Having discontinued the sale of inflation-linked bonds in 2008, the Japanese government will resume the sale of this type of bond in October 2013. The way these bonds work is that the holders of the bonds have the principal adjusted by the inflation rate. This means that holders effectively have their exposure to inflation hedged by the government.
The reason inflation-linked bonds were discontinued was that deflation (which at the time seemed increasingly impossible to ever get rid of) left virtually no demand in the market for these types of bonds.
With the re-emergence of the prospects for positive inflation, institutional investors are now telling the Bank of Japan that they are again willing to buy these bonds, and thus help finance the government’s deficit in this manner. In a meeting with primary dealers it was apparently (but not surprisingly) made clear to the Ministry of Finance that it was mainly foreign investors who are asking the government for these types of bonds.
This is not exactly new news, but NipponMarketBlog believes it is well worth reflecting on.
On the one hand, one might put a positive spin on this and point out that if investors are actively demanding these bonds, then the government and the BoJ have achieved part of what they set out to do, which is to create inflation and thereby (at least theoretically) stimulate demand in the economy. We have written on the details of this monetary stimulus thesis here: Bank of Japan Governor Kuroda: “An entirely new dimension…”
We have also written on why the kind of inflation the BoJ is now creating might not necessarily be of a desirable nature, in our piece about ‘The Hamburger Inflation Falacy’.
However, returning to the sale of inflation-linked bonds, there is a less rosy interpretation of this move by the government, and that is that if the government is re-launching the sale of these types of bonds then it might be because this is increasingly how it expects to have to fund itself in the future, now that domestic institutions are becoming net sellers of JGBs. We have written about the demographics-driven shift in pension funds from being net buyers to being net sellers of JGBs here:
In other words, if the government wants to continue to sell bonds to foreign investors, then they will either have to provide a higher yield (which is already manifesting itself in the fact that 10 year JGB yields are almost 0.5% higher than they were before the QE announcement in April this year), or they will have to issue inflation-linked bonds in order to insure the bond holders against a loss in the principal, should inflation start to rise.
It seems to NipponMarketBlog that if we have interpreted the government’s and the BoJ’s real agenda correctly, then issuing inflation-linked bonds is precisely the only thing the government should not be doing. The massive quantitative easing, the devaluation of the Yen and the creation of cost-push inflation is in reality less of an attempt to spur demand, and more of an attempt by the extremely heavily debt-burdened government at monetizing that debt by creating high levels of inflation. Hence, selling inflation-hedged bonds to investors is utterly counter-productive from this perspective.
NipponMarketBlog has to assume that the government and the BoJ are well aware of these dynamics, which leads us to the inevitable conclusion that they are becoming so worried about the ability of the government to finance its deficit going forward (partly through foreign investors), that it now finds itself forced to change its offering of ‘funding products’.
Put differently; If the government had a healthy balance sheet and a deficit that was under control, and if it was presiding over a strong economy, and if the BoJ was perceived to be a credible guarantor of price stability, then they would not have finance themselves by selling inflation-linked bonds. It would be much more sensible for them to sell only standard JGB’s which it could then gradually erode the value of the principal of, through restrained BoJ money printing.
As a side-note, it might be tempting to think that the BoJ can simply solve this funding problem by buying all the government’s debt ad infinitum, but of course this would ultimately create a hyper-inflationary outcome. In this scenario, the JGB market would almost certainly anticipate that exact outcome. The result would be that the JGB market would crash and do so well before the printing presses inside the BoJ got spun up to full speed, which would in turn send interest rates sky-rocketing and push government interest debt service payments above 100% of tax revenues. We have detailed the mechanics of the government’s debt predicament here:
These observations and conclusions may seem slightly spurious, but NipponMarketBlog believes that seemingly anecdotal qualitative information like this is instructive in obtaining a general sense of investor confidence in the authorities, and more specifically which way the all-important JGB market ‘sentiment pendulum’ is swinging.