Japan’s stance on Ukraine war could backfire on its economy

Amid rising tensions with Russia, Tokyo faces a dilemma between its massive monetary easing and potential loss of external assets

The yen plunged to a 20-year low of 129 to the US dollar last week amid a widening gap in interest rates between Japan and the United States. Japan is the only Group of Seven country to stick to a loose monetary policy in the face of high global inflation.

The Bank of Japan holds almost half of Japanese government bonds, almost 80 per cent of exchange-traded funds and 7 per cent of Japanese-listed stocks. It also keeps interest rates near zero to maintain a flat yield curve on 10-year bonds.

Tightening monetary policy would therefore negatively affect both government bonds and the stock market at once, potentially throwing Japan’s economy into turmoil.

Still more critically, the yen’s fall has coincided with Russia’s invasion of Ukraine.

For 30 years, the yen has triumphed as a safe-haven currency because of Japan’s consistently neutral position and net foreign assets of US$2.7 trillion, the world’s largest.

Although Japan has relied on the US for 100 per cent of its security since 1951, it has been free to establish and maintain peaceful relationships with all countries, including US rivals such as Iran, China and Russia. This peace policy has allowed Japan to ramp up its foreign investment, including in high-risk countries such as Iran, Syria and Yemen, offering a high return on investment.

It is surprising then that, rather than being bought in the wake of the Ukraine crisis, the yen has been systematically sold.

The answer lies in Japanese Prime Minister Fumio Kishida’s decision to follow the US in standing with Ukraine, placing Japan in opposition to another country for the first time in 70 years.

The penalties imposed on Russia by the US and its allies include banning select Russian banks from the Swift global payment system, cutting energy imports and freezing foreign financial reserves.

US President Joe Biden has twice called Russian President Vladimir Putin a war criminal, saying he could not remain in power.

At the same time, China announced an almost 30 per cent increase in trade with Russia in the first quarter of 2022. India also published a plan in March to boost trade with Russia to US$30 billion by 2025 from US$8 billion in 2021. Turkey, a member of Nato, almost doubled its imports from Russia in March from a year earlier.

While many companies said they would cease operations in Russia, not all have done so.

The Russian rouble now sits at around 75 per dollar, higher than just before the invasion of Ukraine. On April 23, Russia declared a military victory in the Ukrainian port city of Mariupol, and has now shifted its focus to Odesa in the south, another vital trading city.

Should Putin ultimately survive Biden’s sanctions, Japan would be the worse off for it.

Russia said last month it would end talks over the long-disputed Northern Territories, and has been conducting military drills on the islands. In early March, 10 Russian warships passed through the Tsugaru Strait, which separates Japan’s main Honshu island and the island of Hokkaido. Such a move poses a potent threat: the strait is only 17km wide at its narrowest point and 140m at the shallowest point. The Seikan Tunnel, which connects the two islands by rail, runs just beneath the Tsugaru Strait.

Russia could easily decouple Hokkaido from the rest of Japan, costing Japan 3.6 per cent of its gross domestic product. Russia has already announced plans to nationalise the assets of foreign firms that leave the country. This may include its Sakhalin oil and natural gas projects, which are crucial for Japan’s energy security.

The yen has appreciated considerably since 1985 when it was 240 to the dollar. Japan’s national debt has also increased from US$180 billion to US$11.3 trillion. Unfortunately, Japanese industries do not have the same exporting power as they did 40 years ago, leaving the country with a trade deficit of US$3.26 billion as of March, the second biggest on record.

Between the Bank of Japan’s massive easing and the potential loss of its external assets, Japan faces a big dilemma. It would not be unreasonable to forecast the return of the 240 yen-dollar exchange rate soon.

Should Putin ultimately survive Biden’s sanctions, Japan would be the worse off for it