Recognize the Adverse Effects of Excessive Reliance on JGBs

Faculty Fellow, RIETI

There have been widespread concerns among economists and policymakers over a sharp rise in the interest rates of Japanese government bonds (JGBs), a potential risk to the financial markets posed by Prime Minister Shinzo Abe's macroeconomic policy. Nominal interest rates may rise sharply following the shift to an explicit inflation (or price) targeting policy. Aggressive fiscal stimulus packages may end up only exacerbating Japan's fiscal situation, leading to a crash in JGBs, hyperinflation, and the weakening of the yen simultaneously occurring in the future.

These concerns are sensible ones and deserve thorough consideration by policymakers as to the potential long-term implications of the current macroeconomic policy.

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I do not think that Japan will see a drastic rise in interest rates comparable to those experienced by some southern European countries within the next three to four years. Of course, a certain rise is inevitable if Japan indeed succeeds in breaking away toward a steady positive inflation rate, but it seems quite unlikely that this will trigger a rise of as much as several percentage points in JGB yields.

I start from the basics: market interest rates on government bonds are calculated by dividing the amount to be paid at maturity by the current market price. In other words, interest rates and their prices move in opposite directions, so a sharp rise in interest rates means a large loss for bondholders.

In the wake of the sovereign debt crisis in Europe, Dexia, a major Franco-Belgian financial institution, collapsed in October 2011 due to mounting losses from the falling prices of Greek government bonds, throwing the European financial market into turmoil. Negative shocks from the bank failure spread throughout the European financial system through the channel of losses on sovereign bond holdings. There is no guarantee that the same will not happen to Japan.

Why then do the JGB interest rates remain low despite the fact that Japan's public debt is the largest among developed nations and that the risk of a fiscal crisis has long been pointed out? The biggest reason for this is that over 90% of JGBs are held by domestic investors. Japan, as it stands today, resembles a household where the profligate husband (the government) keeps on borrowing money from the frugal wife (households and business sectors). Just like the couple trying to borrow outside of the family budget, the Japanese government will be forced to issue bonds at much higher interest rates upon attempting to borrow from overseas.

Then, how long will the private sector be able to keep compensating for government borrowing? In the following, I discuss the issue mainly from a microeconomic perspective.

Figure 1: Liquid Deposits and Government Bonds Held by Japanese Financial InstitutionsFigure 1: Liquid Deposits and Government Bonds Held by Japanese Financial Institutions
Source: Compiled by the author based on data from the Bank of Japan's Flow of Funds Accounts Statistics
Figure 2: Liquid Deposits and Government Bonds Held by Financial Institutions for Small Businesses and Financial Institutions for Agriculture, Forestry and FisheriesFigure 2: Liquid Deposits and Government Bonds Held by Financial Institutions for Small Businesses and Financial Institutions for Agriculture, Forestry and Fisheries
Source: Compiled by the author based on data from the Bank of Japan's Flow of Funds Accounts Statistics

As indicated in Figure 1, Japanese deposit-taking financial institutions have been increasing their purchases of government bonds almost in proportion to the increase in deposits in recent years. However, as the population continues to age, the amount of new deposits will inevitably stop increasing. The anticipation of a significant slowdown in deposit growth in the near future would give rise to the prospect of higher JGB interest rates. Once that happens, interest rates would rise quickly as no investors dare to purchase assets that are set to fall in value. Therefore, even if the true possibility of a fiscal crisis is very remote, there always exists the risk of a sharp rise in interest rates caused by the self-fulfilling nature of market expectations.

The possibility of such a sudden rise in interest rates may be low. Even so, in 2011, the Liberal Democratic Party (LDP), an opposition party at the time, compiled a report called the "X-Day Project," warning about the potential risks associated with a sharp fall in JGB prices.

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What potential risks will a sharp rise in interest rates bring to the Japanese financial system? Of the overall depository institutions in Figure 1, Figure 2 focuses on those primarily lending to small businesses or borrowers in the agricultural, forestry and fisheries sectors, including the Japan Post Bank. A comparison of the two figures shows that the increase in deposits is more moderate and the increase in government bonds is sharper in Figure 2. Also, the breakdown of the JGBs held shows that the weight of treasury discount bills (T-bills), i.e., government bonds with short maturities, is smaller in Figure 2.

In other words, large financial institutions including megabanks and top regional banks, which account for the differences between Figure 1 and Figure 2, have already taken into account the interest rate risk and accordingly reduced the amount of JGB holdings relative to that of deposits while at the time seeking to shorten the maturities of their portfolios. As a result, the risk of a sharp rise in interest rates is concentrated in those financial institutions represented in Figure 2, namely, lenders to small businesses and borrowers in the agricultural, forestry and fisheries sectors, rather than spread out across the financial system as a whole.

Major JGB holders not included in these figures are life insurance companies and pension funds. They are quite different from deposit-taking institutions in that most of their liabilities are insurance payouts or pension benefits payable in predetermined amounts at predetermined dates. For this reason, life insurance companies are employing a risk management method called duration matching, which matches the maturities of their government bond holdings with the timing of liability payments. For this reason, life insurance companies have been increasing their holdings of long-term and super-long-term government bonds over the last decade or so, and this trend is expected to continue for a few more years.

For pension funds, risk management will pose a tougher challenge because, unlike life insurance payouts which are fixed in nominal terms, pension benefits should be preferably fixed in real terms. Nevertheless, reference to such risk management is rarely found in the published financial statements, pointing to a more serious problem, that is, the pension fund industry as a whole lacks the awareness of the need to manage the interest rate risk by duration matching or other similar schemes.

If the government and the Bank of Japan seriously intend to promote measures to break away from deflation, they should provide the private sector with a means to hedge inflation risk and quickly implement measures to ensure the continuous and smooth absorption of JGBs. More specifically, the government should resume issuing inflation-indexed bonds—those with inflation-adjusted principal, or fixed in real terms—and try to vitalize the market. The new issuance of inflation-indexed bonds has remained suspended following the collapse of Lehman Brothers. This is because the dominant players in the index bond market had been American and European financial institutions operating in Tokyo who were paralyzed by the financial crises in the United States and in Europe. Inflation-indexed bonds can also serve as an efficient channel for the government in assessing inflation expectations in the private sector.

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For the last several years, the Japanese government has had to cope with a series of major external shocks, such as the global financial crisis and the Great East Japan Earthquake, and fiscal stimulus packages have been repeatedly employed to invigorate the economy. Meanwhile, long-term interest rates continued to fall, as deflation persisted and deflationary expectations were reinforced. This made it easy for the government to cover its fiscal deficit by issuing JGBs, but at the same time encouraged certain financial institutions to depend excessively on them as a means of investment.

I have no intention to discuss about the right or wrong of the ongoing macroeconomic policy. What is clear, however, is the responsibility on the part of those financial institutions embracing excessive interest rate risk. It is inconceivable that they have been unaware of such risk given that other financial institutions have appropriate risk management in place on the assumption that interest rate risk does exist. The existing situation, in which risk is concentrated in certain types of players within the financial system, has nevertheless occurred, and it is not hard to imagine that management moral hazard—be it the thoughtless herd behavior of the management, the after-me-the-deluge mentality of individual managers who will have retired by the time interest rates begin to rise sharply, or their irresponsible belief that whatever mess they make would be eventually taken care of by the government and the Bank of Japan—is at work.

If these financial institutions run into financial trouble in the wake of a sharp rise in JGB interest rates, the government should provide the minimum safety net to depositors and pension plan participants. However, it must be ensured that failed institutions along with all of their stakeholders will be held liable and feel their share of the pain. A full-scale bailout by the government would not only worsen the nation's fiscal condition but also give the seal of approval to irresponsible risk management, which may lead to serious problems in the future.

>> Original text in Japanese

* Translated by RIETI.

March 4, 2013 Nihon Keizai Shimbun

May 2, 2013

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