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.

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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

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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:

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/}

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

^1/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.

^2/Figures in parentheses indicate (robust) standard errors. Numbers in bold indicate the 5 percent level of significance.

Table I.1.

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

Sample period: Q4 1997-
(quarterly data)
Dependent variable: banks’	(1)	(2)	(3)
holdings of central
government securities
loans	−0.56	-	−0.34
	(0.067)	-	(0.031)
deposits	-	0.86	0.67
	-	(0.065)	(0.044)
Num of obs	53	53	53
R-squared	0.75	0.86	0.96

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

^1/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.

^2/Figures in parentheses indicate (robust) standard errors. Numbers in bold indicate the 5 percent level of significance.

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Table I.1.

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

Sample period: Q4 1997-
(quarterly data)
Dependent variable: banks’	(1)	(2)	(3)
holdings of central
government securities
loans	−0.56	-	−0.34
	(0.067)	-	(0.031)
deposits	-	0.86	0.67
	-	(0.065)	(0.044)
Num of obs	53	53	53
R-squared	0.75	0.86	0.96

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

^1/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.

^2/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

Sources: Bloomberg and Staff estimates.

^1/Correlation coefficients refer to the correlation of 10-year JGB yields in levels and they are all statistically significant at the 5 percent level.

^2/Average yields refer to the average of 10-year yields on U.S. Treasury, German sovereign bonds, and U.K. Treasury bonds.

^3/Implied volatility refers to 30-day implied volatility of 10-year JGBs as calculated based on underlying options.

Table I.2.

Correlation of Japanese Sovereign Yields

Correlation with 10-year JGB yields 1/	10-year US Treasury yields	10-year German bond yields	Average yields of adv. countries 2/	Implied volatility of JGB yields 3/
Entire sample: (Jan 2000 - May 2011)	0.58	0.37	0.49	0.33
Before Jan 2008	0.61	0.19	0.44	0.31
After Lehman crisis	0.62	0.87	0.75	0.39

Sources: Bloomberg and Staff estimates.

^1/Correlation coefficients refer to the correlation of 10-year JGB yields in levels and they are all statistically significant at the 5 percent level.

^2/Average yields refer to the average of 10-year yields on U.S. Treasury, German sovereign bonds, and U.K. Treasury bonds.

^3/Implied volatility refers to 30-day implied volatility of 10-year JGBs as calculated based on underlying options.

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Table I.2.

Correlation of Japanese Sovereign Yields

Correlation with 10-year JGB yields 1/	10-year US Treasury yields	10-year German bond yields	Average yields of adv. countries 2/	Implied volatility of JGB yields 3/
Entire sample: (Jan 2000 - May 2011)	0.58	0.37	0.49	0.33
Before Jan 2008	0.61	0.19	0.44	0.31
After Lehman crisis	0.62	0.87	0.75	0.39

Sources: Bloomberg and Staff estimates.

^1/Correlation coefficients refer to the correlation of 10-year JGB yields in levels and they are all statistically significant at the 5 percent level.

^2/Average yields refer to the average of 10-year yields on U.S. Treasury, German sovereign bonds, and U.K. Treasury bonds.

^3/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).

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Global Spillovers and Volatility of the JGB Market

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

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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/}

^1/All variables included in the regression refer to the first lag.

^2/Figures in parentheses indicate the standard errors. Numbers in bold indicate the 5 percent level of significance.

^3/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.

^4/The dummy variable spans from September 2008 to April 2009 to include the peak of the global financial crisis.

Table I.3.

Factors Influencing Short-term JGB Yield Movements ^{1/ 2/}

Sample period:
Jan 2006 - May 2011
Dependent variable: 10-year JGB	(1)	(2)	(3)
yields
10-year U.S. Treasury yields	0.16	0.13	0.12
	(0.01)	(0.01)	(0.01)
10-year German sovereign bond	-	0.10	0.10
yields	-	(0.02)	(0.02)
Implied volatility of JGBs 3/	0.05	0.05	0.05
	(0.00)	(0.01)	(0.01)
Equity returns (Nikkei) 3/	−0.07	−0.09	−0.09
	(0.03)	(0.03)	(0.03)
Term premium 3/	-	0.14	0.14
	-	(0.05)	(0.05)
Dummy*U.S Treasury yields 4/	-	-	0.01
	-	-	(0.00)
Log likelihood	3312	3338	3340
Num of obs	1407	1407	1407

^1/All variables included in the regression refer to the first lag.

^2/Figures in parentheses indicate the standard errors. Numbers in bold indicate the 5 percent level of significance.

^3/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.

^4/The dummy variable spans from September 2008 to April 2009 to include the peak of the global financial crisis.

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Table I.3.

Factors Influencing Short-term JGB Yield Movements ^{1/ 2/}

Sample period:
Jan 2006 - May 2011
Dependent variable: 10-year JGB	(1)	(2)	(3)
yields
10-year U.S. Treasury yields	0.16	0.13	0.12
	(0.01)	(0.01)	(0.01)
10-year German sovereign bond	-	0.10	0.10
yields	-	(0.02)	(0.02)
Implied volatility of JGBs 3/	0.05	0.05	0.05
	(0.00)	(0.01)	(0.01)
Equity returns (Nikkei) 3/	−0.07	−0.09	−0.09
	(0.03)	(0.03)	(0.03)
Term premium 3/	-	0.14	0.14
	-	(0.05)	(0.05)
Dummy*U.S Treasury yields 4/	-	-	0.01
	-	-	(0.00)
Log likelihood	3312	3338	3340
Num of obs	1407	1407	1407

^1/All variables included in the regression refer to the first lag.

^2/Figures in parentheses indicate the standard errors. Numbers in bold indicate the 5 percent level of significance.

^3/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.

^4/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