Japan's Perilous Bet on Bonds

Desperate investors are bidding up prices

It's the rule fledgling bond traders learn their first day: Bond prices are supposed to fall when risk or the supply of paper increases, with yields rising conversely. By those criteria, Japan's $4 trillion bond market exists in a parallel universe. Risk? There's plenty. The economy has been in a recession for close to 10 years. Bank loans are going bad at record rates. And supply? You could paper the globe with Japanese government bonds. The ratio of government debt to gross domestic product, already the worst of the major industrial nations, will hit 134% in 2001, according to Standard & Poor's--and that's just counting what the state admits to. On Feb. 22, S&P cut Japan's sovereign rating from AAA to AA.

Yet after hitting its 2000 low last Sept. 6, the price of the benchmark 10-year Japanese government bond has risen 35%--risen, not dropped. The yield has fallen accordingly, from 1.97% to 1.28%.

GRIM NEWS. The big question for bondholders: Is the steep rise in JGB prices a bubble, and if so when will it burst? Those who say the bonds are fairly valued point out that a bond buyer's worst fear, inflation, isn't a problem in Japan. With cheap imports, excess production capacity, and anemic spending, consumer prices keep falling. No one is buying houses, companies, or factories either. Moreover, with such grim statistics as April's 3.2% annualized plunge in industrial production, there's no danger that the Bank of Japan will raise interest rates soon, thereby making existing, lower-yielding bonds less attractive.

It isn't, however, a benign inflation outlook that's behind the runup in bond prices. It's investor desperation. With the stock market offering risk with little return and deposit rates effectively zero, the only place Japanese investors--institutions, companies, banks, and individuals--want to put their money is in Japanese government bonds. "JGBs are really the only investment out there where you can make some money," notes Tetsufumi Yamakawa, a Goldman, Sachs & Co. economist.

This desperate calculus could be a danger sign: Complacent investors may be ill-prepared for a sudden lurch in prices. No one thinks the government will default outright. But with so much wealth wrapped up in government IOUs, financiers are asking awkward questions. If the bond market crashes and long-term rates rise, what happens to the fragile and indebted corporate sector? How would the government cope with dramatically higher debt costs? Among the major industrial nations, only Italy has a sovereign credit rating worse than Japan's.

One respected observer, former Vice Finance Minister for International Affairs Eisuke Sakakibara, has called the level of banks' JGB holdings "alarming"; they have almost doubled, to $573 billion, in the past two years. He says there are "various triggers out there" that could send bonds tumbling. Banks now hold roughly 20% of outstanding state debt. "The real danger of losses on bond portfolios kicks in after [yields hit] 2.5%," because that's the average at which the banks bought their bonds, says Hironori Nozaki, an analyst at ABN Amro in Tokyo.

Prime Minister Junichiro Koizumi vows to clean up national finances, but his plans are shock therapy for a sick patient. If he survives the July election for the Upper House of the Diet and implements his scheme, it will cost Japan 1 million jobs and 1.2% of GDP over three years, estimates HSBC Holdings PLC. That means shrinking tax revenue and worse deficits, leaving the Ministry of Finance struggling to service the debt.

Sakakibara, dubbed "Mr. Yen" for his stewardship of the currency while at the MOF, thinks that revelations from the government's investigations into Tokyo's off-balance-sheet liabilities and its failed public works schemes could send bondholders into full retreat. He warns that Japan's debt load is far higher than assumed. "It is quite substantial," he says, and another downgrade could shake the bond market. David Asher, Japan analyst at the American Enterprise Institute, thinks that Japan's real debt load could be 200% of GDP.

Perhaps the biggest risk to bondholders could come from the Bank of Japan's efforts to galvanize the economy by boosting the money supply. It's becoming apparent that Japan's deflation is so intractable that the BOJ might be drawn into buying bonds directly from the market in far greater amounts than the $3.2 billion a month it averages now. That would expand the amount of yen in circulation. BOJ insiders figure the bank will have to ramp up money-supply growth from its current 1.5% a year to 5% to have much impact.

The danger is that with the BOJ standing ready to snap up bonds, Koizumi--or his successor--might lose their resolve to tackle Japan's fiscal problems and just keep borrowing instead. Koizumi has promised to slash public-works spending, capping government bond issues at $245 billion a year starting in 2002, and forcing the banks to clear a big chunk of their dud loans in two or three years. At least as important, the MOF has begun to dismantle the wasteful, off-balance-sheet Zaito program, under which it used a big chunk of Japan's $2 trillion in postal savings to buy bonds--and then funneled the cash it earned from selling them into an array of state companies and public works.

Yet those reforms have not really kicked in yet. Without them, the BOJ's reflation efforts could backfire, sparking serious inflation before the economy recovers. That could be the last straw for the bond market. If investors start selling, there would be two negative consequences: First, an ailing Japan would still have to borrow to fund expenditures at higher rates. Second, the BOJ and just about every commercial bank would be sitting on huge bond losses that would require write-offs or maybe even another taxpayer bailout.

Given all this, Japan's fixation with bonds--like its previous ones with stocks and real estate--could end in tears. Sure, the bond market has offered stability, a cheap source of cash to the state, and reliable, if small, returns. But if it ever starts acting like a real capital market attuned to risk, look out.

By Brian Bremner in Tokyo

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