BitMEX Co-Founder Arthur Hayes Discusses YCC: How Does the Bank of Japan Manipulate Interest Rates? What Consequences Does Severe Depreciation of the Japanese Yen Bring?

In his latest article "A Samurai, a Knight, and a Yankee," BitMEX co-founder Arthur Hayes discusses Japan and the EU's yield curve control (YCC) and their resistance to the impact of Russia on their economies, as well as how the US government can help them overcome their difficulties, ultimately allowing the crypto market to break free from the current bear market situation.

This is a translation and summary of the article. For more details, please refer to the original article.

About Yield Curve Control, YCC

At the beginning of the article, Arthur Hayes pointed out that the Japanese government and the European Union are employing explicit or implicit methods to implement Yield Curve Control (YCC), which involves central banks using legal tender to buy government bonds of their own country to "control" the yield of government bonds and peg the interest rate to a target value.

Continuously buying bonds will raise bond prices and lower yields. However, under constant money printing and unchanged conditions, this will weaken the country's currency, leading to depreciation.

The Scenario of Weakening Currency due to YCC:

1. The central bank sets an upper limit on the yield of one or more government bonds.
2. The central bank is prepared to print money, leading to an increase in the money supply, and may buy enough bonds to lower the yield below the upper limit.
3. If the market believes that the yield should be higher than the YCC upper limit, the government will start printing money until all outstanding bonds are purchased, or the market stops demanding yields higher than the limit.
4. Due to the increase in money supply relative to physical goods, services, and other currencies, this process expands the money supply, thereby weakening the legal tender.

While Japan and the European Union generally prefer their currencies to be relatively weak compared to other developed countries to benefit their export industries, the excessive depreciation caused by the COVID-19 pandemic, inflation in food and fuel, and the cancellation of exports to Russia have affected the basic living of people in Japan and the EU.

In response to this, Arthur Hayes stated that Japan and the EU still have strong political reasons to implement YCC, aligning with the US and resisting energy exports from Russia. However, for YCC to continue, Japan and the EU will need assistance from the US.

So, how can the US provide assistance? Arthur Hayes referenced a speech by former Federal Reserve Chairman Ben Bernanke in 2002:

"The Fed can inject money into the economy in other ways. For example, the Fed has the authority to buy foreign government debt and domestic government debt. Such purchases potentially provide the Fed with a huge amount of leeway because the amount of foreign assets that the Fed can buy is several times the stock of US government debt. However, because the economy is a complex and interconnected system, the Fed's purchase of foreign government debt could affect many financial markets, including foreign exchange markets."

Arthur Hayes suggested that under the guidance of the US Treasury, the New York Federal Reserve Bank could print money to buy Japanese yen, euros, and their government bonds. This would help weaken the US dollar against the yen/euro currency pair and assist them in importing goods priced in US dollars at a cheaper rate. Additionally, while reducing bond yields, it would not lead to an increase in the balance sheets of the Bank of Japan or the European Central Bank.

However, at the same time, the Federal Reserve is tightening its monetary policy through Quantitative Tightening (QT) to curb domestic inflation and protect the wallets of the American people. QT refers to the central bank selling its holdings of US Treasury securities and mortgage-backed securities to tighten credit conditions. In this scenario, not only does the government face higher borrowing costs, but individuals and businesses in the US face the same situation. Therefore, an obvious question arises, how can the Federal Reserve effectively loosen credit conditions globally by purchasing foreign government bonds while efficiently implementing QT?

Although purchasing foreign bonds would expand the US dollar money supply and the Federal Reserve's balance sheet, potentially offsetting the impact of its QT actions on the domestic economy, Arthur Hayes believes that this is not contradictory. He mentioned that the Federal Reserve could simultaneously sell its holdings of US government bonds and MBS while printing money to buy foreign bonds.

The US, EU, and Japan are all experiencing unprecedented levels of high inflation, but only the Federal Reserve has raised interest rates to a meaningful extent. According to the Purchasing Power Parity theory, countries with loose monetary policies are likely to have relatively weak currency trends. Given that global commodities are priced in US dollars, the US's tight monetary policy has positioned the US dollar as the strongest fiat currency currently.

As a cryptocurrency advocate, Arthur Hayes expressed his concern about YCC because if the US Treasury announces a policy shift or finds an increase in the balance of the Exchange Stabilization Fund (ESF), it can be assumed that the Federal Reserve believes inflation has peaked and decides to print more money to prevent economic recession and assist Japan and the EU's YCC operations. However, this move would lead to high inflation and fundamentally alter the liquidity of global fiat currencies, causing risk assets, including cryptocurrencies, to bottom out and quickly begin to recover as fiat liquidity rises.

To make this assumption a reality, Arthur Hayes believes the following conditions must be met:

1. The US is committed to using economic sanctions to counter Russia, and its allies must avoid purchasing Russian food and energy.
2. Japan and the EU must use YCC to save their banks and political systems.
3. Sanctions on Russian food and energy intensify the inflation caused by YCC.
4. To prevent public opposition, Japan and the EU need US assistance to reduce domestic inflation.
5. The US prints money and buys Japanese and European bonds, or lowers the Fed's rate to reduce discrepancies in interest rate policies.
6. This fifth point would lead to the devaluation of the US dollar, increase liquidity by hundreds of billions of dollars in the financial system, and risk assets would rebound.

How Will Japan and the EU Repay Debt?

Gross Domestic Product (GDP) is an indicator of economic activity, with governments taxing certain activities to pay for services they provide. When debt generated by one unit exceeds economic output, GDP rises, and tax revenues increase, making the debt productive.

However, when the economic output generated by debt is less than one unit, the government must issue more debt to repay maturing debts, leading to exponential growth in debt burdens.

Arthur Hayes proposed three ways to improve this situation:

1. An increase in population boosts economic output and generates more tax revenue.
2. The invention or discovery of a new technology or energy source that significantly boosts the productivity of existing workers. This increases the economy's potential and subsequently raises future tax revenue.
3. Government default

Government default in the third point can occur in the following ways:

1. Issuing currency and nominally using it to repay debt, leading to inflation.
2. Completely canceling debt through a jubilee.

Note: A jubilee is an anniversary celebration of a specific event, often marking the 25th, 40th, 50th, 60th, or 70th anniversary.

In the next section, Arthur Hayes will evaluate Japan and the EU's financial situation from the perspectives of population growth/decline and the cost of energy inputs, believing that only through the government default proposed in the third point can they help repay the debt.

Demographics

"When you live on a farm, children are free labor. But when you live in an apartment, children are expensive conversation partners," said Arthur Hayes.

When the productive members of society, aged 15-64, increase in the labor force, a country's economic potential also grows, and vice versa. However, for advanced countries like Japan and the EU, reversing their declining birth rates in a short time is not practical. The fastest solution is through slavery and immigration. However, with the abolition of slavery in the 19th century and differences in religious beliefs between the EU and the Middle East and North Africa, these countries face challenges in implementing immigration policies and benefiting from immigration. Ultimately, they cannot obtain sufficient manpower to generate the activity level needed to repay debts.

Energy Policy

According to the Energy Return on Investment scale, nuclear energy provides the highest return on energy investment. However, Japan significantly reduced its use of nuclear energy after the Fukushima nuclear disaster, leading to excessive reliance on hydrocarbons and less stable energy supply.

When Western countries decided to freeze Russian assets and people in the Western financial system, the EU's previous policy of overly relying on cheap Russian natural gas is now met with countermeasures from Russia, resulting in higher energy costs for the EU.

Arthur Hayes expressed that resisting Russia puts Europe and Japan in a more precarious situation, as both countries need cheap energy to sustain their manufacturing capabilities. However, as responsible allies, they must stand behind the US in attempting to economically sanction Russia. Nevertheless, during this process, the soaring production prices will continue to rise.

Next, Arthur Hayes will present economic data illustrating the economic crises faced by Japan and European countries.

German Producer Price Index YoY Change

As strong nations like Germany refuse to purchase Russian energy, China is enjoying discounted Russian energy costs. Currently, Germany's producer prices have hit historic highs, reaching +30%, and as input costs continue to soar, the country may struggle to maintain its global competitiveness.

This has led to Germany experiencing its first monthly trade deficit in 30 years. Many large German industrial companies cannot survive without Russian natural gas. Most European countries' fiscal conditions do not allow them to produce the same quantity of goods at the same price without cheap natural gas.

Japanese Producer Price Index YoY Change

Japan's trajectory mirrors Germany's. With input costs at their highest level since the 1970s, Japan is losing its competitive edge against China. Currently, the yen's weakness is somewhat helping mitigate the impact, but China will not stand idly by and allow the yen to continue to weaken against the renminbi. Arthur Hayes believes that China will devalue the renminbi against the yen and euro to give Chinese export industries a competitive advantage.

Repaying Debt through Inflation

The majority of government debt is held by large banking institutions or the wealthiest citizens, and defaulting directly or canceling debt would severely impact stakeholders. Arthur Hayes believes that resolving Japan and the EU's population and energy dilemmas through inflation is the only solution.

According to the two charts below, both Japan and the EU are facing peak and declining labor force populations aged 15-64, and the GDP production efficiency per unit of energy, i.e., oil, has plateaued or is declining. In response to this situation, Japan and the EU have resorted to printing money.

Arthur Hayes states that rulers prefer to restructure debt through inflation to shift costs to the poorest people rather than lower the value of their assets to a level corresponding to the actual economic value.

In the following section, Arthur Hayes will explain how Japan may continue implementing the YCC policy, also known as money printing, and the political reasons behind it.

The Severe Consequences of Japan's Money Printing

Since the 1989 Japanese real estate bubble, the Japanese government has been printing money to combat the deflationary effects of asset bubbles, until eventually, the Bank of Japan started controlling the price of Japanese government bonds (JGBs) to manipulate the yield curve. Ultimately, the Bank of Japan has achieved the expected inflation.

So, how does Japan's YCC work? Assuming the 10-year JGB yield is above 0.25%, the Bank of Japan will buy unlimited JGBs until the yield falls to or below 0.25%, or all JCBs that can be purchased in the market are bought. Under this operation, the Bank of Japan is willing to expand its balance sheet indefinitely by printing yen and buying Japanese government bonds.

However, when the yield on Japanese government bonds is significantly lower than other countries, it leads to a decline in the yen exchange rate.

From the chart below, it is evident that when the yield spread between US and Japanese ten-year government bonds widens, the USD/JPY exchange rate continues to rise.

This phenomenon will have a severe impact on the Japanese economy, as the country relies heavily on imports for energy, and under the dual pressures of rising oil prices and currency depreciation, many manufacturers will have to raise prices to maintain operations.

According to Bloomberg data, Japan's outstanding government debt currently stands at around 1,020 trillion yen, with semi-annual bond interest payments of 15.45 trillion. With Japan's current tax revenue, this is enough to cover interest payments, as long as interest rates rise significantly before the cost of debt repayment exceeds tax revenue. The government can slightly mitigate the current predicament.

Why Does the Bank of Japan Continue YCC?

Arthur Hayes mentioned that due to slow growth, poor population structure, and financial repression, Japan's bank deposit interest rates are almost zero. To boost Japanese people's consumption desires, deposit rates have even been negative in recent years.

Moreover, unable to attract user deposits, Japanese banks are offering increasingly diverse structured products to remain profitable. Among these, the simplest and most widely issued is the "callable deposit," which is similar to a callable bond.

For example, a 20-year callable deposit with a deposit rate of 0.25% offers higher interest than a standard bank deposit. If the deposit rate decreases the following year, the bank can request the return of the deposit; but if the deposit rate rises and the user wants to withdraw the deposit, it results in a certain amount of loss. In recent years, with declining deposit rates in Japanese banks, most users view these deposits as one-year deposits rather than 20-year commitments.

However, if Japan discontinues YCC and the trend of falling interest rates is reversed, users' short-term deposits, originally considered one-year deposits, would turn into long-term commitments. For many depositors who need to withdraw funds regularly, this could lead to widespread losses. Therefore, Arthur Hayes believes that the Japanese government, rather than engaging in what would be equivalent to political suicide, should continue to control market rates. While YCC will impact the economy, it has reasons to continue.

However, the Bank of Japan is close to exhausting the bonds it can purchase. To continue purchasing, it must continue issuing bonds so the central bank can buy them and maintain the 0.25% interest rate level.

Therefore, under the assumption that YCC in Japan does not end, the Japanese economy will remain trapped in a vicious cycle of issuing bonds, printing money, and buying bonds, exacerbating the yen's inflationary dilemma. In this situation, Arthur Hayes believes that to salvage the yen's value, the US