The Japanese Government Bond (JGB) market has been stable in Japan since the earthquake, but the factors holding down JGB yields could diminish over time. To limit these risks, fiscal policy should aim to reduce public debt quickly and lengthen maturity of JGBs. The Bank of Japan’s (BoJ) easing measures have had a significant and broad-based impact on financial markets. Policies to support employment and protect incomes have been effective, but have to be phased out and complemented with training and job search assistance programs to facilitate a smooth reallocation of labor.

Abstract

The Japanese Government Bond (JGB) market has been stable in Japan since the earthquake, but the factors holding down JGB yields could diminish over time. To limit these risks, fiscal policy should aim to reduce public debt quickly and lengthen maturity of JGBs. The Bank of Japan’s (BoJ) easing measures have had a significant and broad-based impact on financial markets. Policies to support employment and protect incomes have been effective, but have to be phased out and complemented with training and job search assistance programs to facilitate a smooth reallocation of labor.

I. Assessing Risks to the Japanese Government Bond Market 1

A. Introduction

1. Since the earthquake, yields on Japanese government bonds (JGBs) have remained low and stable. Despite expectations of additional JGBs to finance reconstruction, 10-year JGB yields have remained steady around 1.1–1.2 percent since March of this year. The sizeable financial surpluses of the corporate and household sectors continue to provide steady funds to the JGB market through the banking sector. Recent JGB auctions have been met with robust demand from banks who continue to purchase short-term securities and from life insurers and pension funds looking to lengthen the duration of their bond portfolios (Figure I.1).

Figure I.1.
Figure I.1.

Overview of the JGB Market

Citation: IMF Staff Country Reports 2011, 182; 10.5089/9781462329458.002.A001

2. These factors holding down JGB yields in the near term, however, could wane even though the risks of a near-term disruption to the market are low. The supply of funds for financing JGBs could decline as business investment picks up to repair the damaged capital. Given the high correlation of JGB yields with other sovereign yields (such as for U.S. Treasuries), a rise in global financial distress could spillover and affect the JGB market. An unwinding of positions in the futures and swaps markets, where foreign participation is high, could amplify these inward spillovers, and an increase in market volatility or a sudden rise in yields could also push banks to sell JGBs to limit losses. All of these factors could contribute to a rise in yields, worsen the public debt dynamics, and pose a risk to financial stability.2

3. The market’s capacity to absorb new debt is also likely to diminish gradually as the population ages and risk appetite recovers. Japan’s large pool of domestic savings, a stable investor base, low share of foreign ownership of JGBs, and current account surpluses have helped maintain stability in the JGB market. But these favorable factors are likely to diminish over time as population aging reduces household saving and a rise in risk appetite lowers demand for safe assets. Without a significant policy adjustment, the stock of outstanding JGBs could exceed the level of household financial assets (currently at 300 percent of GDP) within 5 to 10 years, suggesting that the government may need to turn more to other sources, such as the corporate sector or foreign investors, to help finance its deficits.3

4. To assess the risks to the JGB market, this paper addresses the following questions.

  • What are the key risks to stability in the JGB market? What are the possible channels through which global financial distress could affect JGB yields?

  • What would be the implications of high interest rates for public debt dynamics? What should be the policy priority to mitigate the risks to the JGB market?

B. Risks to the JGB Market from Shrinking Fund Supply, Global Spillovers, and Market Volatility

5. In the near term, changes in fund supply, global spillovers, and market volatility could push up interest rates, although these risks appear low at present.

Decline in Fund Supply

6. Fund supply to the JGB market from the corporate sector, insurers, and pension funds could decline in the near term due to earthquake-related damage. Corporate financial surpluses, which amounted to 6 percent of GDP in 2010, have been an important source of JGB funding through the banking system. These surpluses could decline as corporates undertake investment for reconstruction or expansion overseas. Demand for JGBs from insurers and pension funds could also weaken if insurers come under pressure to sell JGBs to settle claims, while pension funds could accelerate payouts. One of the largest institutional investors, the National Pension Fund, has already begun reducing assets to make payouts to retirees.

A01ufig02

Japan: Net Purchases of JGBs and FBs

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 182; 10.5089/9781462329458.002.A001

Source: Bank of Japan Flow of Funds Statistics

7. Estimating a basic demand function for government securities can help assess the impact of a decline in corporate financial surpluses on banks’ JGB holdings. Here we estimate the following equation:

govtsec=β1loans+β2deposits+β3controlvariables,

where govtsec is banks’ holdings of central government securities (JGBs and FBs), 4 loans is the stock of bank loans, and deposits is the sum of household and corporate sector deposits (all in percent of GDP). Control variables include real GDP growth, spreads between long-term prime lending rates and 10-year JGB yields, and CPI inflation.5 Financial surpluses of the corporate and households sectors channeled through the banking sector are observed when loans decrease or deposits increase, or both. That is, corporates and households can use their financial surpluses either by repaying loans (loans decrease) or making additional deposits (deposits increase). If financial surpluses of these sectors have a positive impact on banks’ holdings of central government securities, the coefficients in the regressions should read as β1 < 0 and β2 > 0. We run regressions in level form assuming cointegration (where estimates are robust to endogeneity).6

8. The results suggest that a decline in financial surpluses of the corporate sector could significantly reduce banks’ purchases of central government securities. The estimates indicate that a 1 percentage point of GDP increase in loans would reduce banks’ holdings of central government securities by 0.3–0.6 percent of GDP, while a similar decline in deposits would cut banks’ holdings of these securities by 0.7–0.9 percent of GDP (Table I.1). These coefficients in turn imply that if corporate surpluses come down to zero from 6 percent of GDP in 2010, banks’ net government security purchases could fall by 2–4 percent of GDP. This would be a sizeable reduction, about one third of annual net government debt issuances in recent years (10 percent of GDP).

Table I.1.

Impact of Loans and Deposits on Banks’ Holdings of Government Securities 1/,2/

article image
Source: Bank of Japan Flow of Funds Statistics; Haver; CEIC.

Cointegration is assumed. Other regressors include a lag of quarterly growth (SA), spreads between long-term prime lending rates and 10-year JGB yields, quarterly CPI inflation, and quarter dummies.

Figures in parentheses indicate (robust) standard errors. Numbers in bold indicate the 5 percent level of significance.

9. Based on historical trends, such a decline in corporate financial surpluses would likely have a modest impact on yields, but a more substantial response cannot be ruled out. Japan’s historical data suggest that the immediate impact on yields from a decline in corporate financial surpluses to zero would be at most about 10 basis points.7 Moreover, a recovery in tax revenue following a pickup in business activity may also reduce the fiscal deficit and partially offset the impact on yields. However, the response of yields to a funding shock could be nonlinear and become more significant once public debt exceeds a certain threshold.8

Global Spillovers

10. Global financial distress could have negative spillover effects on the JGB market through the banking system. Japan’s sovereign yields are sensitive to global risks, including in the U.S. Treasury and some European sovereign debt markets, where the estimated correlation on 10-year sovereign yields ranges from 0.37 to 0.58 (Table I.2). In response to capital losses on their foreign bond portfolios, Japanese banks could reduce their holdings of JGBs to minimize losses. For example, late last year, the sudden rise in JGB yields mirrored those in U.S. Treasuries (Figure I.1), as Japanese banks pared back their JGB holdings and shortened maturities in response to losses on their U.S. Treasury holdings.

Table I.2.

Correlation of Japanese Sovereign Yields

article image
Sources: Bloomberg and Staff estimates.

Correlation coefficients refer to the correlation of 10-year JGB yields in levels and they are all statistically significant at the 5 percent level.

Average yields refer to the average of 10-year yields on U.S. Treasury, German sovereign bonds, and U.K. Treasury bonds.

Implied volatility refers to 30-day implied volatility of 10-year JGBs as calculated based on underlying options.

11. Another channel for global spillover could be through the derivatives markets where foreign participation is high. Despite low foreign ownership of JGBs (5 percent of the total outstanding), foreign investors are active in the JGB futures market, holding about one-third of outstanding contracts.9 Compared to domestic players, foreign investors appear to be more sensitive to Japanese sovereign risk, as indicated by the rise in spreads on JGB CDS contracts—traded mostly among foreign investors.10 Overseas financial distress could lead to a rise in global yields, which could in turn amplify pressures on JGB yields through these derivatives markets (Figure I.2).

Figure I.2.
Figure I.2.

Global Spillovers and Volatility of the JGB Market

Citation: IMF Staff Country Reports 2011, 182; 10.5089/9781462329458.002.A001

12. Regression analysis confirms that 10-year JGB yields in the short run are largely driven by global risk factors and investor risk appetite. We estimate the global spillover channel by using a time-series regression and taking into account global factors and investors’ risk appetite. The analysis uses daily data from 2005 with an ARIMA specification that accounts for the auto-regressive and heteroscedastic features of short-term yield movements.11 Granger-causality tests show that movements in global yields generally precede those of JGBs, though the reverse causality from JGB yields to global yields does not appear to be statistically significant.12 The results indicate that global factors that drive U.S. Treasury and European sovereign yields, which in turn affect the JGB yields, are significant at the 5 percent level (Table I.3). These estimates imply, for example, that a one percentage point increase in U.S. Treasury yields (or a change in global risk factors that raise U.S. Treasury yields by one percentage point) could increase JGB yields by nearly 15 basis points. The last specification includes an interaction of the U.S. Treasury yields with a dummy variable that corresponds to the peak of the global crisis after the Lehman collapse. It shows that the JGB yields were more closely driven by the U.S. Treasury yields during the peak of the global crisis. The magnitude is statistically significant and generally robust across various specifications. In addition, measures of investors’ risk appetite, such as the implied volatility of JGBs, also have a strong impact on JGB yields. For example, a rise of implied volatility, similar to what took place after the Lehman crisis, would push up JGB yields by more than 40 basis points.

Table I.3.

Factors Influencing Short-term JGB Yield Movements 1/2/

article image

All variables included in the regression refer to the first lag.

Figures in parentheses indicate the standard errors. Numbers in bold indicate the 5 percent level of significance.

Implied volatility refers to 30-day implied volatility of 10-year JGBs as calculated based on underlying options. Equity returns measured by the first difference in logs of Nikkei. Term premium refers to the slope between 2-year and 5-year JGBs.

The dummy variable spans from September 2008 to April 2009 to include the peak of the global financial crisis.

Market Volatility

13. A rise in market volatility could prompt an unwinding of JGBs held by the private sector.

  • Higher interest rate volatility could induce a JGB sell-off by banks if the risk exposures exceed the calculated thresholds of the banks’ risk management model. A notable example was the so-called ‘VaR shock’ in June 2003, when 10-year JGB yields more than tripled over three months, surging from a historically low of 0.45 percent to 1.6 percent (Figure I.2).13 Although banks have now strengthened risk management practices by including qualitative assessment in addition to the quantitative risk measures in VaR models, banks’ JGB holdings are significantly larger, suggesting that a similar shock today could still be disruptive. A possible rating downgrade or weak JGB auctions that pushes up yields or raises volatility could induce a sale of JGBs by banks to limit losses, which in turn could lead foreign investors to unwind their positions in the futures and swaps markets.14

  • The rollover risks of JGBs have risen along with the government’s annual financing requirement, which now amounts to about 55 percent of GDP (including financing bills). Given the large amount of bonds that need to be rolled over, uncertainty over the supply and demand of JGBs could disrupt the smooth absorption of new issuances.15

C. Implications of a Rise in JGB Yields

14. A potential rise in yields arising from these risks would make fiscal consolidation much more difficult. If sovereign yields rise by 100 basis points over the next 5 years, the net debt-to-GDP ratio would remain at high levels over the long term, even after a 10 percentage points of GDP adjustment in the structural fiscal balance. This would leave the fiscal position vulnerable to interest rate or funding shocks and risk undermining public confidence.

15. Yield increases could also pose a risk to banks. With banks holding a large amount of JGBs (more than 15 percent of total assets), a rise in yields would generate capital losses. For example, a 100 basis point increase in interest rates across all maturities would generate capital losses of around ¥250 billion at the major banks and about ¥500 billion at the regional banks. This could reduce Tier 1 capital of major banks by 10 percent and by 30 percent for regional banks who face greater duration risks.16

A01ufig03

Japan: Net Public Debt 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 182; 10.5089/9781462329458.002.A001

Source: Cabinet Office; IMF WEO database; and staff estimations.1/ Net debt of the general government including the social security fund.2/ Assumes a 10 percent of GDP improvement of the structural primary balance between2010-20.3/ Yields hike by 100 basis points gradually over 5 years between 2011-16. As a result, nominal interest rate growth differential is assumed to converge to 225 basis points over the long term (125 basis points (pre-global financial crisis average since 2000) + 100 basis points).4/ Nominal interest rate growth differential is assumed to converge to 125 basis points over the long term.
A01ufig04

Japan: Interest Rate Risk in the Banking System

(100 basis point value; in percent of Tier-1 capital)

Citation: IMF Staff Country Reports 2011, 182; 10.5089/9781462329458.002.A001

Source: Bank of Japan

D. Summary and Conclusions

16. The JGB market has been stable since the earthquake, but the factors holding down JGB yields could diminish over time. Since March, JGB yields have been supported by robust demand from banks and insurance companies. However, going forward, a decline in fund supply, particularly from the corporate sector, spillovers from global financial distress, and higher market volatility could create upward pressure on JGB yields. Over the medium term, population aging and a recovery in risk appetite are also likely to reduce domestic saving and the demand for safe assets.

17. To limit these risks, fiscal policy should aim to reduce public debt quickly and lengthen maturity of JGBs. Committing to a credible medium-term fiscal strategy based on clear and specific tax and entitlement reforms could help support confidence in public finances. Lengthening debt maturities, such as by shifting to long-dated JGBs, would also help lock in low interest rates and guard against market volatility.

References

  • Ardagna, Silvia, Francesco Caselli, and Timothy Lane, 2004, “Fiscal Discipline and the Cost of Public Debt Service: Some Estimates from OECD Countries,” NBER Working Paper Series, No. 10788.

    • Search Google Scholar
    • Export Citation
  • Bank of Japan, 2010, Financial System Report, September.

  • Faini, Riccardo, 2006, “Fiscal Policy and Interest Rates in Europe,” Economic Policy, Vol. 21, No. 47, pp. 443489.

  • International Monetary Fund, 2011, Japan Spillover Report for the 2011 Article IV Consultation (Washington).

  • International Monetary Fund, 2010, Global Financial Stability Report, October.

  • Tokuoka, Kiichi, 2010, “The Outlook for Financing Japan’s Public Debt,” IMF Working Paper 10/19 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
1

Prepared by W. Raphael Lam and Kiichi Tokuoka.

2

Yield increases in Japan could also have outward spillovers (see Japan Spillover Report, 2011).

4

Excluding Japan Post Bank due to data constraint.

5

These variables are included to control for business cycles and risk appetite. Including other variables (e.g., equity returns) to control for risk appetite does not change the results much.

6

Unit root is not rejected for govtsec, deposit, or loans.

7

Estimated using regression results in Tokuoka (2010), which report that a decline in corporate and household financial net worth of 1 percent of GDP would raise 10-year JGB yields by 1–2 basis points.

8

There is some empirical evidence consistent with the view that the impact of a rise in debt on yields is nonlinear and becomes significant once the debt exceeds a certain threshold (e.g., Faini, 2006; Ardagna, Caselli, and Lane, 2004).

9

Statistical analysis, however, does not point to a particular direction of causality.

10

Japan’s CDS market is not very liquid and consists mainly of foreign hedge funds. Foreign investors looking to short JGBs typically acquire short positions on JGB futures, or buy out-of-the-money put options on interest rate swaps.

11

The regression uses lagged variables as regressors. An autoregressive integrated moving average (ARIMA) model applied as a statistical test on sovereign yields suggests that the time series are non-stationary. The regression includes U.S. Treasury and German yields, and the implied volatility of JGB yields as a proxy for the investor’s risk appetite. Other risk factors, including exchange rate volatility and term premia, are also included. These risk factors in essence capture both domestic and external risks.

12

The hypotheses that 10-year U.S. Treasury yields and 10-year Germany sovereign yields do not Granger-cause 10-year JGB yields are rejected with F-statistics equal to 51.7 and 35.4 (both p-values close to zero), indicating the statistical significance at the 5 percent level. However, the reverse causality from 10-year JGB yields to 10-year U.S. Treasury yields or 10-year Germany yields is not statistically significant, with p-values close to 0.3 and 0.2, respectively.

13

This episode was termed the “VaR shock” because the rise in volatility increased risk measures in banks’ internal value-at-risk (VaR) models and led to one-sided selling by banks as they attempted to shed risk (Bank of Japan, 2010).

14

A large portion of JGB holdings are held in banks’ balance sheet outside the trading book such that the JGB holdings do not need to be marked-to-market. Banks also tend to select the higher ratings on JGBs from domestic rating agencies in assigning risk weight on their holdings of government securities. For example, Japan Credit Rating Agency and Rating and Investment Information both assign ‘AAA’ to Japanese sovereign bonds, higher than the ratings from other international rating agencies. Nevertheless, a sustained rise of sovereign yields is likely to pose significant interest rate risks in banks’ balance sheets from unrealized losses.

15

For example, so called “FILP shock” took place in 1998 when yields spiked due to confusion over the purchases of JGBs by the Fiscal Investment and Loan Program (FILP) Special Account.

16

Global Financial Stability Report (October 2010), IMF and the Financial System Report (September 2010) of the Bank of Japan.

Japan: Selected Issues
Author: International Monetary Fund