Paul Krugman, a Nobel Prize-winning economist and a regular contributor to The New York Times, wrote in 2010 that he was perplexed about the different bond yields between the Italian Government Bonds and the Japanese Government Bonds.
Think about it: Italy’s debt-to-GDP ratio is 126%, Japan’s ratio is 214%, and US’ ratio is 73%. Whereas Italy’s 10-year government bond yield is 4.61% and the US 10-year -- dubbed “risk-free” -- rate is 2.64% as of 9/30, Japan’s bond 10-year government yield is a mere 0.68%! This low yield seems to be very illogical for the following reasons: (1) Japanese economy has performed terribly in the past two decades, where Japan grew at a virtually 0% for twenty years (Some critics call the period as the Lost Decades); (2) Japan’s debt-to-GDP ratio is enormously high to the point that it is beginning to be choked by debt interests. Then why are the yields so low? What’s happening?
There are three reasons: 1) financial repression; 2) home bias; and 3) dysfunctional equity markets.
Financial repression
Financial repression is governments' measures to channel funds to themselves, which would go elsewhere, such as to private consumption, in a normal market.
Japan has a unique financial system that is resembles more of the East Asian countries. Although it follows a free market structure, the government exerts strong influence over the economy, both formally and informally. Although Japan's economic development is primarily the product of private entrepreneurship, the government has directly contributed to the nation's prosperity by helping initiate new industries, cushioning the effects of economic depression, creating a logical economic infrastructure, and protecting the living standards of its citizens. Indeed, so pervasive has government influence in the economy seemed that many foreign investors have popularized the term "Japan Inc." to describe its alliance of business and government interests. Following the Lockheed Martin scandal in the 1970s, which jailed the incumbent prime minister and a series of reforms in the 1980s and the 1990s, some critics have voiced that government influence has waned, but its agencies still exert heavy influence through various policies.
The Ministry of Finance (MOF) requires banks to hold a certain amount of their capital in "safe assets," which in practice means the Japanese Government Bonds (JGB) only. Foreign bonds are considered risky by this regulation even if the exchange risk is hedged through currency swaps. A vast majority of the demand for the JGBs come from small and regional banks, whereas large banks are slowly shifting to shorter-term JGBs. For an example, Bank of Tokyo-Mitsubishi-UFJ, the largest Japanese keiretsu bank which was born out of big mergers, holds Y38 trillion JGBs, which comprise 18% of its total balance sheet. During the global recession from 2008 to 2010, its holding of JGBs more than doubled from Y15 trillion. This pushed down the 10-year yield to approx. 1%. The banks nevertheless had to purchase more bonds, and the yield now stands at roughly half the ratio of 0.68%.
The ever-increasing demand for JGBs has allowed the central government to borrow money at, if we include inflation rate and other variables, a negative interest rate. The cost was levied upon the households. Dr. Michael Pettis, a professor at Peking University’s Guanghua School of Management, calls it a “stealth tax” because it eventually depresses household consumption.
The extremely low JGB yields pushed down deposit rates on Japanese households’ saving accounts to 0%, since the banks need to maintain their spreads coming from the purchase. As a result, the Japanese households have incredibly low net household saving rate. Japanese households have increasingly begun JGBs as relatively attractive investments and began buying JGB-related products.
Domestic bias
Then a question arises: “Why aren’t the Japanese households buying foreign bonds, such as the U.S. Treasury Bills, that are safer and pay higher yields?” In order to answer this question, we have to dig deeper into the country’s recent economic history.
Between 1981 to 1984, the Japanese yen depreciated by approximately 50% against the U.S. dollar. The U.S. industry found itself in a difficult competition against increasingly cheaper, higher quality Japanese goods and lobbied the U.S. government to take action. The Reagan administration passed protectionist measurements and pressured other Group-7 (G7) states to draft the Plaza Accord, in which central banks of the G7 nations would intervene in the foreign exchange market to appreciate their currencies against the U.S. dollar. The Plaza Accord had an effect that was much greater than originally anticipated. After hitting a low of ¥350/$1 in January 1985, yen appreciated by 51% in just two years! (On a separate note, yen is currently valued at ~¥100/$1.) In other words, the Japanese exporters lost 51% of their income in terms of yen. A series of wide fluctuations led the Japanese investors to avoid securities that involve foreign exchange.
Underperforming Equity Market
Resulting recessionary effects on the Japanese export market (1985 - 1986) incentivized the central government to intervene with the monetary expansion policy that led to the Japanese asset bubble of the late 1980s. In January, 1990, the stock market began to collapse, followed by the collapse of the overall asset price in 1991. After hitting an intra-day high of 38,957.44 on December 29th, 1989, Nikkei 225 -- analogous to the Dow Jones Average -- quickly collapsed and closed at 7,054.98 on March 10th, 2009, which makes it an 81.9% drop from two decades ago.
Most American investors believe that the stock market rises in long-term, but the opposite belief is true in the minds of the Japanese investors. This mindset is reasonable if we take a look at the Nikkei 225, which has largely been in a huge downward trend in the past 15 years (See Figure 2). Therefore, the Japanese were correct -- if not making a self-fulfilling prophecy -- that at least their equity market goes down in long-term.
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