The Japanese bond market has been hijacked by the BoJ
The purpose of government bond markets is to allow a government more flexibility when financing its expenditure. Ultimately and in the long term only taxes can sustainably finance government expenditure, but in the short term bond markets can provide governments with a way to manage and stabilize cash flows without having to wait for tax revenues to come in. In addition, governments can decide to borrow money in order to stimulate the economy in the short term, if some extraordinary external factor has temporarily impacted the economy’s ability to function and grow.
Over the past several decades the Japanese government (along with virtually every other government in the world), has systematically maintained expenditure levels well above revenue levels, which means they have been running deficits almost constantly. This in turn has forced governments to (mis)use the bond market to continuously borrow more money to finance these deficits, and in the process they have built up enormous amounts of government debt.
Apart from an ever growing debt burden being obviously unsustainable in the long term, the problem of how to finance the interest burden is also a problem in the short term. Logically, if a government can not afford to cover its expenditure on the various public services it has committed itself to providing, and thus has to borrow, then it also can not afford to cover the interest payments on the existing debt.
The obvious ‘solution’ is to borrow more money, but of course that is so blatantly unsustainable that the cost of borrowing would rise substantially, as bond market investors recognize that the government’s position is untenable. This would quickly drive down bond prices, push up interest rates and in short order leave the government unable to service its debt and interest obligations. We have written about this in detail here).
An alternative solution is to task the central bank with ‘solving’ the problem by asking it to buy up the new debt issuance. The central bank can do this, because it has a monopoly on printing money, and it can in theory print as much money as required. This is exactly what is happening in Japan, but also in the US and increasingly in Europe as well.
So what is the problem with this approach? It seems ideal, in that government finances keep ticking over, and the government can keep funding itself and covering the expenditure that it has committed itself to, as well as paying interest on its debt. The problem is that this monetization of the government’s debt is inherently inflationary, and it will ultimately end in hyperinflation, which in turn erodes the real value of all non-productive assets (such as savings), as well as lowering the real value, in terms of actual purchasing power, of people’s wages. If inflation is running at 20% and your wages are going up by only 2%, it doesn’t take very long for you to struggle to pay your bills. And if your savings only deliver a return of 1%, then soon their value will also be eroded.
In effect, this monetization is just a huge wealth transfer from the average citizen’s savings account to the fiscally dysfunctional government, the latter of which then proceeds to squander it on historically ineffective short term fiscal stimulus programs.
In Japan this phenomenon has now reached a stage where the bond market has effectively ceased to function as intended. Like any other market, the bond market is ultimately a pricing mechanism. The actions of thousands of economic agents acting as potential buyers or sellers of government bonds, implicitly determine the value of those bonds and consequently the interest that they require in order to hold them. That is how the market is supposed to function. A free market, that is.
However, with the BoJ now being responsible for as much as 70% of government bond purchases, the pricing mechanism has been rendered severely impaired, and prices possibly completely meaningless. When a country’s central bank is a constant and completely predictable buyer of as much as 70% of new debt, the remaining 30% will have little to no impact on the pricing of that debt. If anything, the remaining 30%, which is made up mainly of banks and other institutional investors, will have little incentive to go against the BoJ. It is exactly the same effect seen in the US equity market where the S&P500 is on a steady trajectory upwards simply because the Federal Reserve is pumping liquidity into the market on a very large scale (although not quite as large as in Japan), and any rational investor would conclude that it is safer to go with the Fed than against it. The effect thus becomes self-reinforcing.
Another indicator that the JGB market is dysfunctional is that it barely reacted to the announcement on the 1st of November that the Japanese government is initiating a 5 trillion Yen spending program, ostensibly in an effort to offset the negative impact of the upcoming increase in the consumption tax. The non-reaction in the bond market displays the apathy that now seems to have taken hold in that market.
That aside, when observing the obvious ridiculousness of increasing government spending as a direct consequence of having raised taxes in order to reduce the deficit, NipponMarketBlog is left in a state of not knowing whether to laugh or cry, but we are frankly leaning quite heavily towards the latter.
Yet another indicator of bond market apathy in the face of the overwhelming force of the monetary Shock-and-Awe tactics of the BoJ, is the level of participation in the bond market on the part of large institutional investors. An easy way to measure this is by looking at trading volume in the bond market. If trading volume is high, it tends to indicate that the market is functioning as intended and lots of investors are trying to use it to position themselves according to what they believe is the outlook for the market (and ultimately government finances) in both the short term and the long term across the entire yield curve. Low trading volume indicates the exact opposite, i.e. a dysfunctional market where there is little to no ability of the market to arrive at a meaningful price, because the entire market is completely dominated by just one player – the BoJ.
The Japan Securities Dealers Association has released its latest data for bond market volume, and it makes for some interesting reading. Below is a chart showing the total monthly trading volume (buys) of government bonds by city banks, regional banks, trust banks and all others, going back to early 2004.
From this we can see how bond market activity is near the lows for the period in question, despite there being enough to be either excited or concerned about for the average bond market investor. One can only wonder what this lack of order flow has done to the bond trading departments of major investment banks. NipponMarketBlog predicts lower bond trading revenues for investment banks for some time to come.
From the Japanese government’s perspective it might seem like a good thing that the bond market is so subdued, and that the BoJ effectively owns most of the government’s new debt, which is predominantly what prices the already existing debt stock.
However, there are (at least) two major problems with this.
Firstly, this dysfunctional bond market with its lack of accurate pricing of return versus risk, represents a sort of coiled spring in the sense that when the market finally breaks and investors properly lose faith in the Abenomics program, the reaction will be that much more violent.
Secondly, the fact that the JGB markets is artificially held in check by the massive influence from the BoJ’s buying, where it would otherwise have been much more active, volatile and with upwards pressure on interest rates, means that the government itself is likely to mistake this lack of activity and upward pressure on interest rates for an indication that things are going well and that there is no need to do anything too rash too quickly. In other words, it may encourage complacency and remove the urgency from the political process when it comes to implementing the much needed structural reforms that this and many previous governments have long struggled to get under way. Unless Shinzo Abe’s government gets serious about these structural reforms, Abenomics will – as we have said many times in the past – fall flat on its face, and once that has happened there will be no option left but to default on the government debt.
As we have mentioned in the past, Japan is very much between a rock and a hard place, and there is no easy solution to the problems facing the country.
NipponMarketBlog can not help feel that there is excessive focus on taxation and monetary policy, and far too little attention on finding ways to permanently reduce government expenditure. The declining birthrate, the shrinking workforce and the growing number of elderly simply dictates that the current expenditure level (and by implication the current level of overall public service) is entirely unsustainable, and raising taxes with its negative impact on economic growth is not a solution, just as monetizing government debt and thereby effectively robbing the average citizen of his or her private wealth through rampant inflation, simply does not represent a long term solution.
We very much fear that the Japanese government has begun to believe its own hype, and that complacency with regards to serious (and probably painful) public finance and service reform is beginning to creep in. With the government’s deficit running at 10% of GDP every year, and the bond market that sustains it becoming ever more fragile, there really is no time to lose. Sadly, if history is anything to go by, humans in general, and the Japanese political class in particular, are re-active as opposed to pro-active, and will only react in a meaningful way to a problem after it has blown up in their faces.
NipponMarketBlog would like to be optimistic, but we continue to feel compelled to be ‘realistically pessimistic’…