Has Japan’s central bank created a monster? – Charles-Henry Monchau, Syz Bank

By Charles-Henry Monchau, chief investment officer, Syz Bank

The BOJ (Bank of Japan) will become the first central bank in history to hold more than 50% of its country’s public debt securities. This is an unprecedented situation with some key risks attached to it.

The last few decades have all been marked by a major stock market crisis, the main reason being excessive leverage. At the end of the 1990s, a speculative bubble had formed on new economy stocks.

Investors had used leverage to gain as much exposure as possible. The bursting of the bubble in 2001 then impacted household savings and risk appetite, resulting in an economic recession and a widespread bear market in all equity markets. The great financial crisis of 2008 originated in the so-called “subprime” mortgage crisis. The over-indebtedness of American households and banks in this sector once again led to an economic crisis and a financial crash.

Today, over-leverage and excesses affect neither households nor companies, but the public sector. Since 2008, the governments of most developed countries have tried to solve crises caused by debt by issuing even more debt. This over-indebtedness accelerated during the Covid crisis, creating record levels of global government debt, equivalent to 103% of the OECD’s GDP, compared with a ratio of 75% at the height of the great financial crisis. Heading the most indebted governments are the so-called ‘advanced’ G20 countries, whose debt exceeds 140%, a ratio well above the 116% seen at the end of the Second World War.

OECD public debt as a percentage of GDP (in %)

OECD public debt as a percentage of GDP (in %)

Source: Euromonitor.com

Government debt has soared

Like any borrower, a government must pay interest on its debt and eventually repay it. Years of low inflation and even deflation after the subprime crisis have kept the cost of debt low or even insignificant. That has allowed several developed countries to borrow at zero or even negative rates for a long time. This advantageous situation is partly the result of a decade of quantitative easing (QE), where central banks buy government debt or other financial assets on a massive scale to inject money into the economy and so stimulate growth.

The Bank of Japan (BOJ) was the QE pioneer. Following the bursting of the real estate and stock market bubbles in 1991- 92, the Japanese economy slowed, leading to a long period of deflation. To combat this, the BOJ gradually lowered its key interest rate to zero. After the dot-com bubble bursting 2001 and faced with a still-deteriorating economy, the BOJ introduced a QE programme in March 2001.

This was designed to help banks absorb losses from bad loans, and was to remain in place until inflation returned to a sustainable positive level. After a pause in 2006, the BOJ was soon forced to return to QE to combat the sharp decline in industrial activity and the resurgence of deflationary pressures.

Two decades of QE in Japan have led to a recovery in economic activity, financed stimulus packages, and stabilised the public finance deficit. But the abuse of QE has also created many imbalances.

Indeed, the Japanese government took advantage of this zero-interest-rate policy and QE to issue massive amounts of bonds.

Issuance of Japanese Government Bonds and Interest Rates

Source: nippon.com

The result is a debt ratio, of 225% of GDP, that far exceeds other developed countries’.

The result is a debt ratio, of 225% of GDP, that far exceeds other developed countries'.

Source: ceicdata.com

The unconditional support of the Bank of Japan

Any developing country would have seen the cost of its debt explode faced with such a rise in indebtedness. But Japan’s public debt is largely owned by domestic investors, with only 5% of these bonds held by foreigners. Despite very low or even negative rates, Japanese bonds (JGBs) continue to find buyers among Japanese investors. Insurance companies hold 20% of JGBs, banks 15%, and pension funds 7%. Finally, the BOJ now owns almost 50% of Japanese public debt!

BoJ is on the threshold of owning half JGBs

Source: Bloomberg

At a time of global inflationary pressures, the BOJ is going against the flow by maintaining an ultra-expensive monetary policy just as the rest of the world is raising interest rates and phasing out QE policies. One consequence of this differential between the BoJ and Western central banks is the weakening of the yen, which inflates the cost of importing food and energy products from Japan.

In a way, the BoJ is achieving its objective as Japan faces inflationary, rather than deflationary, pressures. This should lead to higher bond yields, but Japan cannot afford to pay too much interest, because of its very high debt. That is why it uses a mechanism known as yield curve control (YCC), which consists of buying JGBs to ensure that yields do not exceed an upper limit -which currently stands at 0.25% for 10-year JGBs.

However, hedge funds are now betting that the YCC is unsustainable and are therefore selling JGBs short in a repeat of George Soros’ attack on the Bank of England in 1992. This latest ‘big short’ became visible in statistics of non-residents’ weekly net Japanese bond investments (see chart below).