This Selected Issues paper examines implications for long-term bond yields in case of Japan. The analysis finds that so far, upward pressure on interest rates from high public debt has been offset by domestic factors, including a stable investor base with a preference for safe assets. As these effects could decline with population aging, yields could rise unless reforms are implemented to stimulate growth and reduce the public debt-to-GDP ratio. In such a scenario, long-term Japanese government bond rates would remain relatively low and stable. The paper also analyzes to what extent rising health care spending poses a fiscal risk to Japan’s economy.

Abstract

This Selected Issues paper examines implications for long-term bond yields in case of Japan. The analysis finds that so far, upward pressure on interest rates from high public debt has been offset by domestic factors, including a stable investor base with a preference for safe assets. As these effects could decline with population aging, yields could rise unless reforms are implemented to stimulate growth and reduce the public debt-to-GDP ratio. In such a scenario, long-term Japanese government bond rates would remain relatively low and stable. The paper also analyzes to what extent rising health care spending poses a fiscal risk to Japan’s economy.

Japanese Financial Institutions Expanding Abroad: Opportunities and Risks1

Overseas activities of Japanese financial institutions have risen, mainly in Asia, since the global financial crisis. Stagnant growth and low interest margins in Japan have added to incentives to seek opportunities abroad. This note explores the determinants of Japanese banks’ overseas expansion and assesses whether these cross-border activities will continue under the new macroeconomic policies. The analysis finds that Japanese banks are well positioned to scale up foreign exposures, thanks to their relative resilient balance sheets and the robust growth in the region. Stronger domestic growth in Japan could mitigate the pace, but is unlikely to reverse a long-standing trend because empirical estimates suggest that global and regional factors play a more prominent role in the growth of Japanese cross-border claims. The increasing cross-border activity would pose funding risks and supervisory challenges that require continued close monitoring. In addition, an incomplete set of domestic policies that fails to raise growth could undermine domestic financial stability.

A. Introduction

1. Cross-border activities of Japanese financial institutions have risen over the past few years, particularly to the Asian region. Overseas loans by major banks are growing by over 20 percent year-on-year and major Japanese banks have attained an important global and regional presence, particularly in areas of syndicated lending and project finance. Foreign claims on Asia have recouped the decline at the height of the global financial crisis and are now at levels comparable during 2005–08. Moreover, brokerage firms and life insurers have sought acquisitions or strategic partnership overseas.

2. The overseas expansion has been driven by regional and domestic factors. Stagnant growth and limited domestic credit demand have added incentives for Japanese financial institutions to seek opportunities abroad. The relative resilience of Japanese banks during the financial crisis has provided some capacity to take on further foreign exposures, despite higher global uncertainty. Outside Japan, robust growth in Asia and deleveraging of European banks in the region contributed to a rise of cross-border lending. The exchange rate appreciation in the past years might offer additional incentives for expanding abroad.

3. This note assesses whether this trend will continue under the government’s new policy framework often referred to as Abenomics. The Bank of Japan’s (BoJ) new quantitative and qualitative monetary easing (QQME) framework—part of the three-pronged strategies to revive growth and exit deflation—intends to encourage financial institutions to shift away from government bonds and take on greater exposures of risky assets (such as loans and investment securities).2 An improved domestic outlook could increase financial institutions inward focus to satisfy rising credit demand. On the other hand, uncertainty over the Japanese government bond (JGB) market and yen movements may stimulate diversifying needs outside Japan. The note seeks to answer the following questions:

  • What factors contribute to Japanese financial institutions expanding abroad? Would the cross-border activity of these financial institutions continue or reduce under the Abenomics?

  • What are the risks in light of increasing cross-border activity and the implications for financial institutions and supervisors?

4. The trend of expanding overseas is likely to continue, but will depend on a supportive domestic economy under successful Abenomics and careful risk management and supervision. Empirical analysis indicates that modest global uncertainty, large growth differentials, and the resilience of domestic banking systems are key drivers for cross-border claims. In addition, robust growth in Asia and sufficient liquidity at home would imply the trend of expanding abroad is likely to continue. Although stronger domestic growth might slow the expansion pace, it is not expected to reverse the trend unless an incomplete Abenomics poses risks to domestic financial stability. Increasing cross-border activity also adds to funding risks and supervisory challenges that require continued close monitoring.

5. The note is organized as follows: Section B analyzes the determinants for banks’ expanding abroad based on an empirical analysis and Japan’s experience. Section C discusses the outlook and risks of Japanese financial institutions expanding overseas after the global financial crisis, followed by policy implications and conclusions in Section D.

B. Determinants of Banks’ Cross-Border Expansion and Japan’s Experience

6. The expansion of Japanese financial institutions abroad over the last two decades was only partly successful (text charts). During the mid to late 1980s, financial institutions rapidly raised overseas exposures in tandem with outward FDIs of real estate and construction companies, but that ended abruptly with losses incurred after the domestic asset bubble burst. Subsequently, in the years leading up to the Asian financial crisis, banks financed overseas loans to developing Asia mostly through foreign exchange financing. Banks incurred sizeable valuation losses and higher nonperforming loans (NPLs) after the Asian financial crisis, forcing them to recede on overseas lending. Losses abroad added to financial vulnerabilities at home (for example, credit risks in SMEs and declining interest rates) and contributed to the subsequent banking crises in Japan in the early 2000s.3

uA06fig01

External Bank Assets and Liabilities

(in trillions of yen)

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A006

Source: Haver.
uA06fig02

Nominal and Real Lending Rates

(in percent)

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A006

Source: Bank of Japan1/ Real interest rate is derived from nominal rate net of inflation rate.

7. Japanese banks have increased their cross-border activity, mostly to the Asian region. Cross-border consolidated claims of Japanese banks abroad have increased since 2005 and reached near US$3 trillion (about 15 percent of total banking and trust assets) according to the Bank of International Settlement (BIS). Claims on Asia have more than doubled since the global financial crisis (now accounting for about 16 percent of total foreign consolidated claims), and is now at a level comparable during 2005–08. The exposures to Europe, however, have significantly slowed after the global financial crisis (Text table and Figure 1). A large share of the rising foreign claims is attributed to growing overseas loans by major banks. Overseas loans account for about 15–20 percent of the total outstanding loan balance as of September 2012, with the lending activity to Asia the strongest.

Figure 1.
Figure 1.

Cross-border Activity of Japanese Banks

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A006

Foreign Consolidated Claims of Japanese Banks

article image
Source: BIS.

As of September 2012.

Pheripheral European countries include Italy, Ireland, Greece, Portugal, and Spain.

Core European countries include France, Germany, Switzerland, and United Kingdom.

8. The trend on overseas expansion by Japanese financial institutions has recently picked up again, driven by several regional and domestic factors:

a. Domestic factors:

  • Limited domestic opportunities have pushed a need for major Japanese banks to expand abroad. Credit demand was sluggish in the past few years due to stagnant growth, though it has picked up recently. Large corporations have limited funding need as they accumulated sizeable surpluses (rising to about 6 percent of GDP).4 Structural factors—such as high leverage among SMEs, population aging, and sluggish growth in Japan’s regions—have limited domestic opportunities. At the same time, low interest rates have persisted for a decade but lingering deflation has limited the decline of real interest rate to sufficiently stimulate credit demand. Shrinking net interest margin on loans (about 0.6-1.2 percent now relative to about 1.2–2.1 percent in early 2000s) tends to limit banks’ core profitability as interest income accounts for more than two-thirds of banks’ total income.

  • Major banks have remained resilient during the global financial crisis and have some capacity to take on foreign exposures. They have abundant yen liquidity supported by a stable deposit base, and have further strengthened their capital adequacy (Tier 1 ratio at 12 percent) after the global financial crisis, in part to meet the Basel III requirements. The resilience of balance sheets in the Japanese banks has placed them in a better position to further expand overseas, despite lingering global uncertainty. The exchange rate has appreciated until recently, which may offer an additional incentive for expanding abroad.

b. Regional and global factors:

  • Robust growth and large financing needs in Emerging Asia offer new business opportunities for Japanese banks. Japan’s proximity to the rest of Asia is an advantage. Major banks have also benefited from the increasing outward FDI and trade links of Japanese firms. Financing needs for infrastructure in Emerging Asia are large (about US$8 trillion), according to the Asian Development Bank. These generate demand for cross-border financial activity between Japan and various FDI destinations (text chart).

  • The deleveraging of European banks since 2010 has accelerated the pace of overseas expansion. Japanese banks, among other local Asian banks, have stepped up financing to gain market share against the scale-back of European banks in the region.

uA06fig03

Outward FDI to Asia

(In 100 million yen)

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A006

Source: Haver.

9. An empirical analysis is used to assess determinants of banks’ overseas expansion and provide insights to whether the current trend is different from previous episodes. The analysis uses the quarterly consolidated year-on-year growth of foreign claims on an immediate borrowers basis published by the BIS. The sample is from 1984–2012, spanning across a panel of banking systems consisting of both origination and destination of cross-border claims: the origination countries/regions are mostly advanced countries, including Australia, Japan, France, Germany, Italy, Switzerland, Sweden, the United Kingdom, the United States, and Developed Europe; the destination countries or regions include Emerging Asia (China, India, ASEAN5), Developing Europe, and Latin America. The foreign claims are in U.S. dollar terms and are subject to valuation changes driven by exchange rate movements, which could be partly controlled by including the weighted exchange rates as an explanatory variable.5 The explanatory variables are broadly classified into three categories with the specification as follows:

FCi,tj=β0+γi,j+β1FCi,t1j+β2GFt+β3RFtj+β4HFti+εi,t

where i and j stand for origination and destination countries/regions of foreign claims, respectively. A fixed effect coefficient γi,j is included for each group. The explanatory variables include:

  • Global factors (GF) consisting of the VIX index, and the Fed Fund rate;

  • Regional factors (RF) consisting of growth differentials and real effective exchange rate movements between destination and origination countries/regions. The regression also considers alternative indicators of growth differentials using the change of fixed investments.

  • Home factors (HF) consisting of domestic interest rates, real effective exchange rates, growth of domestic credit to GDP ratio, several indicators for the soundness of the banking systems in origination countries/regions that include Tier 1 capital ratios, nonperforming loan ratios, and the return on assets.

10. The empirical results provide an intuitive explanation of the growth of banks’ foreign claims in Japan and other advanced countries (Table 1). Empirical results show that higher global uncertainty (measured by the VIX index) tends to reduce banks’ activities abroad, though the magnitude is not statistically significant for Japanese banks. In terms of regional factors, interest rates at the destination, as a proxy for the tightness of financing conditions, also play some role. The growth differential is also an important driver for banks’ foreign claims. For instance, a 1-percentage-point increase of the real growth differential could increase the foreign claims by about 0.3–1.6 percentage points. While a currency appreciation in the origination countries tends to increase banks’ activity overseas, the coefficients are not statistically significant across all specifications. Regarding home factors, higher domestic credit growth is generally associated with slower growth overseas, possibly suggesting some substitution in banks when extending credit between home and abroad. In addition, the soundness of banking systems at home is important in banks’ overseas activity. Higher capital adequacy and lower NPLs are usually associated with higher cross-border activity with strong statistical significance.

Table 1.

Empirical Analysis on Bank’s Foreign Claims 1/2/

article image
Source: author’s estimates.

Notation i and j refer to origination and destination countries or regions of the foreign claims, respectively.

*’. ’**’, and ’***’ denote the statistical significance at 10 percent, 5 percent, and 1 perecnt, respectively.

11. Applying the results to Japanese banks would imply that global and regional factors play a key role in explaining the rise of foreign claims. As an illustration, Japanese banks’ foreign claims on Asia have grown by 103 percent since end-2008, of which about 40 percentage points are attributed by a decline of global uncertainty proxied by the VIX index, while regional factors contributed another 20–25 percentage points. Regarding home factors, the soundness of the banking system, particularly the strengthening of capital adequacy, contributed to around one-third of foreign claims growth. The substitution between domestic and foreign credit contributed modestly by about 5 percentage points.

C. Outlook and Risks for Major Banks Expanding Overseas

12. The expansion abroad has made Japanese banks key players in regional and global syndicated loans and project finance (Figure 1). Megabanks have stepped up project finance and syndicated loans business, particularly in Asia, because of their strong balance sheets and long-term approach in lending. Besides interest income on lending, banks also earn fees from arranging and underwriting deals. The three megabanks in Japan have played an increasing role in these areas, with the average ranking and market share rising, particularly following the recede of European banks.6 In addition, Japanese banks are often the only Asian banks that were ranked among the top global banks in these types of finances outside Asia.

13. Overseas lending performance among Japanese banks has been stronger in several ways compared to domestic lending (Figure 2). Overseas gross profits now account for about 30 percent of total gross profits (about half of which arise from net interest income).7 Net interest margins for overseas loans have improved after the global financial crisis and exceeded those for domestic loans. As megabanks have been cautious in lending abroad to firms with established credit history, credit risks on overseas loans are moderate. The average risk-monitored loans ratio for overseas lending was about 0.7 percent as of September 2012, much lower than that on domestic lending (about 2 percent). Syndicated loans to foreign firms usually carry high investment ratings, while those to firms in emerging markets are relatively small (less than the global average in proportion) and about one-fifth of the syndicated loans have covenants that limit credit risks. Though project finance could be more risky because of the longer duration, it is usually backed by underlying infrastructure assets.8 At the margin, overseas loans therefore appear more profitable in general but are associated with less risk.

Figure 2.
Figure 2.

Comparison of Overseas Lending Activity by Three Megabanks

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A006

14. Japanese banks are likely to continue expanding overseas under successful Abenomics. Policies under Abenomics would mostly affect home factors and exchange rates based on the IMF 2013 Spillover Report. Successful policies may also reinforce the trend if there are positive spillovers globally and to the region. In Asia, growth is expected to remain robust over the medium term and the global recovery takes hold, Japanese banks will likely continue expanding abroad. Recovering domestic opportunities under Abenomics may slow the expansion pace but empirical estimates suggest that the substitution effect between domestic and overseas lending contributed modestly to the trend (about 5 percent in the growth of foreign claims).

15. The current trend of overseas expansion has some differences from previous episodes but may pose additional challenges (text charts). In the past, Japanese banks have traditionally expanded abroad to support the expansion of Japanese corporations (e.g., real-estate companies in 1980s). But over the past few years, banks have also moved toward extending loans to non-Japanese entities, now reaching about 70 percent of overseas loans. Second, over time Japanese banks have accumulated net external foreign assets while the short-term liabilities have remained stable. While part of the increase is attributed to higher foreign assets held by trust banks, the increase may suggest banks have relied on domestic yen-denominated funds to finance long-term overseas loans.

16. Foreign currency and maturity mismatches are likely to rise going forward as the long-term funding base in Japanese banks has fallen short of total external loans. Japanese banks extend most overseas lending in U.S. dollar and in long maturity for which they do not have a natural funding base. These create dollar funding risks and add to the maturity mismatch in foreign lending. Major banks have increased their local deposit base (e.g., corporate deposits)— accounting for about half of the funding base—but it still falls short of the total external loans. Banks therefore have to rely on short-term instruments such as yen-dollar basis and currency swaps that are subject to volatility, and by issuing foreign exchange-denominated bonds. The loan-to-deposit ratio for overseas loans continues to exceed 100 percent (compared to the loan-to-deposit ratio for domestic loans at about 70 percent), potentially contributing to funding risks. Funding cost and availability depend on credit ratings, which also affect prospects of securing certain lines of business. In an event of credit downgrades, funding cost could rise substantially and the loss of certain lines of business precipitate initial difficulties. In addition, an incomplete set of domestic policies that fails to raise growth could undermine domestic financial stability and affect the prospects of overseas lending.

uA06fig04

Banks’ Net Foreign-Currency Denominated External Assets

(In trillions of yen)

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A006

Source: Ministry of Finance.
uA06fig05

External Foreign Currency-Denominated Loans and Deposits of Japanese Banks vis-a-vis All Sectors

(In billions of USD)

Citation: IMF Staff Country Reports 2013, 254; 10.5089/9781475563795.002.A006

Source: BIS Locational Banking Statistics Table 7.

D. Policy Implications and Conclusions

17. The trend of expansion abroad by Japanese financial institutions is likely to continue, though the pace may slow as domestic opportunities recover under successful Abenomics. Limited domestic credit demand and the relative resilience of balance sheets have added incentives for Japanese financial institutions to take on further foreign exposures. Robust growth in Asia and deleveraging of European banks in the region also contributed to the rise of cross-border lending. Japanese banks have also broadened their financing to non-Japanese entities and local demand, in contrast to previous episodes of overseas expansion in the late 1980s and 1990s. An incomplete set of policies under Abenomics, however, could pose risks for financial stability that could halt the overseas expansion.

18. Japanese financial institutions should rely on a gradual and cautious approach in their overseas strategies. Banks’ expansion overseas is positive but a rapid expansion could lead to buying foreign assets at high prices or entering unfamiliar local markets that could eventually result to heavy losses as in the earlier episodes of expansion in late 1980s and 1990s. Banks may favor a gradual expansion to maintain their balance sheets given the new global regulations (e.g., Basel III requirements).

19. Supervisors would need to closely monitor the funding risks on cross-border activities and continue to enhance the cooperation with foreign supervisory authorities. Securing stable and long-term dollar funding has remained a risk for Japanese financial institutions. Supervisors should encourage banks to further improve their resilience against shocks by strengthening their funding sources and risk management, such as by closely monitoring the overseas maturity mismatch and FX-denominated loans-to-deposits ratios. At the same time, overseas activities add to challenges on cross-border supervision for financial institutions. Cross-border risk monitoring arrangements with foreign supervisory authorities can help monitor risks from cross-border activities, including foreign exchange funding risks. In that regard, following discussions at the Financial Stability Board (FSB), the Japan Financial Services Agency and the Bank of Japan have signed the Multilateral Framework for sharing the information of globally systemically important banks (G-SIBs) collected through the FSB Data Gap Initiatives in early 2013.

20. Ensuring a complete package of Abenomics would be important for financial stability. An incomplete set of policies that fails to raise growth and reverse the rising public debt-to-GDP ratios, however, could pose risks for financial stability, thereby could reduce foreign exposures as occurred in the previous overseas expansion episodes in the late 1980s and in the early 2000s.

1

Prepared by W. Raphael Lam (APD).

2

The three-pronged strategies Abenomics include flexible fiscal policy, aggressive monetary easing, and structural reforms to exit deflation and raise growth.

3

Since then, consolidations in the financial sector gave rise to a concentrated market with a few megabanks in the form of financial groups, securities firms, and life insurers.

4

Estimates suggest that business capital expenditures for fixed investment only account for less than 30 percent of total credit demand. External financing through capital increases has been negative (on average about ¥5 trillion per year) for the past decade due to weak equity markets. Bank lending has somewhat picked up recently, reflecting reconstruction and housing loans demand.

5

Including the exchange rate as an explanatory variable controls only partly for valuation changes in the BIS data. Strictly speaking, the exchange rate to be included should reflect the composition of foreign claims of origination countries/regions. By using the real effective exchange rate based on external trade weights as a proxy would imply an assumption that those weights are identical to those of foreign claims composition.

6

They have been among the top 25 mandated arrangers and bookrunners over the past few years. Mitsubishi UFJ Financial Group, which includes Bank of Tokyo-Mitsubishi UFJ (BTMU), was the top-ranked global mandated arranger of project finance deals in the first nine months of 2012, with Sumitomo Mitsui Financial Group and Mizuho Financial Group in the third and fourth places, respectively.

7

For instance, Mizuho Financial Group has about 25 percent of net business income are derived from overseas customers, with return on assets for overseas loans at about 3.3 percent in FY2012.

8

According to the BoJ, default rates on selected overseas loans ranged from 0.4–1.3 percent, much lower than the respective loan margins (FSR Chart III 3-11). Banks are relatively cautious in choosing overseas loan extension and setting loan conditions.

Japan: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept