While fully consistent with Japan’s improved economic outlook and equity market gains, the upwards shift in JGB yields since early April has raised concerns. Not least of these is the impact on the health of Japan’s banks, which own more than 40% of the JGB market. And as yields spiked early yesterday, equity prices of Japanese banks were disproportionately hit. But are these concerns well-founded?
As the BoJ made clear in its own most recent analysis, rising JGB yields do indeed pose risks for Japan’s banks. But, for the major institutions, we would need to see a far more extreme shift in yields – perhaps ten times the size of the move of the past six weeks – to be especially worried.
With an average maturity of bond holdings of only 2½ years, the major banks should be relatively immune to a marked steepening of the JGB yield curve. For example, the BoJ calculates that a marginal rise in short-term rates accompanied by a very significant rise in long-term yields (about 300bps, taking 10Y yields to their highest levels since 1996) would generate unrealised capital losses of up to ¥3.6trn for the internationally active banks. But the impact on their capital ratios would be 'trivial' since they would benefit from higher lending margins.
The BoJ also assesses that the small number of very large internationally-active banks could also comfortably withstand an upward shift of about 100bps in JGB yields right across the curve – four times the recent rise at five-year maturities where the move has recently been most marked – with capital losses on bond-holdings of about ¥3.2trn offset by other factors to leave their Tier 1 capital ratios little changed.
For some of the regional and shinkin banks, the story is a little less sanguine. The average maturity of these institutions’ JGB holdings is between 4 and 5 years. The impact of a marked steepening of the curve would, on paper at least, therefore be more significant than for the major banks. But despite the potential for larger unrealised losses on their bond-holdings than the internationally active banks, their Tier 1 capital ratios would not necessarily be affected significantly as these institutions typically house the bulk of their JGBs in banking book portfolios, meaning that they would not have an immediate impact on capital ratios.
So, if the BoJ’s analysis is to be believed, we should not be overly exercised by recent market moves. And that is perhaps why BoJ Governor Kuroda remained relatively sanguine when he faced lawmakers in the Diet earlier today.
However, an extreme jump in JGB yields across the curve back to levels last seen in the mid-1990s – the magnitude of shift seen in the first half of 2012 in Italy and Spain – would leave none of the banks unscathed. Indeed, it could knock 1ppt or more off the Tier 1 capital ratios of those that are internationally active. But under such a scenario, that might be the least of the problems.
For the Government, the resulting higher debt service costs could eventually absorb up to half of the extra revenues set to accrue from the 3ppt increase in the consumption tax due next April.
Most importantly for the BoJ, however, such an extreme shift in the curve would provide a major hit to economic growth due to the impact on interest rates charged by the banks, which will restrain lending. In particular, according to the BoJ’s arithmetic, a 200bps upward shift in the curve might knock about 1.7ppts off nominal GDP growth to leave output broadly flat over the coming couple of years, despite the major policy stimulus.
And because that kind of growth performance would leave the achievement of its 2% inflation target well out of reach, although yields ultimately have further to go, we remain confident that the BoJ will do its utmost – if necessary amending its asset-purchase programme – to avoid damaging scenarios of rates rising too far too fast.
Chris Scicluna, Head of Economic Research