As the Japanese yen makes a counterattack towards the key level of 140 against the US dollar, Deutsche Bank poses a striking question: Has the 20 trillion dollar carry trade conducted by the Japanese government reached its end?

The yen carry trade, in simple terms, refers to investors borrowing yen at low interest rates and then investing in assets with higher yields to earn the spread. This strategy has been a routine operation for the Japanese government and financial institutions over the past forty years.

Deutsche Bank's Chief FX Strategist George Saravelos points out in his latest report that the success of the carry trade depends on several key factors: a low-interest-rate environment, the stability of the yen, and high yields on global assets. With inflation rates continuing to rise, the Bank of Japan is forced to raise interest rates, which will deal a huge blow to the liability side of the government's balance sheet.

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Deutsche Bank notes that this pattern faces the risk of liquidation, and the Bank of Japan is in a dilemma.

The interest rate environment will no longer support the carry trade.

According to the latest report by Deutsche Bank's Chief FX Strategist George Saravelos, the Japanese government finances by issuing low-yielding Japanese government bonds and utilizing bank reserves, while obtaining higher returns on domestic and foreign assets.

Over the past decade, the Bank of Japan has essentially replaced half of the Japanese government bond stock with devalued yen, cash that is now held by banks. In terms of assets, the Japanese government mainly holds loans, such as through the Fiscal and Investment Loan Fund (FILF), and foreign assets, primarily held through Japan's largest pension fund (GPIF).

This strategy has provided the Japanese government with additional fiscal space to some extent, and also partly explains why Japan has not faced a debt crisis despite having a public debt/GDP ratio of over 200% and continuously rising over recent decades.

In addition, more importantly, is the structure of this debt's balance sheet.

Saravelos explains that the Japanese government's balance sheet totals about 500% of GDP or 20 trillion dollars. In short, the Japanese government's balance sheet is a huge carry trade, which is the key to Japan's ability to maintain its growing nominal debt levels.However, the success of the carry trade strategy depends on several key factors: a low-interest-rate environment, the stability of the yen, and high yields on global assets. If these conditions change, the profitability of the carry trade will be severely affected. As inflation continues to rise, the Bank of Japan is forced to raise interest rates, which will deal a huge blow to the liability side of the government's balance sheet.

How can the Bank of Japan safely exit the carry trade?

Deutsche Bank believes that, on one hand, if the Bank of Japan substantially tightens policy and raises interest rates, the cost of carry trade will increase, forcing the trade to unwind. On the other hand, if the Bank of Japan maintains the current low-interest-rate environment, this could lead to financial repression, which is the practice of keeping interest rates artificially low to support the financing of government debt. While this can sustain the carry trade in the short term, it may pose serious financial stability risks in the long run and could even lead to the collapse of the yen.

Saravelos emphasizes that whichever path is chosen, it will have profound implications for Japanese society. If the carry trade is unwound, wealthier and older demographics will face the risk of higher inflation and rising real interest rates; if the carry trade is maintained, younger and poorer groups will suffer due to a decline in future real incomes.

Saravelos suggests that the Japanese government could mitigate the impact of high inflation on the economy and older households through fiscal policy. For example, the government could increase transfer payments to protect vulnerable groups while controlling fiscal deficits by raising taxes or cutting spending. However, these measures need to be carefully designed to avoid excessively dampening economic growth.

He also believes that although fiscal consolidation may have a short-term dampening effect on economic activity, by balancing spending cuts with tax increases, it can sustainably reduce government leverage, and its negative impact on economic growth is also smaller. Moreover, a shift in fiscal policy could have a significant impact on the long-term interest rate outlook, especially in addressing future strategic geopolitical challenges.