By Ichiro Suzuki
In the highly volatile financial markets so far into 2020, there were a few movements that might show signs of changes in long-lasting trends. One of them is yields on Japanese government bonds (JGBs). Yields on 30-year JGBs have failed to go into the negative territory after two attempts. This double-bottom formation often makes a powerful underpinnings to a change in directions. After four decades of persisting fall in yields, though with many ups and downs, and after relentless accumulation of debt, the market might be at last signaling the Japanese government “You can no longer borrow at lower costs”. The Japanese government got onto a path of issuing new debt in the early 1990s after the burst to the infamous bubble at the outset of the decade. In order to make up for weakened demand, the government embarked on fiscal policies through tax cuts and public works. The latter was often derided as building bridges to nowhere. Pundits began to predict fiscal collapse of the government that would accompany sharply higher yields on JGBs and tanking of their prices. Some hedge fund managers began shorting JGBs in the hope of profiting from the bonds’ melt-down in the market. Defying hedge funds' expectations, however, a long-term trend of falling bond yields kept going. This perplexing and market-beating behavior of JGBs came to be interpreted as the power of the depth of Japan’s financial resources to finance the profligacy of the public sector. While the government piled up debt, the ever so cautious private sector held onto cash on their balance sheets. Notably, the household sector deposited its cash with banks, which intern bought JGBs, recycling household sector savings into the hands of the Ministry of Finance (MOF). Since the aftermath of the Global Financial Crisis (GFC), the Bank of Japan (BOJ) has been an aggressive buyer of JGBs, too, along with the world’s other major central banks. There doesn't to seem to be any limit on expansion of central bank balance sheets. They are capable of buying government debt as much as and as long as possible. Therefore, yields on government bonds keep going lower indefinitely. Can this be right? If the household sector savings are underpinning the bond market, it can keep doing so as long as their money lasts. The household sector does have its limit. The sector has 1,900 trillion yen ($17.7 trillion at the exchange rate of 107 yen to the dollar) in financial assets, more than three times the size of the Japanese economy. Deducting liabilities that are mostly mortgages, the sector is still left with net financial assets of approximately 1,550 trillion yen. This is still a massive amount. However, the public sector has already accumulated liabilities of 1,100 trillion yen, leaving only 450 trillion that could support additional borrowing by the government. The size of the household sector financial assets is not expected to grow much amid slow rates of economic growth and low savings rates that have almost come down to zero in recent years from double digit figures. In the old days, Japan boasted of significantly high savings rates, well in the north of 10%. Savings rates have fallen considerably as the population aged. The older generation that no longer works draws down their savings that they accumulated when they were younger and used to work. This is going to happen in the rest of the world, and Japan is ahead of the world in this game. Net borrowing by the government never came really under control though Prime Minister Abe made it one of his policy goals when he rose to power in 2012. Net issuance of JGBs did fall somewhat as the Japanese economy got a new lease on life. Nonetheless, the government has been still required to borrow additional 30 trillion yen to finance the budget of approximately 100 trillion. Borrowing requirements are already expanding amid the deepest economic downturn since the 1930s and are expected to remain higher than it had been at least in the next several years. Future borrowing requirements do not make the remaining hypothetical capacity look large enough. The capacity has a strong chance of being depleted some time down the road. While this does not deny the Japanese government’s ability to borrow further, it would definitely make them listen to the financial market that would request higher yields. The JGB market could no longer defy the gravity, at long last. Higher borrowing costs would give the MOF and the government serious headaches. More resources would have to be allocated to debt-service while social security and healthcare costs continue to rise. The balance sheet of the BOJ is set to reach 600 trillion yen this year, well above the size of the Japanese economy, 550 trillion. It keeps expanding in an uncharted territory. In contrast, the Fed’s balance sheet still remains at a ‘modest’, less than 30% of the U.S. economy, even after the very aggressive QE4 this spring. The BOJ might not be too far way from the inflection point that makes the market question the credibility of the central bank. A potential credibility question on the BOJ on top of the MOF’s nearing the borrowing capacity appears to be affecting the value of the yen. This is another trend shift this spring. The Japanese currency did not rise against the dollar amid two conditions that would have driven its value up in the past. One is heightened volatility in the financial market and the other is the Fed’s QE4. Narrowing interest rate differentials between Japan and the U.S. may have reduced the attractiveness of carry trades between the two currencies. It was popular among hedge funds to buy the yen at low cost to be invested into U.S. since Treasury securities offer much higher yields than Japan’s. Falling U.S. interest rates have made this trade less attractive than before. Declining ‘debt capacity’ is simply a deterioration of fundamentals on the part of the MOF and Japan. Such deterioration is thrown back onto the value of the currency.
About the author: Mr. Suzuki is a retired banking executive based in Tokyo, Japan.