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Abenomics poses risk for Japan banks

For an understanding of just how treacherous the road back from zero interest rates can be, have a look at what might happen to Japanese banks if Abenomics actually succeeds.

In short, it might not be pretty.

Rising interest rates, both a tool of Abenomics and evidence of its success, will hit the value of older Japanese government bonds (JGBs) hard. And Japanese banks own a lot of JGBs, having grown ever more dependent on them over decades of deflation and recession.

In fact, if interest rates in Japan rise by just two percentage points, according to a report by Standard & Poor’s, 47 large and medium-sized Japanese banks would be unable to meet capital adequacy targets.

Given that a two-point rise in rates from 2012 levels still leaves prevailing rates, now at 0.83 per cent for a 10-year JGB, below three per cent, that is hardly even a normalisation. If rates rise by three percentage points, fully 70 per cent of Japan’s biggest 112 banks would be in capital trouble, according to the report.

“An additional risk is that markets tend to incorporate expectations at an early stage. One example of this is a sharp fall in stock prices of Japan’s major banks,” Naoko Nemoto of S&P wrote in the report.

“The major banks, in particular, depend on wholesale funding and have a high percentage of overseas investors that hold their equity and bonds. If investors anticipate that long-term interest rates will increase in a short period of time and it causes capital erosion, the major banks may face higher risk premiums in the wholesale market or encounter liquidity risk when they conduct foreign currency-denominated financing.”

In other words, as in 2008, banking crises don’t happen little by little, they happen all of a sudden. This may also give some insight into the future for the US, not only on risks for its banking system but a taste of why many, including some inside policy-making circles, would like to see interest rates rise as soon as possible.

Prime Minister Shinzo Abe’s ambitious plans for structural reforms, called Abenomics, are a mix of fiscal and monetary stimulus combined with structural reforms. One of the key tools for bringing Japan out of the mire of deflation — prices are now falling at a 0.4 per cent annual clip — is a two per cent inflation target the Bank of Japan aims to meet in the next two years.

To the extent the market believes the BoJ will achieve this, it will front-run the move, driving interest rates higher. That appeared to be happening quite rapidly in the spring, as JGB yields spiked higher, but some doubt has since crept in and 10-year yields have stabilised at the extremely low level of about 0.83 per cent.

Japanese banks have greatly increased the amount of JGBs they own in the past decade, at least in part because deflation and economic malaise have hurt both demand for loans and the creditworthiness of borrowers.

Between fiscal 2002 and 2011 City banks, as the largest banks in Japan are called, have increased their holdings of JGBs by 240 per cent, taking the total to well over a trillion dollars. Government bond holdings have also grown faster than profits, leaving banks more vulnerable to a fall in their value.

To be sure, much depends on why interest rates are rising and what else happens. Optimism over Abenomics caused a surge in stock prices, and as banks also hold stocks, that will, if sustained, partly offset losses on JGB portfolios. As well, if a rise in rates comes along with an improvement in the economy, banks will have better lending opportunities. That will help to dampen the effect of JGB losses and will generally help confidence, making it easier for those banks which need to sell assets or raise capital.

On the other hand, a rise in rates which is not followed swiftly by an improvement in conditions could easily spark a sell-off in Japanese bank stocks, as investors reason that they will need capital and to sell assets. Those situations have a way of getting out of control quickly, and though Japan would likely support its banks, this would be a dangerous situation.

This is not an argument against Abenomics. There are no risk-free ways of bringing back Japan, and a rise in interest rates won’t simply cause weakness in its banking system, it will more simply demonstrate it.

Arguably Japan ought to have started long ago, before imbalances grew so large. Arguably the rest of the world could learn from that example. — Reuters

The writer is a Reuters columnist. Views expressed by the author are his own and do not reflect the newspaper’s policy