Nobusuke Tamaki delivered a speech at a recent conference in Tokyo organised by AsianInvestor in which he warned the audience of pension funds and investment professionals that Japanese government bonds’ “risk-free” image was a matter of perception.
It’s one thing for economists overseas to warn of the dangers of overexposure to JGBs; quite another to hear it come from a former BoJ official.
Tamaki joined the Bank of Japan in 1979, where he held a number of roles, including a stint representing the bank in Washington, DC and another heading its policy research arm.
He has also run the planning department at the Government Pension Investment Fund, whose $1.5 trillion in assets makes its running akin to a central bank’s reserves. Today Tamaki has gone into academia and has become freer to voice opinions.
Harking back to his central-banking experience, Tamaki notes that the near-default in the US last August has shifted the world of investments into a “post risk-free world” (as did AsianInvestor’s September cover). What this means is a recognition that there never was a true “risk-free” asset, rather than a change in the real economy. (Tamaki spoke in Japanese; these comments were reported via an interpreter.)
Tamaki suggests that such a recognition has not taken place with regard to holding JGBs, but is possible and, if it happens, could turn quickly.
As at the end of 2011, Japan’s gross public debt-to-GDP exceeds 200%, according to the International Monetary Fund, yet JGB yields remain low and stable, with the 10-year bond yielding 1-1.2%. That's thanks to a high domestic savings rate, a stable investor base and a high share of domestic ownership (only about 5% of outstanding JGBs are held by foreigners, versus over 50% of German bunds or nearly 50% of US Treasuries).
However, as the population ages, the demand for savings is expected to decline, in turn reducing banks’ purchases of central government securities. Similarly, Japanese companies may expand investments overseas, reducing their surpluses held in domestic bank deposits. A rise in interest rates or losses in foreign bond portfolios in the event of more European turmoil could force banks to sell JGBs (see our story on the FSA’s concerns about a credit squeeze in Europe).
Tamaki says there are plenty of precedents for societies to believe that certain price levels will remain stable. Such “myths”, he says, include assumptions in the 1980s that land prices in Japan could never fall; that the government would never allow the S&L crisis in the US to affect Japan; that, in the Edo period, lending to daimyo was a safe proposition.
Today, he says many people have assumed the price of gold will remain high relative to rice and other commodities, but in fact it has risen sharply. “Why then do people view government bonds as risk-free?” he wonders.
This is based on trust. People would expect, say, North Korea to default on debt. But there is an assumption that Tokyo can meet its debt, even if that means raising taxes (such as the consumption tax now roiling Japanese politics) or cutting spending. Markets previously assumed this of European sovereign debts; and they assumed this of the US, until political gridlock struck.
So why hasn’t there been a collapse in JGBs? Real interest rates are high given deflation, and the stock market has performed poorly since 1989, so there is a natural demand for JGBs, which are seen as liquid. But behind this is an unspoken assumption that the government will prioritise avoiding default over, say, raising taxes.
“But I’ve worked at a central bank, and my job there was to worry,” Tamaki says, “because confidence can be undermined overnight.”
The question of whether Japan should raise consumption taxes, which at present are a relatively low 5% on goods and services, is a political hot-button issue.
The current Democratic Party of Japan-led administration of prime minister Yoshihiko Noda says it wants to raise this to improve national finances. But the dropping of corruption charges last week against DPJ backroom wizard Ichiro Ozawa, who opposes such a tax, makes its passage uncertain.
Although Tamaki expects the government to address public finances, he believes its soundness is fragile, and that domestic investors are too optimistic about holding JGBs.
This has deep implications for how Japanese pension funds and other investors allocate and risk-manage assets. Right now JGBs are viewed as risk-free. But other certainties in Japanese finance have crumbled over the past 20 years, from real estate to the value of the yen. Indeed, the ending of the Bretton Woods system in 1971 has introduced currency and other measures of risk, and in some ways today’s fears are nothing like the fears of inflation that Japan faced in the 1970s.
The good news, says Tamaki, is that today more people are aware of this history of failed assumptions. And there is a precedent of some risks being properly addressed, referring to the decision in the 1990s among G20 banks to implement a global FX settlement system.* The lesson, says Tamaki, is that financial systems do have resilience but they require constant vigilance and, where necessary, protective measures.
*This addressed so-called Herstatt risk, after a German bank whose cross-border FX trades failed to settle; I broke the story of the G20 solution as a young reporter at Operations Management,a New York-based newsletter, in 1995.