On Japanese government bond yields (part 1 of 2)

Having just spent over a week in Japan, I wanted to share what I have read about the Japanese economy, specifically the low yields on Japanese government bonds (JGBs).

While I have only visited Japan a few times, each visit has provided me with a consistent and somewhat timeless experience. I feel that the Japanese have prided themselves on having a unique and well-mannered culture, however, its shift towards an economy focused more on tourism has changed the way I perceive how their service-based Japanese employees behave in the workplace. In my experience, dealing with mainland Chinese tourists has been unpleasant and gives an insight to the underdeveloped ethical and moral standards of the Chinese citizenry as a whole. It would be most unfortunate if Japanese service-based workers have changed their own mannerisms as a result. They should stay true to their own culture of being well-mannered and respectful in the treatment of others.

A few years ago, Paul Krugman posed the question: “Why are the interest rates on Italian and Japanese debt so different? As of right now (2011), 10-year Japanese bonds are yielding 1.09%; 10-year Italian bonds 5.76%. I ask this because in a number of ways the two countries look similar. Both have high debt levels, although Japan’s is higher. Both have awful demography. In other respects, the numbers if anything favor Italy, which has a much small current deficit as a percentage of GDP.” So what is Krugman talking about when JGBs yielding roughly 1%?

By definition, the yield-to-maturity of a bond measures the annual return an investor would receive if they held the bond to its maturity; such that, if the price of the bond goes up, the yield falls, and vice versa. Typically, bond yields are higher in emerging markets since they usually present higher risk with regards to economic, social and political factors. In developed markets, bond yields are typically much lower as they command a higher price, or a premium, in comparison to those in emerging markets. So what does the yield on Japanese 10Y government bonds look like historically?

JPY10Y - 1984 - 2015

The above graph shows the yield on Japanese 10-year government bonds between 1985 and 2015. Yields on 10Y JBGs fell dramatically from 1991 to 1998, and as a result, yields have slowly hovered lower between 1998 to now. In fact, between 1984 and 2015, yields reached an all-time high of 7.59% in May 1984 and an all-time low of 0.20% as of January 2015. So at this all-time low of 0.20%, how much did an ‘investor’ receive as an annual return?

If they held 1,000 yen of Japanese government debt, their annual return would be roughly 2 yen. Now to put this into comparison, a Big Mac in Japan costs 370yen, or roughly US$3 (@US$1:123.59yen), and US$4.80 in the US, which would require an exchange rate of US$1:77.08yen or a 60.34% appreciation of the Japanese yen against the USD to make the two Big Macs comparable (excluding IRP).

So what are the contributing factors to having such high market prices on Japanese 10Y bonds? According to Noah Smith, it is a result of three factors: financial repression, home-bias, and dysfunctional Japanese equity markets.

Japan’s financial system is dominated by big banks and along with these banks, the Ministry of Finance puts pressure on the banks to purchase lots of Japanese government bonds. This pressure is a result of regulation, rather than being an informal process. The regulation requires Japanese banks to meet their capital adequacy measures by holding “safe assets,” which result in being Japanese government bonds. As a result of this pressure, the interest rates on bonds issued are kept very low, thereby reducing the deposit rates on household saving accounts. Therefore, as the Ministry puts pressure on banks to purchase government bonds, individuals view Japanese bonds as a relatively safe and higher yielding alternative for their deposits, thereby also reducing the yield as a result of greater demand. In fact, Smith indicates that net household savings are quite low as a result of the shift of money from savings accounts to JPY bonds.

In comparison to China and thanks to the US, Japan does not have capital controls. So why don’t Japanese financial institutions purchase foreign assets instead? As a result of the Japanese asset price bubble, the Yen appreciated from 260.34yen/US$1 in February 1985 to 133.72yen/US$1 in December 1990. Japanese investors have remained skeptical about exchange rate risks ever since. Furthermore, portfolio diversification seems almost non-existent to Japanese investors, even though they understand that it can help dramatically lower portfolio risk.

Personally, I am a big proponent of the rational expectations theory and I believe the Japanese equity market is a perfect example of this. Smith indicates that Japanese investors are convinced that the stock prices fall in the long run, rather than rise as the Gordon growth model would indicate. Is this is a question of Keynesian vs. Neo-Keynesian thinking? What has the Nikkei 225 returned to investors in comparison to the S&P 500?

S&P 500 (1985-2015)Nikkei 225 (1985-2015)

In terms of dysfunctional equity markets, Smith identifies two key factors: all-insider boards of directors and cross-shareholding.

Christina Ahmadjian’s Changing Japanese Corporate Governance (PDF) identifies how Japan is experiencing a ‘corporate governance crisis’. Ahmadjian criticizes how, “Corporate misbehavior and economic doldrums are blamed upon lack of concern for shareholders, cozy cross-shareholding relationships between firms and banks, board of directors that look more like old boys club than responsible monitors, and executive compensation packages that give CEOs little incentive to improve the bottom line.

While Ahmadjian’s paper examines whether the idea of global convergence or inertia of public scrutiny will improve Japanese corporate governance, the fact is that it should be in transition. However, is it in transition towards standards that actually improve stock market performance? The paper identifies that empirically, the evidence is slim on whether “better corporate governance leads to better performing firms.” On the other hand, this does not shy away from the recognition that, “there is considerable agreement that strong, developed economies are based upon effective and coherent systems of corporate governance, which protect the interests of investors.

Smith concludes his piece by clearly identifying the following need for a restructure of the Japanese economy:

  • As a final note, it seems to me that the Japanese government’s success in holding down its borrowing costs has probably had big negative effects on the economy. Banks that are forced to buy JGBs can’t lend as much to firms, which seems like it would depresses economic activity, holds down growth, and probably contribute to deflation via suppressed wages. Households have been squeezed and squeezed by falling incomes until their savings rates have gone negative, yet they are still earning nothing on their savings. As a result, households are dead set against tax hikes to close the budget deficit, but politically powerful farmers and construction companies won’t allow spending to fall either. It’s hard to see how this vicious cycle will be broken, until Japan is forced to default from the sheer weight of interest payments. That would be the biggest and most catastrophic sovereign default in world history, unless of course the U.S. manages to pull one off first.

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