I've been fascinated for a while by a real puzzle in the markets: Why is the yen so weak, even though Japan should be doing everything right? The country has world-class companies, and the central bank has raised interest rates from -0.1% to 0.75% — normally, that would attract capital and strengthen the currency. Instead, the yen is nearly as weak as in 2024, when it hit a 38-year low. This is truly counterintuitive.

The paradox becomes even greater when you look at the debt ratio. Japan has a net debt-to-GDP ratio of 130% — one of the highest worldwide — while maintaining the lowest interest rates. Analysts like Robin Brooks from the Brookings Institution argue that the ongoing yen weakness is actually a hidden warning sign. It could reflect that a fiscal crisis is slowly developing. The Bank of Japan has been massively buying government bonds for years to fight deflation. That pushes down yields, lowers debt repayment costs — but it has also weakened demand for the yen.

Here's where it gets interesting: Goldman Sachs estimates that the yen is undervalued by about 50%. The fair value should be around 90 yen per dollar; currently, we are at 153. That’s a huge difference. And yet, the yen’s weakness persists. Some even suspect that Japan and the U.S. are considering a joint intervention to support the exchange rate.

But there’s another side to the story. The good news: Japan’s fiscal situation has actually improved in several areas. Since 2020, the debt-to-GDP ratio has been decreasing annually. The basic budget deficit last year was only 0.9% of GDP — which is manageable. The main reason is inflation. After years of zero or negative inflation, the annual inflation rate recently exceeded 3%, which leads to faster tax revenue growth than higher spending. The nominal growth outpaced the low coupon rates Japan secured on its debt.

Looking at real interest rates makes it even more interesting. In March 2024, the Bank of Japan abandoned its yield curve control. Since then, 10-year yields have risen from 0.7% to 2.3% — approaching German levels of 2.8%. But inflation has become more persistent, so inflation-adjusted yields remain extremely low. Japan’s real 10-year yields are only about 0.2%, while Germany has 1% and the U.S. nearly 2%. This is characteristic of an economy with low growth.

A big cushion for Japan: the public sector holds a huge amount of assets — land, foreign corporate bonds, much of which isn’t included in official debt statistics. Researchers estimate that true net liabilities are only about 78% of GDP. This gives the country more room for maneuver than surface numbers suggest.

Another explanation for the yen’s weakness could be inflation itself. Since 2024, Japan’s inflation rate has risen faster than in China, the U.S., and the EU in about two-thirds of the time. This has caused the yen’s purchasing power to decline more quickly. But honestly: that doesn’t fully explain the entire decline. The yen is much cheaper than current inflation alone would justify.

What really concerns me are the three main risks. First: if the Bank of Japan does its job and brings inflation to 2%, real yields could rise — putting pressure on the fiscal situation. Some estimates suggest that the central bank’s bond purchases in the 2010s suppressed 10-year yields by 1 to 3 percentage points. That’s a massive hidden subsidy on financing costs.

Second: most of Japan’s asset reserves are held abroad. This makes the country like a hedge fund issuing cheap debt to earn high returns. Low interest rates, a weak yen, and strong growth in asset prices have brought Japan roughly 6% of GDP annually. But if market conditions change, these capital flows could reverse. That would pose a significant risk of market value losses.

Third: the political risk. Prime Minister Sanae Takaichi has called for early elections to gain support for fiscal expansion. If new incentives come, they will be inflationary — and then even tighter monetary policy will be needed, which again burdens the fiscal situation.

So, returning to the original question: why is the yen so weak? It’s not just a matter of interest rate differentials or inflation. It’s about deeper structural issues — hidden fiscal risks, dependence on asset prices, and how normalization of monetary policy can proceed without triggering a crisis. Japan has benefited from higher inflation, but that doesn’t mean everything can be ignored. If real interest rates rise alongside nominal rates, Japan will realize that normalization also has its downsides. That could explain why yen weakness remains so persistent despite everything.