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Apocalypse not now

31 May 2013 By Andy Mukherjee

The Bank of Japan’s money-printing plan is failing to keep borrowing costs in check. Since the central bank pledged on April 4 to double its holdings of Japanese government bonds in two years, the yield on 10-year government debt has doubled. On May 23, it briefly touched 1 percent.

If interest rates spin out of control, Japan’s nascent economic recovery could be choked off. The government, already the most indebted in the developed world, could have trouble financing its debt. Banks and insurance companies could suffer. For now, however, the yield surge is within manageable levels.

But why are bond yields rising when the central bank is buying more government debt?

The Bank of Japan’s bond-buying is pushing yields down, but Japanese investors are simultaneously demanding higher rates to lend to the government. That’s a rational response if investors believe that Prime Minister Shinzo Abe’s aggressive policies will boost inflation. So rising yields are an unintended consequence of the early success of Abenomics. At the same time, expectations of an early end to the Federal Reserve’s quantitative easing programme are pushing up U.S. Treasury yields – increasing the opportunity cost for global investors of holding Japanese bonds.

However, it’s important to get the recent moves into perspective: though bond prices have fallen sharply in the last two months, the yield on 10-year Japanese government debt remains less than 0.9 percent – only slightly higher than when Abe was elected in mid-December.

Don’t rising yields threaten the government’s ability to service its debt?

With national debt at about 237 percent of GDP, investors worry that even relatively small shifts in borrowing costs will quickly push up the government’s interest bill. Japan’s average borrowing costs are currently about 1.2 percent a year. But it needs to refinance one-seventh of its 713 trillion yen ($7.06 trillion) in outstanding bonds every year.

Add new issuance, and Japan may need to borrow about 170 trillion yen this year. Even if the government borrows at a 3 percent rate, its overall average interest cost will rise to just 1.6 percent. It would take several years of elevated yields, unaccompanied by higher taxes or lower spending, before investors seriously started to question Tokyo’s ability to service its debt.

Will high yields undermine Japan’s economic recovery?

The key figure to watch is real, not nominal, interest rates. Japan’s consumer prices are still sliding 0.5 percent a year. With 10-year bonds yielding close to 0.9 percent, that means the real interest rate is around 1.4 percent. Compare that to the United States. Nominal yields are more than twice Japan’s, but rising prices mean that the real interest rate is just 1 percent.

If inflation in Japan rises to the Bank of Japan’s target of 2 percent, borrowers would still be better off even if yields hit 3 percent. As long as consumer prices are still falling, though, rising yields will discourage investment and borrowing.

Volatility is another worry. Though yields are still low by historic standards, fluctuating prices will force banks to charge a premium for uncertainty, limiting demand for credit.

Japanese financial companies hold lots of government bonds. Will they suffer a crisis?

Falling bond prices hurt banks and insurers, which have assembled large government debt portfolios. However, according to the Bank of Japan, even a 3 percentage point jump in interest rates would leave banks’ capital ratios above the minimum levels required by regulators.

If yields rise as a result of increased optimism, banks will also be able to deploy their balance sheets more profitably by increasing lending to companies and consumers. However, if borrowing costs rise over concerns about fiscal mismanagement, then there won’t be as much additional revenue to compensate financial companies for mark-to-market losses on their bond portfolios. That is when the financial system could get into trouble.

What else can the authorities do to calm markets?

The short answer: more of the same. If yields show signs of spiralling out of control, the Bank of Japan may have little choice but to commit to buying even more debt. But the recent surge is also a wake-up call to the government not to neglect the third arrow in Abe’s revival plan – structural reforms.

Borrowing costs are not all that prevents companies from investing: employment rules are too rigid and electricity tariffs paid by Japanese manufacturers are among the highest in OECD. Unless Abe’s administration takes decisive steps to make the economy more competitive, Japan may never be able to surmount its ageing population and achieve decent growth without excessive government borrowing and spending. Fortunately, Japan is still a long way from such a fiscal and financial Armageddon.


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