Japan household already funds 55% of JGB. Banks can't buy more government bond due to Basel 2. Consumption tax increase and Post Bank are will not be enough. Japan will have to print.
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This is a printable version of a blog post Aileen Chang wrote on http://www.uprofish.com . Please come to the website for better quality viewing. Your feed back is welcome. Email: [email protected]U.PRO.FISH RSS Feed: http://feeds.feedburner.com/uprofish Twitter: uprofish 1 How Will Japan Fund Future Government Bond Issuance? July 27, 2010 Since FY1995, Japanese government has net issued about JPY 25T of bonds every year and between April 2010 and March 2011, the government plans to net issue JPY 33T worth of bond (JPY 44T gross.) However, where will the extra funding come from? Well, looking at the above picture, the first thing that comes to mind is let banks to buy more JGB. Comparing to insurance and pensions or to Japan Post, banks’ asset allocation to JGB is relatively low. Also, given the close relationship between banks and MoF in Japan, MoF should be able to persuade or direct the banks to buy more. However, this does not seem likely.
Transcript
This is a printable version of a blog post Aileen Chang wrote on http://www.uprofish.com. Please come to the website for
better quality viewing. Your feed back is welcome. Email: [email protected]
How Will Japan Fund Future Government Bond Issuance?
July 27, 2010
Since FY1995, Japanese government has net issued about JPY 25T of bonds every year and between April 2010 and March 2011, the government plans to net issue JPY 33T worth of bond (JPY 44T gross.) However, where will the extra funding come from? Well, looking at the above picture, the first thing that comes to mind is let banks to buy more JGB. Comparing to insurance and pensions or to Japan Post, banks’ asset allocation to JGB is relatively low. Also, given the close relationship between banks and MoF in Japan, MoF should be able to persuade or direct the banks to buy more. However, this does not seem likely.
First, Japanese banks already have more government bonds than other banks. European banks on average has about 5% of their assets in government bonds, and Greek banks have about 8% of total assets in Greek government bond. Also consider that the coming Basel rule change is trying to make banks to have about 8% of assets in cash and government bonds. Well, Japanese banks already have double that amount voluntarily! (Note: I do not know why BoJ Fund of Flow data and Japan Bank Association data have such big differences. I
think fair value vs. at-cost accounting is one of the reasons, but I don’t know.)
Second, it seems that instead of increasing JGB holding Japanese banks might have to reduce their asset allocation in JGB. Economist reports:
Kazuto Uchida, chief economist at MUFJ, says he has briefed the government of Naoto Kan about the pressures the banks will face to diversify their assets. …
Mr Uchida notes that under Basel 2 bank-capital rules there are so-called “outlier criteria” for banks with a heavy exposure to interest-rate risk, such as the Japanese banks. This will eventually limit how many JGBs the Japanese banks can hold. Under a stressed scenario in which JGB yields move up or down by two percentage points, the loss the banks would suffer must not exceed 20% of Tier-1 and Tier-2 capital. That would be a big move in yields but, if market sentiment turns, a perfectly possible one. Mr Uchida says Japanese banks are currently well below the 20% threshold (MUFJ does not reveal
its level; Mizuho put its at 8.5% in March 2009). But if they continue to increase their holdings at the current pace, in a number of years they may exceed it, Mr Uchida says.
On the other hand, GPIF, the public pension fund was a net seller between April 2009 and March 2010 and is likely to be a net seller on going forward. Foreigners are unlikely to be a buyer. Other (financial and non-financial corporate sector, government, fiscal loan fund, and other) is other and I think difficult to move much. So, unless Japan wants BoJ to print, that leaves MoF household. Or raising taxes and cutting spending. No wonder unconventional measures are taken/discussed:
Ministry of Finance put advertisements on taxis (Aug 2009) and magazines (June 2010) to persuade average Japanese people to buy more government bond.
Japan Post reform is getting reversed and it is proposed to double customer deposit limit at Post Bank to 20 million JPY and Japan Post Insurance maximum coverage to 25 million JPY (source)
Consumption tax increase (LDP proposed doubling it from current 5% to 10%) is discussed and seems to get public supporting when economy is dull and there is deflation(source)
Well, as you can see from the below calculation, even these desperate measures is likely to earn Japan only a few more years.
And there is a bigger problem. It seems that by 2015, there will not be enough Japanese household financial asset to cover Japan’s public debt, even when you assume the savings rate will stay at 2.2%, which is unlikely.
All these point that Japanese government is in deep trouble and aggressive movement from BoJ is inevitable. The prime minister Naoto Kan (though he may have to step down soon) tried to make BoJ to set inflation target to make BoJ when he was finance minister. The Your Party is aggressive in making BoJ to target inflation to get Japan out of deflation. BoJ plans to introduce 0.1% loan for banks if they lend it to certain growth sector. (I haven’t been able to find report of implementation) With the understanding of fiscal constraint and the importance of getting out of deflation, the general direction seems to be demanding BoJ to do more. Well what can BoJ do if it has to do more?
Betting short on Japanese government’s ability to fund is not easy. Many money managers lost money on the trade in the past decade(s). Not few investors (including myself) talk about JGB today, and their investment thesis is not too different from their predecessors. If any, the situation surrounding Japanese government’s funding ability has gotten worse. Debt/GDP, interest payment/Tax receipt, age of population is all higher and deflation persists. Yet, JGB yield is lower today than anytime in the past. Through the years, short JGB trade became death trap for traders. (And, Japanese Government Bond credit rating,
which was once lower than Botswana’s (which seems fair) has actually improved in the past decade!) That is why I haven’t initiated a position even though every time I look at JGB, I come to negative conclusions. (See my old JGB posts) But I have initiated a small short JPY strategy recently. As an individual investor, I cannot buy JGB CDS. I will examine Japanese bank puts and US treasury shorts.
I just cannot help but to think that some day down the road, we will look back and wonder “what the hell were we smoking thinking that Japan can go on like that?” Japan is the black swan. Japan singly changed the way we think about sovereign debt. We learned to consider domestic saving rate, domestic ownership of government bond, deflation (0.5% 2-yr JGB actually has real yield of c.1.5%), citizen’s risk-aversion, local currency denomination, private sector deleveraging, presence of big
domestic institution buying government bond, etc. (And, I think the reason Italy was largely saved from the PIIGS debt scare this year is (more than) partly because Italy has high domestic saving.) So, we learned from Japan to think of sovereign risk more benignly. But what if Japan gets into trouble? What will that teach us about how we should think of the sovereign risks of US, UK and many other countries?
And, let’s be honest. Japan is not okay. The situation doesn’t make any sense. Japan’s private and public sectors have debt of 460% to GDP. In the year to March 2011, the Japanese government has JPY 92T budget of which JPY 37T is to be financed with tax revenue and JPY 44T is to be financed with borrowing. And when average interest rate is only about 1.5%, Japanese government spends more than 25% of its tax revenue in paying interest.
<Reference: Historical Credit Rating Change of Japanese Government Bond>
See here for what each company’s rating means.
<Reference: Japan and Consumption Tax>
Raising consumption tax rate is interesting. According to OECD, Japan’s tax to GDP ratio is one of the lowest in the rich world but with one of the highest corporate tax rate and lowest consumption tax rate. So, raising consumption tax seems to be a now brainer for Japan, but Japan has never succeeded tax reform. Yet, though it might not rise immediately, it seems there is political consensus and public understanding about the need for consumption tax rise. (source)
