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Summary of Japan's fragility in two graphs [ClearOnMoney]
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Summary of Japan's fragility in two graphs

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Commentary

Summary of Japan's fragility in two graphs

10 Aug 2012 by Jim Fickett.

Neither the Japanese government nor the banking system could survive any significant rise in the yield of government bonds (JGBs). It is a game of chicken. As long as interest rates are extremely low, all is fine. But if market participants start to worry, and rates rise, a crisis will proceed very quickly.

Here is a chart I showed some time ago showing the main categories of government expenditures (Debt service and retirement costs are swallowing Japan's budget). Even with the 10-year JGB yielding less than 1%, almost a quarter of all government expenditures were on bond interest. If interest rates were to rise to the levels of European peripheral countries, say 7%, interest costs would rapidly rise to swallow the whole budget, and massive default or high inflation would be the only possible ways forward.

Next, here is a chart showing the banking sector's exposure to JGBs, from a study released last month by the IMF:

The banks are holding an amount equivalent to over 90% of GDP in JGBs – much worse than in the current banking crisis in Europe. Obviously, if yields start to rise there will be a self-reinforcing panic of the first order as they all try to sell.

Here is more from the IMF report:

JGB and sovereign funding risks: The financial system’’s massive holdings of government bonds leave it exposed to a spike in yields. While the large public financing needs have been fully absorbed by the market thus far, the willingness of market participants to continue to do so at low yields is contingent on sustaining confidence in long-term fiscal sustainability and growth, and on corporate and household savings trends. …

Growing risks to fiscal sustainability have heightened concerns about possible feedback to financial stability. Gross public debt has grown sharply over the past decade, reaching 220 percent of GDP at end-FY2011, the highest ratio globally. An increasing share of the financial system’’s balance sheet is invested in JGBs. …

Interest rate risk sensitivity is especially prevalent in regional banks and insurance companies (JGBs representing about 70 percent of life insurers' securities holdings and 90 percent of insurance cooperatives’’ securities holdings). …

Complementing the stress test analyses, [we] separately assessed the soundness and resilience of a few large and potentially systemically-important financial institutions (Japan Post Bank and Insurance, and Norinchukin Bank), based on publicly available data.

Japan Post Bank collects large amounts of domestic deposits and is not allowed to make commercial loans (with a few exceptions), nor does it have major equity holdings [in other words, this semi-governmental institution is a captive buyer]. As such, its main risk exposure is interest rate risk, with JGBs representing 76 percent of its total assets (70 percent in held to maturity (HTM) account), and resulting in a very high CAR [Capital Adequacy Ratio] given the zero risk weight assigned to JGBs [the assignment of zero risk to government bonds by regulators is the major fiction keeping the house of cards up for now]. … A simple sensitivity analysis suggests that a 100 bps interest rate shock would lead to MTM [mark-to-market] losses of about 35 percent of Tier 1 capital … Japan Post Insurance faces similar risks (nearly 80 percent of its financial assets are domestic securities, in particular JGBs and local government bonds)