The Bond Market That Shook The World

Tokyo's about-face has brought calm for now, but more nasty surprises lie ahead

The effect was electrifying. When Finance Minister Kiichi Miyazawa announced on Feb. 16 that his ministry would snap up $3.4 billion worth of Japanese government bonds in the ensuing six weeks, investors rejoiced. Finally, they figured, the government was showing it would be the buyer of last resort for its own bonds. That meant the government bond market would not collapse, as had been feared. Bond prices soared, bringing yields down to 1.9% from recent highs of 2.4%. And with a slew of officials also talking down the Japanese currency, the yen slid to a two-month low of 118 to the dollar. Later the same day, as Wall Street reopened after the Presidents' Day holiday, U.S. bonds rallied, too, and yields came back from the six-month high of 5.43% reached the previous Friday.

So everything is hunky-dory, right? Wrong. True, policymakers all over the world welcome the temporary easing of the squeeze inflicted on their economies by rising Japanese bond yields, which push up their own interest rates and threaten to choke growth. But Miyazawa didn't go far enough to promise long-term relief. Expect the Japanese bond market to have more nasty surprises as policymakers grope for a solution.

Here's the problem: Japan has already promised $700 billion in tax cuts and aid to ailing banks and companies. So it doesn't have much scope for further fiscal action. Instead, U.S. Treasury Secretary Robert E. Rubin calls for Japan to use "all possible policy tools" to kick-start its economy. Rubin and others want Japan to refloat its sinking economy on a flood of liquidity. MOF's bond buying won't create that liquidity. In effect, the ministry is taking money out of one pocket--the vast trust funds that it manages, such as the $2 trillion in the postal savings system--and putting it in another. What's needed now is for the Bank of Japan to buy bonds, effectively monetizing the debt and juicing Japan with new cash. "[Rubin and others] want the Bank of Japan to step in," says one international monetary official.

But the bank, led by Governor Masaru Hayami, steadfastly refuses to jump into the bond market as a big-time buyer. On Feb. 12, it made a token cut in short-term rates, trimming them to 0.15% from 0.25%. Hayami will even take rates to zero, but he won't write the ruling Liberal Democratic Party a blank check to spend Japan into fiscal oblivion, as he sees it. And it was that obstinacy that helped push U.S. long bonds up the same day as Hayami's rate cut.

Why all the drama about the arcane world of the Japanese government bond market? Simply, it's massive. Already $2.5 trillion worth of such bonds are outstanding and at some point this year, says J.P. Morgan & Co., the market will surpass the U.S. Treasury Bond market, now the world's biggest, in size. Indeed, with budget deficits of 10% of gross domestic product, Japan is heading for a huge government debt binge (chart) that will make it an even bigger factor in setting world interest rates.

In effect, Japanese official debt markets have grown such a long tail that they can wag the global dog. That's shown by the market action of Feb. 16, which was the complete reverse of what happened on Dec. 21. Then, the Ministry of Finance announced it would stop buying government bonds on the market. That decision sent both bond yields and the yen into orbit. Indeed, until Miyazawa blinked in February, Japanese long-term interest rates had tripled, to 2.4%, while the yen had appreciated 24% since last fall.

BIG BRAWL. For years, Japan has been a massive exporter of capital--helping to keep U.S. and other global interest rates lower than they might otherwise have been. But in January, Japan suddenly starting sucking in funds from around the world. Japanese investors, mostly life insurers attracted by improving returns at home, sold off $8 billion worth of foreign bonds and stocks. Meanwhile, global bond funds, long underweight in Japan, pumped $6 billion into Japanese bonds because with a mix of higher Japanese rates and currency gains they could earn more than a straight play on U.S. bonds.

So when Miyazawa meets with Rubin and other finance ministers from the developed world in Bonn on Feb. 20, he'll certainly get another earful about the need to keep Japan's bond beast in a cage. But he's more attuned to the huge political brawl at home. Fiscal conservatives at MOF and the central bank, mostly bureaucrats, are ranged against would-be big spenders in the LDP. The party faces a tough general election within the next 18 months, so its backbenchers are angling to inject massive amounts of government money into the economy, regardless of the impact on the nation's overall solvency. "It's like a morphine injection to keep a dying patient alive," says Ronald Bevacqua, a senior economist with Merrill Lynch & Co. in Tokyo.

The LDP simply panicked when it saw the havoc being wreaked by high interest rates and a strong yen. Heavily indebted construction companies and big exporters, two powerful groups in Japan, were being badly squeezed. So the party tried to pressure the Bank of Japan to print yen, kick the money supply into overdrive, and start buying a big chunk of the $350 billion of new government debt to be issued this year.

But with Hayami digging in his heels, the LDP strong-armed Miyazawa. Just a week before his Feb. 16 about-face, he had professed to be blase about Japan's rising interest rates. But "MOF is now reflecting the will of the politicians," figures Hiroshi Kuribayashi, an economist with Barclays Capital.

And the LDP hasn't given up on Hayami, either. Prime Minister Keizo Obuchi called for a debate in the Diet to prod the central bank to do more. And some think it's only a matter of time before BOJ caves in. The Japanese money supply is creating a bottleneck for the economy because it is growing at a barely perceptible 3.6% annual rate. "Unless we see a double-digit increase in the money supply, the problem isn't going to go away," says Jeremy Fand, senior foreign-exchange strategist at BankBoston Corp. He thinks the yen could easily tumble to 130 to the dollar by the end of March.

But like so many other dimensions to Japan's economic mess, this merely creates a whole new set of trade-offs. If the yen tanks, it will create all sorts of mayhem in Asian markets, which buy 40% of Japan's annual exports. Besides, lower interest rates would take the pressure off debt-burdened companies. So they could easily dodge painful restructuring needed to burn off Japan's excess capacity in autos, semiconductors, and steel.

Japan would also forgo a golden opportunity to get the banks back on their feet. Until the latest policy reversal, a sizable spread was emerging between short-term borrowing rates and long-term lending rates. Imagine the windfall if the banks could have raised funds at less than 1% in the interbank market and then lent the stuff out at 5%. This kind of steep yield curve helped U.S. banks regain profitability in the early '90s. It could have done the same for Japanese lenders.

So once again, Japan seems to be feinting left and right to avoid the pain of radical restructuring. Domestic political imperatives are driving policy. But now the Japanese bond markets are so big that when they sneeze, the rest of the world catches cold.

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