Japan hikes rates: What will be the impact on yen carry trade and Indian borrowers?

It is now the highest policy rate by Japan since the mid-1990s, ending a long era in which Japan stood apart as the last major economy clinging to near-zero interest rates. Although 0.75 per cent is still among the lowest policy rates globally, it signals that the BoJ is no longer prepared to underwrite global risk-taking indefinitely, according to analysts.

Implications for India

Several Indian companies borrow in Japanese yen, particularly public sector undertakings and large infrastructure firms, to take advantage of Japan’s historically low interest rates and access long-tenor funding. Borrowers include power and infrastructure players such as PFC, REC and NLC India, as well as some corporates and financial institutions through overseas loans or Japan-backed facilities.

However, yen borrowing carries currency risk and any sharp appreciation of the yen can raise repayment costs for unhedged borrowers and lead to mark-to-market losses.

With the BoJ hiking rates and signalling a gradual policy normalisation, any appreciation of the yen increases repayment costs, raises foreign exchange losses, and erodes the savings gained from lower interest rates. “If the yen continues to strengthen, companies with large unhedged yen loans could face pressure on earnings, cash flows and balance sheets, forcing them to reassess their foreign currency borrowing strategies,” said a Mumbai-based analyst.

For India, the BoJ’s move adds another layer of uncertainty to an already complex global environment and borrowers in the Japanese currency. If yen-funded capital starts retreating, emerging markets could see intermittent outflows, putting pressure on currencies and asset prices. While India’s macro fundamentals remain relatively strong, it is not completely immune to global liquidity swings.

Why the BoJ raised rates

In a widely anticipated decision, the BoJ’s policy board, led by Governor Kazuo Ueda, raised the benchmark rate by 25 basis points to around 0.75 per cent. The move reflects a delicate domestic balancing act.

The Bank of Japan (BOJ) Gov. Kazuo Ueda arrives at the headquarters of BOJ in Tokyo, Friday, Dec. 19, 2025. (Kyodo News via AP)

On the one hand, the new government under Prime Minister Sanae Takaichi is keen to rein in inflation and protect household purchasing power. On the other hand, Japan’s massive public debt means the authorities cannot afford a sharp rise in borrowing costs. This rate hike is also symbolically important as it is the first increase since January and the first under the current leadership of both Ueda and Takaichi, underscoring a gradual but clear shift away from the BoJ’s long-standing emergency stance, according to agency reports.

Japan’s central bank acted against the backdrop of rising domestic pressures as the country is grappling with a sustained cost-of-living squeeze, driven by higher food and energy prices and a weak yen that has inflated import costs. Inflation, once a distant worry in Japan’s deflation-prone economy, has become politically and economically sensitive.

What is the yen carry trade?

The global relevance of this decision lies in its impact on the yen carry trade. For years, investors have borrowed cheaply in Japanese yen and deployed that capital into higher-yielding assets overseas, ranging from US Treasuries and emerging market bonds to equities and alternative investments. The strategy worked because Japan’s interest rates were close to zero and the yen was broadly stable or weakening.

Carry trades thrive on two conditions: a large interest rate differential and currency stability. As long as returns on foreign assets comfortably exceed borrowing costs in Japan, and the yen does not strengthen sharply, the trade remains profitable.

Japan’s rate hike threatens both pillars. Even a gradual rise in borrowing costs reduces the attractiveness of funding positions in yen. More importantly, a shift in monetary stance increases the risk of yen appreciation, which can quickly wipe out gains when investors convert foreign returns back into yen.

Risk of unwinding and global volatility

As rates rise in Japan, some investors may choose, or be forced, to unwind their carry trades. This process typically involves selling foreign assets and buying back yen to repay loans. Such moves can have destabilising effects, especially if they occur in a crowded and leveraged market.

An unwinding of the yen carry trade could trigger bouts of volatility across asset classes. Emerging market currencies and bonds, which have historically benefited from carry-driven inflows, are particularly vulnerable. Equity markets, especially those that have seen strong foreign participation, could also face pressure as global liquidity tightens.

The risk is not necessarily a sudden collapse, but rather episodic shocks. Even partial unwinding can lead to sharp currency moves, higher bond yields and risk-off sentiment globally. Markets that have become reliant on cheap offshore funding may find themselves exposed.