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Commentary

GFSR 4: Tail risk in Japanese Government Bonds

5 Oct 2010 by Jim Fickett.

Though the danger is small at present, there is a realistic scenario for a sovereign debt crisis in Japan. Domestic banks are currently the main buyers of JGBs and, if more interesting lending opportunities arise, or if interest rates rise, a mass exodus could ensue.

Japan seems to be in little danger of a sovereign debt crisis at present. But given that it is highly dependent on domestic savers who, due to the aging of the population, are moving out of saving and into spending mode, the risk is slowly growing. This makes Japan an important case to keep an eye on, both for its own sake and as a possible early warning for the US case.

While stressing that the risk in Japan is currently small, the Global Financial Stability Report does lay out an interesting scenario of possible crisis. The main idea is that the banks are currently the main buyers of JGBs and, if more interesting lending opportunities arise, or if interest rates rise, a mass exodus could ensue.

Japan’s government bond market has several structural features that could allow a small risk of distress to quickly transmit through the banking system and telescope medium-term fiscal solvency issues into near-term funding difficulties. Japan has a shorter debt profile and higher gross funding needs than other countries. Weak corporate demand for loans, limited domestic investment opportunities, and strong home bias have induced domestic banks to increase their Japanese government bond (JGB) exposures significantly over the past two years. … This heavy dependency on bank purchases of JGBs brings with it a risk of a disorderly reversal in that market if a potential rebound in credit demand prompts banks to reduce their JGB holdings. Since Japanese banks are now the dominant buyer of JGBs, the market could become disorderly, especially at the shorter end of the yield curve, if banks begin to slow or reverse their bond purchases.

a sudden spike in JGB yields is not unprecedented. In June 2003, 10-year yields more than tripled in the course of three months, surging from a historically low 45 basis points to 1.6 percent. … Despite better risk management practices, a similar correction today could be far more dramatic, given the higher exposure of banks to JGBs and heightened investor concerns regarding sovereign risk following the euro area turmoil.