Recently Japanese equity markets were hit by an ‘earthquake’. The biggest bank in Japan – Bank of Tokyo-Mitsubishi UFJ (BOTM) – resigned of his primary dealer status. The reason for such decision is the structure of government debt which can be described as a huge speculative bubble. Who inflated it? The Bank of Japan through countless interventions. Tokio is a leader of zero or negative interest rates scaring any small investor away from the debt market. Today even 10-year bonds are sold with a negative interest rate – a guaranteed loss.
In the long-term, the situation we see today in bonds is not sustainable. Prices are too high, owners of government debt can lose a lot of money in case of a rate hike or even slight change of the BOJ policy. The price drop is going to hurt more the longer the maturity of the respective bond. Subsequent sell-off of such asset with higher price has low chances of success and bears a lot of risks. This is why banks having the privilege of being a dealer of government bonds resign of such status.
What does it mean to have a ‘primary dealer’ status?
Thanks to this a commercial bank is able to be the middleman in a transaction of selling bonds between the government and investors. As a primary dealer you have to provide liquidity in the debt market – invest share of your capital in bonds. Apart from serving buy/sell orders, buying bonds you also have to prevent the price from collapsing (when there are not enough buyers). This is called market making.
Being a primary dealer is nothing else than to cooperate with politicians and economists of the central bank. Knowing terms like the price and the amount of debt sold, enables commercial banks to enjoy a privileged position. Bank gets access to important information used every day to trade around the globe, premiums paid by investors but - given that the government requires pension funds (and other dependent institutions) to buy bonds - you don’t even need to look for clients.
Why BOTM resigns of its primary dealer status?
Why BOTM is resigning, if it is so good? The pricing of Japanese debt reached the level of absurdity. Japanese government asks for money for the privilege of entrusting them with capital. The investor is bound to lose money unless he finds somehow a way to sell the bond at a higher price. In a normal situation, the interest rate is paid on the risk of insolvency of the issuer and this is how the investor is rewarded for lending money. The risk of insolvency is low but still exists. Interest rates are higher the bigger problems of the country-issuer. For example: Greek 10-year bonds – 7.8%, Polish – 3.2%, American – 1.6%.
You can ask a question then: if Japan is not offering any money does it mean Japan’s bankruptcy is impossible? Of course not. The state having 230% debt to GDP ratio and facing terrible demographic and energy problems can go bankrupt any moment. The price of government bonds is a variable of machinations and rounds of JPY printing. In addition to this, the margin for bond price growth is very limited but there is plenty of room for a nose dive. In the scenario that interest rate on 10-year bonds increases by 2% - it happened in 2012 – prices would drop by 20%. In the worse scenario of returning to high interest rates (7%), prices could plunge even 70%! The longer the duration of a bond the bigger volatility. Being a primary dealer you are obliged to keep at least 4% of your balance in bonds – the same bonds that are systematically losing money. This is why being a middle-man in this case is a growing burden with huge risks.
Debt market in Japan
Commercial banks have on their balance sheets bonds worth 229 trillion yen (2.13 trillion USD). This is 30% less than just two years earlier. The one responsible for that is the BOJ which continues to issue more debt and prints currency against the opposition from commercial banks. Today the BOJ increases its position in bonds by 80 trillion JPY (744 billion USD) each year. As a result, the central bank is the owner of the biggest share of Japanese bonds in the world and holds more than the rest of institutions combined.
The BOJ buys not only the debt of government but also expands its position in ETFs (red) – investment funds – now it equals more than 50% of the whole market (blue). The BOJ is now the biggest hedge fund in the world.
Strong position of the BOJ resulted in further inflation of the speculative bubble to enormous size. The takeover of a significant share of debt would mean lower liquidity in the market. This is because price volatility – during any potential sale – will be higher and can affect balances of commercial banks (especially those with a primary dealer status). This risk is observed and there are days with no buy orders at all.
During previous years Japanese market was abandoned by a number of foreign institutions bearing the primary dealer status and now the count of such dealers is 22. This is to say that the resignation of BOTM – the biggest bank bearing this privilege – made everyone worried. Another two groups - Sumitomo Mitsui Financial Group and Mizuho Financial Group - already plan to follow BOTM.
Were it not for the BOJ, no one in the right mind would buy Japanese government debt. Japan should have bankrupted years ago. Unfortunately, today’s situation reached the new heights of irrationality because even the central bank intervening does not provide enough incentive to be a primary dealer.
The result of Japanese interventionist monetary policy.
I wrote before about interventions in the free market which can have bad results - The law of unintended consequences – policy of the BOJ is another example. They failed and the result is opposite to what they planned to achieve. Instead of kick-starting the economy and preventing its bankruptcy and inevitable economic crisis, there is, even more, debt. Constantly postponing unavoidable depression only leads to exacerbating the incoming crisis because there will be no means left to answer it. At the end, any economic recovery will be slower and weaker affecting not only the depth of the crisis but also its length.
The façade of normality is increasingly harder to uphold. The BOJ and its printing policy aimed at stimulating the inflation rate, scares people (increased risk of bank bankruptcy, negative interest rates on deposits) and money is being withdrawn from the system. People feeling that economy is in bad shape already limit consumption and save more for a ‘rainy day’.
The BOJ started a war with deflation and this can bring even more problems, for example, strengthening of JPY. During the last two years, JPY gained 15-20% vis-à-vis other currencies making Japanese exports less attractive. This coupled with lower consumption can make the crisis worse. How can it worsen the crisis? Consumers due to visible economic slowdown save for the future. This leads to fewer sales, more unemployment and in turn scares consumers even harder – the vicious circle.
According to Kyle Bass, this only plays into the hands of the BOJ and its monetary stimulus. When citizens of Japan take last yens from their sockets and go on the shopping spree to get rid of worthless currency we will see hyperinflation. Kyle also forecasts that Japan will be the first developed country to destroy its currency in XXI century through inflation.
What you read above is a total failure of Japanese monetary policy. While the BOJ tried to save the debt market it made the situation worse and now to prevent the bankruptcy of Japan it has to intervene in the future with an increasing strength. No one wants to invest in government’s debt and only institutions arbitrarily required to do so are left in this market . The Japanese economy is being 'saved' for almost three decades but there seems to be no light in the tunnel. The important factor which can speed up the whole process of decline is a tragic demography affecting the situation of pension funds already.
During last crisis, we could see investors treating JPY as a safe haven storing your capital. Seeing how incompetent Japanese government policy is and how destructive interventions of the BOJ are, this status is lost. Today we are left with gold, shallow market of silver and Switzerland with its CHF.
Independent Trader Team