on Chapter VII, Chapter IX, and Chapter X of IMF (2011).

These results are derived from a refined version of the structural macroeconometric model of the world economy documented in Vitek (2010), which features extensive linkages between the real and financial sectors, both within and across Group of Twenty economies.

Interbank network analysis confirms that a withdrawal of Japanese funding would not be severe enough to trigger systemic distress in other countries.

    Other Resources Citing This Publication