Japan QE and demand for government bonds

25 Apr 2011 by Jim Fickett.

If and when Japan begins to enter a sovereign debt crisis, we will see either (1) a significant rise in government bond yields or (2) a significant rise in government bond holdings by the central bank. Either of these signs will be a call for heightened alertness and deeper analysis of the data.

It is quite possible (I would even say likely) that Japan will have a sovereign debt crisis in the next couple years. If and when that happens, it will be far more disruptive than the cases of Greece, Iceland, Ireland and Portugal. Hence it is important to be thinking ahead of time about what warning signs might appear.

The difficult here, as with all cases where debt becomes unmanageable, is that as long as the government of Japan can borrow very cheaply, the situation may remain stable but, if interest rates start to rise, things could change quite abruptly.

I have mentioned before the IMF warning that Japanese banks have greatly increased their exposure to JGBs and, if interest rates rise and the value of those bonds starts to fall, banks might sell off significant holdings. This could become a vicious circle, with any sell-off causing a further drop in value, thence accelerating the sell-off.

Debt service costs are now about a fourth of the government budget, so a sudden rise in interest rates could result in major disruptions very quickly.

Some commentators have suggested that, at the first sign of trouble, the Bank of Japan will have no choice but to monetize the debt. That may be correct, so it will be worthwhile to watch the holdings of the central bank, and note any increase. Here is a history, which can give some background against which to evaluate changes:

(Data are taken from the Ministry of Finance's Quarterly Newsletter.)

Although two data points are missing, the outline of events is clear. The first major episode of quantitative easing, which began in 2001, raised the holdings of the central bank rapidly and substantially. Then there was a long period of slow reduction in holdings. Finally, the most recent episode of quantitative easing has again caused holdings to rise. The recent rise is so far quite modest.

Here is my bottom line about how to watch the situation. There has been a great deal of analysis on how demand from households, banks, or some other group might fall. In the end, what matters is the overall demand, and that is measured by the interest rate. So there are two possibilities. Either demand falls and rates begin to rise, or this is prevented by the central bank. So we will see either (1) a significant rise in rates, probably accompanied by increased JGB issuance to pay the rising debt service cost, or (2) a significant rise in Bank of Japan holdings, to keep interest rates down. In the latter case, of course, the BoJ will hardly announce that they are attempting to forestall a debt crisis, so any purchases will still be called QE, and justified as normal monetary policy.

There is a new Reference page, Japan government debt, where key indicators will be updated at least quarterly, and more often if there is significant news.