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Liquidity Crisis in the Making- Japan’s Role in Financial Stability
Liquidity Crisis in the Making is part one of a two-part article. Part 1 sheds light on the Bank of Japan and its three-decade attempt at a soft landing following the bursting of massive asset bubbles.
In propping up Japan’s economy and financial markets, they indirectly provided liquidity to the world’s financial markets. While the liquidity was well received by investors, certain events, as we discuss in Part 2, leave us concerned the BOJ could unleash a liquidity vacuum felt around the world.
Part 1- Liquidity Crisis in the Making
Over the last three decades, the Bank of Japan (BOJ) has employed the world’s easiest monetary policy. Initially, the motivation for the bank was to soften the blow resulting from the popping of enormous equity and property bubbles thirty years ago. While the bubbles are well in the rearview mirror, Japan has become reliant on the BOJ.
The BOJ’s policies to avoid a massive liquidity crisis not only severely impacted Japan’s markets and economy but have and continue to benefit asset prices around the world.
Inflation is finally perking up in Japan. Accordingly, this massive source of liquidity for global markets may be on the verge of drying up, resulting in a liquidity crisis felt around the world.
If you would like to learn much more about Japan’s bubbles and the role of the banks and BOJ, we highly recommend Richard Werner’s book the Princes of the Yen. You can also watch a movie adaptation of the book via YouTube- LINK
Bubble Economy– バブル景気, baburu keiki
In late 1991 Japan’s real estate and financial market bubbles popped. Instead of allowing significant bankruptcies and defaults in its banking/investment sectors, the government and central banks supported the banks by enabling them to hold onto non-performing, defunct assets. Instead of having a bad recession or a depression lasting multiple years, they stymied growth for decades. The nominal GDP is currently at the same level as in 1998.
As an aside, stagnant economic growth is not entirely the fault of the BOJ and government. A poor demographic profile also hamstrings Japan’s economy. The working-age population is almost 15% below its peak of 1995. Over a third of their population is 65 or older, to make matters worse. They are becoming increasingly dependent on the remaining population.
Easy Money Distortions
One of the BOJ’s critical policy tools of the last 30 years has been extremely easy monetary policy. Low and even negative interest rates and later QE support massive government deficits and keep interest rates extraordinarily low. Banks could fund non, or poorly-performing assets given borrowing money was nearly free. They did not need to write off the loans and take appropriate losses. However, their ability to conduct new lending was hindered
The graph below shows Japan’s debt to GDP ratio at 2.25x is nearly twice that of the United States. For context, many economists, ourselves included, think the United States ratio at 1.23x is problematic.
As we show below, the BOJ has maintained its overnight discount rate, like Fed Funds, near zero percent for the last 20 years. Since 2016 it has been negative. Also shown, three-month bill and ten-year note yields have hovered above and below zero percent over the previous five years.
Like many central banks electing to keep interest rates at zero or negative, Japan relies on QE. The BOJ’s assets have risen by six trillion since 1998. While nominally somewhat on par with the Fed, Japan’s economy is less than a quarter of the size of the U.S. The following graph shows how much more egregious the BOJ’s asset purchases are versus the Fed.
As a result of QE, the BOJ now owns more than half of the nation’s Treasury debt and is the largest holder of its stocks.
Liquidity
The excessive liquidity spewed by the BOJ grossly distorted asset and interest rate markets in Japan and provided liquidity to the world. Japanese citizens and large pension funds are crowded out of local bond markets by the BOJ. Between the BOJ’s massive holdings and the large number of bonds held to maturity by pension funds, liquidity in its bond market evaporated. The lack of supply resulted in negative rates and no incentive to invest in bonds.
With limited choices, domestic retail and institutional investors went to foreign markets and sent their money abroad in search of extra yield and liquidity.
The graph below shows the significant yield pick-up between Japanese and U.S. Treasury 10-year notes.
Per the U.S. Treasury Department, as of January 2022, Japan holds over $1.3 trillion of U.S. Treasury debt, $286 billion of U.S. agency bonds, $310 billion of U.S. corporate bonds, and $861 in U.S. stocks.
Summary Part 1
It wasn’t just Japanese investors sending liquidity abroad. In Part 2, we introduce the yen carry trade and inflation, the potential fly in the ointment. Stay tuned; the story gets more intriguing.
We leave you with a recent quote and teaser for part of this article from BOJ Governor Haruhiko Kuroda:
“The BOJ should persistently continue with the current aggressive money easing toward achieving the price stability target of 2% in a stable manner."
JAPAN'S ROLE IN GLOBAL FINANCIAL (IN)STABILITY, PART 2: TRAPPED AHEAD OF UNAVOIDABLE INFLATION
Authored by Michael Lebowitz via RealInvestmentAdvice.com,
We ended "Japan's Role In Global Financial (In)Stability, Part 1: Liquidity Crisis In The Making" with the following quote regarding inflation from BOJ Governor Haruhiko Kuroda: “The BoJ should persistently continue with the current aggressive money easing toward achieving the price stability target of 2% in a stable manner.”
While many central bankers are anxiously waging war against inflation, the Japanese are egging it on. Over the last few weeks, the BOJ has offered to buy as many 10-year notes at 0.25% as the market will offer them. In central bank parlance, we call that unlimited QE. While the BOJ caps bond yields with “aggressive” QE, they are doing so at the expense of the yen.
Carry Trade
In Part 1, we discussed how Japanese citizens and pension plans invested abroad to earn higher yields. They were not the only ones taking advantage of the difference in interest rates between Japan and many other countries.
Hedge funds and institutional investors worldwide were also making the most of the situation by borrowing yen cheaply in Japan, converting the yen to another currency, and investing the funds at much higher rates. Such a trade is called a carry trade.
To understand the allure of the carry trade, let’s consider a popular carry trade that many of you are actively engaged in.
Buying a house with a mortgage is a type of carry trade. If you purchase a home for $500,000 with a $400,000 mortgage and $100,000 in cash/equity, you are leveraged at a rate of 5:1. Any change in the home price affects your return on the investment by a factor of five. For instance, a 10% increase in the price ($50k) results in a 50% gain on your equity ($50k/$100k).
Leverage can be much greater than 5:1 in financial market carry trades, thus resulting in more significant gains and losses than in our example.
Yen Carry Trades
Unlike mortgage payments and house values denominated in dollars, the yen carry trade introduces currency risk. If you borrow in yen and it appreciates, you pay back the loan with more expensive yen. Therefore, appreciation of the yen eats into profits and discourages the yen carry trade.
For example, you go to a Japanese bank and put down $100,000 in assets to borrow 1,000,000 yen for one year at 0%. You convert the yen to dollars and buy a one-year U.S. Treasury note at 3%. Assuming the yen’s value doesn’t change versus the dollar, the return will be 30% (3% * 10x leverage). If the yen appreciates by 1% over the year, and you did not hedge the currency risk, the return falls to 20%. 5% appreciation of the yen results in a 20% loss.
As you might surmise, yen carry trades are very sensitive to yen price movement. Understanding this, the BOJ has acted numerous times to arrest the yen’s appreciation. We share the following from the book The Rise of Carry:
“Over a period of just seven months up to March 2004, the BOJ/MOF accumulated well over US$250 billion in foreign reserves in the attempt to prevent the yen from appreciating. At the end of this period, the yen dollar exchange rate was basically flatlining as the BOJ stood in the market and absorbed all the dollars that yen purchasers wished to sell.”
At that time and many other times, the BOJ bought dollars and sold yen to keep the exchange rate stable. By minimizing currency risk, the yen carry trade retained its attractiveness to foreign investors. The size of the yen carry trade has declined in recent years, as shown below. Even at 100 trillion yen, carry trade investors control approximately $80 billion worth of assets worldwide.
Japan’s Achilles Heel
Currently, the yen is rapidly depreciating. It is the direct consequence of the BOJ’s aggressive actions to halt yields from rising. As we share in Part 1, Japan can ill afford higher interest rates with its massive debt levels.
However, as the BOJ tries to stop rates from rising, they weaken the yen. Japan is in a trap. They can protect interest rates or the yen but not both. Further, its actions are circular. As the yen depreciates, inflation increases and the Japanese central bank must do even more QE to keep interest rates capped.
The graph below shows the recent depreciation of the yen in blue. The graph charts the amount of yen needed to buy a dollar; ergo, the rising amount represents depreciation. With interest rates capped in Japan and in rising in America, you can see the widening difference in yields in orange. Essentially the graph highlights the stark contrast between the Fed’s hawkish policy and the BOJ’s dovish policy.
The BOJ, with full government support, appears willing and able to do everything in its power to keep monetary policy extremely aggressive regardless of what other central banks do. Such a stance by the Japanese central bank might be possible if inflation remains tame.
Japanese CPI and PPI
Japanese inflation is much lower than in most other major economic nations. However, there are signs that prices may catch up. For instance, the prices of input goods (PPI) have begun to rise rapidly. While CPI is still low at .9%, we must consider that PPI and inflation expectations, shown below, often lead CPI.
Japan may be already experiencing a jump in CPI that the government is minimizing, or the data is simply lagging. Either way, this inflationary impulse is far different from minor impulses in the past.
Further, given the surging price of global commodities and Japan’s lack of natural resources, it will be near impossible to avoid inflation.
Inflation and Demographics
Many politicians say inflation is good because of Japan’s massive debt levels. It can essentially reduce the amount of debt as a percentage of the economy.
It appears that for this reason, the BOJ wants more inflation. However, with more inflation, the BOJ must expend even greater efforts to ensure interest rates do not follow inflation higher.
Let’s review Japan’s demographic situation. As we wrote in Part 1- “A poor demographic profile also hamstrings Japan’s economy. The working-age population is almost 15% below its peak of 1995. To make matters worse, over a third of their population is 65 or older and quickly becoming dependent on the remaining population.”
A large percentage of Japan’s elderly population relies on fixed income portfolios. High inflation will be devastating to them. It will severely crush their purchasing power if interest rates do not rise in line with higher prices.
Regardless of whether the Japanese government accurately measures inflation, the citizens already feel it. In an admission that inflation is becoming problematic, the Japanese government is trying to ease citizens’ pain. Per Nikkei Asia- “Japan plans to spend 6.2 trillion yen ($48.2 billion) on additional gasoline subsidies, low-interest loans and cash assistance to alleviate the pain of consumers and small businesses facing rising prices, Nikkei has learned.”
The Stage Is Set
So, what happens if CPI data starts rising rapidly? More importantly, might high inflation and the limited means of many of Japan’s citizens force the BOJ to take a more hawkish stance to limit inflation? Doing so would involve fighting yen depreciation at the expense of interest rates. This hawkish scenario, which hasn’t been seen in Japan in thirty years, is deeply troubling.
A strong yen and higher rates will entice liquidity to flow back to Japan. Yen carry trades will be reversed as their borrowing costs rise alongside an appreciating yen. Such is a recipe for a global drain of liquidity and possibly a financial crisis. Japanese citizens and pension funds will start to bring their money home to take advantage of higher yields without the currency risk.
Such a reversal of liquidity is not a Japan-centric problem as the tentacles of the yen carry trade spread through global financial markets. The loss of liquidity will be felt worldwide.
Summary
The BOJ is trapped. They are conducting unlimited QE to keep rates low and but at the same time, weaken the yen, which promotes inflation. Unlike many other economic pundits, it is not the collapse of the yen that is our chief concern. It is the opposite. The BOJ has avoided inflation for thirty years. The onset of inflation might be too much for them to evade.
Wayne Gretzky claims he was such a good hockey player because he went to where the puck would be. As investors, we should consider what Japan is doing today but focus on what they may have to do tomorrow.
