Why Japan is an unexpected threat to financial stability
In a crisis, the ability of banks to fund their dollar lending would be in question
The reversal of globalisation is by now in full swing in goods markets but nothing remotely comparable is happening to capital flows.
Indeed, it is impossible to understand US monetary policy or the gyrations of the Treasury market without considering the distorting impact of central bank asset-buying in Europe and Japan.
To American or British investors, a yield on 10-year Treasuries of just under three per cent looks pretty threadbare by historical standards. However, to yield-starved investors in Frankfurt or Tokyo, it looks more of a gift horse. Minimal or zero yields on Japanese government bonds have caused a huge exodus of capital into US Treasuries.
You can see it most graphically in the latest annual report of Japan Post Bank, the biggest deposit taker in the world. Between 2007 and the end of March of this year, its holdings of JGBs declined from 88 per cent of its overall portfolio to just over 30 per cent.
At the same time, its investments in foreign securities went from 0.1 per cent to 28.5 per cent, now amounting to ¥58tn ($521bn). That is scarcely peanuts and a great deal of it went towards financing the US government. Adding to the flow is the fact that investors in Japan can lock in a yield pick-up over JGBs even after full currency hedging.
Stuart Graham of Autonomous Research calculates that, using three-month rolling hedges, 10-year Treasuries at a yield of 2.95 per cent offer a 34 basis points pick-up over JGBs yielding nine basis points. Between 2007 and the end of March, Japan Post Bank’s holdings of JGBs declined from 88% of its portfolio to just over 30% while its foreign securities went from 0.1% to 28.5% Those kind of opportunities do not come along often in today’s markets.
It took the world’s most extreme quantitative easing programme to throw up this serendipitous free lunch.
What are the wider consequences of this extraordinary degree of integration in global capital markets? One is that the yield curve — the difference between short- and long-term Treasury rates — may prove to be less reliable as a predictor of recession. More crucially, cross-border capital flows complicate judgments about monetary policy.
The US Federal Reserve has been busy raising interest rates and has embarked on quantitative tightening whereby it shrinks its swollen balance sheet. Yet because short- to medium-term Treasury yields are below the rate of inflation, they are negative in real terms. This suggests that monetary policy is still stimulative, which looks inappropriate when the economy is growing at above its underlying trend rate, unemployment is at its lowest level for half a century and fiscal policy is in galloping expansion mode under Donald Trump.
Another snag is that cross-border bank lending is adding fuel to a US credit cycle that is already well advanced. The latest Fed Senior Loan Officer survey showed further easing of lending standards in the commercial and industrial loan category. This reflects intensifying competition in which the Japanese banks are playing a notable part. As well as operating in a low-growth domestic market, their profits have been squeezed by QE, so they have had to look overseas to plug the gap.
Once again, Japan Post Bank is interesting. It is proposing to build its strategic investment portfolio from a level of ¥1.6tn to ¥8.5tn with much of the money going into credit markets. This dash for yield at a relatively late stage in the cycle looks racy. Other Japanese banks are following suit. These frothy symptoms carry an echo of events before the great financial crisis. The decline in lending standards probably has further to go. But, as yet, there is no real-estate bubble, which is how financial crises so often come about in developed world economies. That is good news.
The longer-term worry is about Japan. After the bursting of the Japanese bubble in 1990, the country’s banking crises had little external impact. The JGB market, though huge, was and remains, largely about Japanese savers lending to the Japanese government. In effect, it was a financially closed economy where a post-bubble collapse of both the stock market and the property market left the rest of the world largely untouched.
With the growth of Japan’s capital exports and the Japanese banks’ shift into foreign markets, the country has become a factor not only in US and European monetary policy but a potential threat to financial stability.
In a financial crisis, the banks’ ability to fund their dollar lending would be in question. Note, too, that the history of banking is littered with cases of lenders running into trouble after taking big risks in novel territory. From a US perspective, the key point is that the pattern of Treasury yields is heavily distorted. When the great central banking experiments in Europe and Japan come to an end, investors in US Treasuries will surely be burnt.
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