The decision was always coming. The Japanese core inflation had been well above 2.6%, compared to the BOJ target of 2%. The BOJ governor and the Japanese prime minister were quite intent on curbing inflation by raising rates. The sense of disappointment among Japanese households was quite high due to high levels of inflation. The weak currency was only making imports more expensive and translating into imported inflation. The 25-bps hike will address multiple issues. It will address the issue of high domestic inflation as well as a very cheap Japanese currency. 

However, the Japanese rate hike decision was not as straightforward as it appears. Just a year back, the Japanese Prime Minister had called rate hikes a bad decision. A lot has changed in the last one year as inflation remained elevated and the government was seeing its popularity ratings dipping. The rate hike is a measure to curb inflation by tightening money and reduce price pressure on households. However, this is also going to make borrowings expensive. That is especially a major challenge for the Japanese government which has one of the world’s highest levels of public debt (~240% of GDP). Higher rates will make Japanese debt more expensive for the government. 

One of the major reasons why the Japanese Yen is at the centre of the global investment flows is the cheap currency. Typically, investors and traders borrow in Yen and then deploy the funds in other developed and emerging markets. The low rates of interest in Japan make it a lucrative trade to borrowing in Yen and then deploy it in higher risk instruments. The stable Japanese currency ensures that at no point the currency losses eat away at the core of portfolio gains. However, that equation holds only till rates are close to zero. At 0.75%, borrowing in Japanese Yen is going to become prohibitive and will also impact the economics of most traders and investors in the region. 

It would largely depend on the size and the intensity of the Yen carry trade. The yen carry trade was extremely powerful and rampant a few years back. However, since Japan started hiking rates from near-zero levels, the attractiveness of the Yen for carry trades has been reducing. Even if carry trades were to unwind, the impact of such unwinding on global market flows will not be substantial. However, the concern is that there is a lot of risk capital in the region that is based on the Yen carry trade; and that could get impacted. More importantly, the unwinding of carry trade could trigger a rush back to safety by the investors. That could be the bigger risk for India flows.