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Japan Ministry of Finance Roundtable

02 Jul 2012

International investment in the Japanese Government Bond (JGB) market has been rising in recent months, reflecting investors’ continued search for safe havens in the wake of the European sovereign debt crisis. But there is also a growing recognition among investors that long-term structural change is now gathering momentum in Japan, and that on a relative basis its economic fundamentals are stacking up increasingly well.

To discuss these changes, and their implications for JGBs, a number of market participants gathered at the EuroWeek/Japanese Ministry of Finance roundtable in London in June. Sitting around the table were:

Alexander Düring, managing director of fixed income research, Deutsche Bank, London

Frances Hudson, global thematic strategist, multi asset investing, Standard Life Investments, Edinburgh

David Rea, Japan economist, Capital Economics Ltd, London

Andrew Rose, fund manager, Japanese equities, Schroders, London

Chris Scicluna, head of economic research, Daiwa Capital Markets Europe

Chikahisa Sumi, deputy director general, financial bureau, Ministry of Finance, Tokyo

Fumiaki Takahashi, senior trader, Capula Investment Management, London

Michael Taylor, director, research group, Lombard Street Research, London

Phil Moore, Moderator, EuroWeek

EUROWEEK: At the end of April, the Bank of Japan revised up its GDP forecast for FY2012 by 0.3 percentage points to 2.3%. The IMF, meanwhile, predicts that growth in Japan will be amongst the strongest of the major industrialised nations this year. Do roundtable participants share the view that the Japanese economy will rebound strongly this year?

Chikahisa Sumi, Ministry of Finance: We are still in the middle of recovery from last year’s disaster and expenditure amounting to 4% of GDP will be channelled into this recovery effort over the next five years. Compared with other economies that are dealing with fiscal austerity, Japan has elbow room to stimulate the economy.

Not only the Bank of Japan but other international observers such as the IMF have estimated that our growth rate will be one of the highest among advanced economies. That is good for the short term.

Andrew Rose, Schroders: The observation that Japan will be one of the more rapidly growing economies this year is correct. Much of this growth will be driven by the continued bounce-back after last year’s earthquake and the floods that struck Thailand later in 2011.

We recently had the data for first quarter GDP growth in Japan which was stronger than most analysts were expecting, with an annualised rate of 4.1%. The consensus view now is that the economy will grow by about 2.5% in real terms this year. If that is realised it will indeed make Japan one of the fastest growing advanced economies in the world.

It is important to point out, however, that the annualised rate of 4.1% in the first quarter probably represents the peak rate of growth in Japan. The positive impact from the restoration of supply chains will become less of an issue, and the rate of change in the increase in public works expenditure in relation to the reconstruction of Tohoku will also begin to recede towards the end of the year.

Alexander Düring, Deutsche Bank: Our expectation for GDP growth this fiscal year is about 3%, which is stronger than the IMF’s forecast.

My view is that the recovery from the financial crisis on a global basis is very strongly correlated with the development of unit labour costs. One of the popular misunderstandings about Japan is that people see it as a very expensive country. In reality, unit labour costs in Japan compare favourably with other large economies such as the UK and Germany.

The reason we’re so optimistic about our forecast for this year is the unfortunate necessity for recovery after the earthquake in 2011. We also view incentive schemes such as the car purchase scheme positively. That is working well and will support consumption this year.

The problem is that this won’t last. Growth will start to slow in the second half of this year and will decelerate substantially next fiscal year.

Japanese debt is obviously very high. But the Japanese owe this debt to themselves, and it’s very important not to confuse accounting and economics. Japan is an extremely rich country which has chosen to have a large liability on the government’s side of the balance sheet matched with large assets on the private sector’s side in the form of huge amounts of bank deposits. It is their choice not to net out these assets against these liabilities. I’m comfortable with this, although of course it would help if there was a clear strategy to wind down this huge amount of debt.

The recipe for this must be growth, and again it’s important not to mistake accounting for economics. Even if you hike taxes to a point where you can stabilise the debt level, the only way to bring stability to the social security and pension systems is through accelerated population growth, which can come through one of two sources: a higher birth rate or more immigration.

Immigration doesn’t seem to be the desired way of addressing this issue. That means Japan needs to encourage a higher birth rate, which I think could be achieved through a change in the tax system. It’s difficult for Japanese people to start a family because so much of the tax system is focused on income rather than consumption. My view is that shifting more of the tax base from income to consumption would encourage people to bring up more children. In that respect, it is disappointing that there has been a suggestion that the increase in the consumption tax will be conditional upon growth.

Sumi, Ministry of Finance: The consumption tax increase is not conditional. The government has a policy obligation to do its utmost to achieve 3% growth, but this is not a precondition for the tax hike.

Düring, Deutsche Bank: I’m pleased to hear that. But I also think it’s unfortunate that so much emphasis has been put on the Bank of Japan as a motor of change. The challenge facing the Japanese banks at the moment highlights the difficulties of running a banking business in a low interest rate environment. The costs of deposits for Japanese banks are higher than the rate at which they can invest, which means the more deposits grow, the more difficult it will be to be a profitable bank in Japan. Arguably some of the larger banks are already facing negative interest rate margins on new deposits, which is not sustainable. So maybe a lesson for the Eurozone and the UK is that lower interest rates are not the way forward to stabilise an economy.

Generally I’m a lot more positive on Japan than a lot of people in the market. We’ve been arguing for several years against the possibility of a fiscal blow-up and a rapid increase in interest rates and volatility in Japan which some people have been forecasting.

Although time may be running short for Japan, it is in a much better position than the Eurozone. It benefits from what some people have called the cleanest shirt theory. But I hope the Eurozone can remove this incentive to buy JGBs.

Sumi, Ministry of Finance: I certainly agree with Alex that growth is the way to address the viability of the social security programme which at the moment is among the most generous among all but a few Nordic countries.

Theoretically, we can divide growth into three main constituents: capital input, labour input and total factor productivity growth. Looking back at higher growth periods in the 1980s, all three elements were strong. In the 1990s we started to reduce our working hours so the labour input contribution turned negative.

Looking at the demographic challenge, over the coming 50 years our population will shrink from 120m to between 95m and 100m. The more pronounced decline is in the age bracket from 15 to 65, although I have some reservations about looking at the data in this way, because few people aged between 15 and 21 are employed. So to describe people between 15 and 24 as being of prime working age is rather old-fashioned. 25 to 74 may be a more representative age range for the working population, especially given that Japan’s life expectancy is 80 for men and 86 for women.

So our challenge is to mitigate as much as possible the negative impact of the lack of labour input growth. Increasing the birth rate is a very long term solution, but by having more nurseries available the female participation rate in the labour force could be raised, which at the moment dips between the age of 25 and 40.

We could also raise the participation rate of the elderly by increasing the mandatory retirement age set by many private firms. Encouraging the elderly to work could play a strong role in helping to mitigate the long term negative impact of the population decline.

On the subject of our road to fiscal consolidation, in the fiscal management strategy outlined in 2010, the government established a medium term goal of halving the ratio of the deficit to GDP by 2015, and of achieving a primary balance surplus by 2020 at the latest. This remains our objective and is based on increasing the consumption tax to 8% in 2014 and to 10% in 2015.

Ratings agency said our fiscal reforms were proceeding at a leisurely pace but I don’t think that is a fair description. These reforms were agreed upon by the G7 leaders and this was before the earthquake.

Rose, Schroders: Japan’s demographics clearly puts pressure on social security buckets, and means there are fewer taxpayers to pay for them, which is a negative.

There is a view that is sometimes expressed that as the population ages so the savings rate comes down, because the elderly save less. Therefore, excess savings may disappear more rapidly than people expect.

I think the jury is still out on that, because on a more positive note, I’ve seen data which suggests that if you break down savings amounts by age cohorts, the wealthiest cohort in Japan is people in their seventies. That contrast with the UK where the richest are those aged between 55 and 64.

So there are two opposite arguments. One is that as the population ages, savings rates come down which is negative for the bond market. The other is that because of the way savings are distributed in Japan, you can’t necessarily conclude that an aging population leads to a lower savings rate.

Chris Scicluna, Daiwa Capital Markets: As we’re talking about the relative attractiveness of Japanese securities in the context of the global market, there are a lot of unfair caricatures and misguided views about the Japanese economy and the drivers of growth.

Alex mentioned the incredible strength of private sector balance sheets in Japan which has been reflected in recent growth performance, especially compared with other major economies. Since the beginning of 2009, with the exception of the quarter of the earthquake, private consumption has contributed positively to growth. The level of private consumption in Japan is now more than 3% above its pre-Lehman crisis level. By contrast, in the euro area it’s still just below its pre-crisis level, and in the UK it is still more than 5% below its pre-Lehman level.

So although people perceive the Japanese economy to be one in which consumers are savers rather than spenders, to the detriment of GDP growth, the opposite is arguably closer to the truth. In Japan there is a relatively reliable driver of growth, at least compared to the major Western economies, which is the household sector.

Japan underwent a decade of adjustment in terms of private sector balance sheets starting in the early 1990s. Today, balance sheets are much stronger, and therefore the private sector is able to support growth.

Alex also mentioned that this year we expect investment to support growth, and of course reconstruction is a big part of that. So even though we have a difficult global environment and headwinds from a strong yen, domestic demand will support an above-trend rate of growth. Although we expect growth to slow more next year than the BoJ does, we are still forecasting growth in fiscal 2013 of more than 1%, which is above trend, and so which is also not to be sniffed at in the current global environment.

In terms of the JGB market, while growth will be above trend it won’t be anywhere near a rate that will generate inflation. So the BoJ will remain supportive, and if and when we have an escalation of the Eurozone debt crisis, and further upward pressure on the yen, I would expect the BoJ to up its purchases of JGBs, and contribute to stability in that market by moving further down the curve too. That is certainly a source of comfort for the MoF.

Politically, too, Japan might be unfairly caricatured. Prime Minister Noda has made considerable efforts to strengthen support for the consumption tax and welfare reform beyond his own party. It looks as though this is a rather more constructive process than the ones we’ve seen in generating support for structural reforms in Europe over the last couple of years. Japanese politics is often perceived to be a weakness, but it remains to be seen whether that is the case. It may be that Japan is unfairly maligned in this respect.

Düring, Deutsche: Increasing the labour participation ratio among women and the elderly may help in the short term, but ultimately it doesn’t address the demographic challenge that Japan faces.

There is a feeling that the Japanese crisis is similar to the European crisis, in the sense that there is too much debt. But the big difference is that Japan has a massive current account surplus, so there is always more money coming on to the island than there is leaving it. For better or worse, Japan has more leeway and can relax a little.

Michael Taylor, Lombard Street: I agree with Chris’s point about consumption. Over the last four quarters, consumption growth has averaged almost 1% per quarter, which in the UK would be regarded as a fantastic achievement, reminding us all of the boom of 10 years ago.

On the external side, one of the big questions is China, which is now Japan’s biggest trading partner. As a house we are notoriously bearish on China. So if we’re going to have a hard landing in China, will the external environment be supportive for Japan, or will it be a drag?

I don’t believe the strength of the yen is a long term problem. The real exchange rate in Japan is highly competitive and as Alex said, unit labour costs are in good shape. So it’s not a question of the exchange rate. It’s a question of global trade. This is where a Eurozone blow-up would feed into Japan, not so much through the banking sector, but more through the global trade cycle.

So although I’m probably slightly less optimistic than the others on the outlook for the next year or so, I have a reasonably positive view on Japan. The eco subsidy for car purchases may well come to an end soon, so there may be a fall-out from that, but not a catastrophic collapse in consumer spending.

David Rea, Capital Economics: We are also more bearish on Japan, although we think there will be above-trend growth this year and next. While I agree with Chris’s point that consumer spending has been very strong, I can’t help but think that when the auto subsidy comes to an end this might slow, because we’ve had so much auto spending brought forward. That has been the main driver of consumer spending in Q1 and I am concerned that this may drop off in Q2 as it did after the last auto subsidy expired.

I agree that strong household balance sheets will help to compensate for this. But we are also quite bearish on Europe and we think there will be a serious fallout globally if Greece leaves the euro or if there is some other form of break-up. We think that will weigh heavily on global growth and trade, and will result in a flight to safety which will push the yen much higher. So Japan will suffer from a loss of external demand and a stronger yen. Neither of these factors need be hugely detrimental to Japan. But the combination of the two may mean that growth could be considerably slower than the 2%-2.5% that consensus seems to be suggesting.

EUROWEEK: The yen has been strengthening again in recent weeks. Andrew, given your equity focus, to what extent would the continued strengthening of the yen derail the forecasts that have been made about economic growth in 2012?

Rose, Schroders: It would be negative for exports. But exports are not that large a part of the Japanese economy. The impact on exports should be compensated for by the fact that Japan is probably the only advanced economy that will enjoy a fiscal boost this year. Wearing my equities hat, I’d say that a stronger yen would have more of an impact on companies’ profitability than on the overall rate of growth.

Sumi, Ministry of Finance: This might make you bearish on Japanese equities, but not on its debt.

Rea, Capital Economics: That’s true. We believe safe haven demand will continue to support the Japanese bond market. There’s no reason in the short term to believe there is going to be any change in demand for JGBs.

EUROWEEK: How do investors see the JGB market?

Fumiaki Takahashi, Capula: I agree that it is not appropriate to compare Japan with what is happening in the Eurozone. The size of Japan’s debt is over 200% of GDP, which is very high. However, we should not overlook the importance of Japan’s net foreign assets of ¥253tr. This has been the world’s highest total of net foreign assets for the last 21 years. This means that although the government has a deficit, the household and corporate sectors have significant surpluses. That makes Japan very different from Europe.

Winston Churchill said that democracy is the worst form of government except all the others that have been tried. So when Fitch says that the pace of fiscal reform has been leisurely perhaps they should remember that democracy needs time. The current level of JGB yields indicates that the nation-state’s net foreign assets allow Japan to take time over its fiscal reform.

Rose, Schroders: There has been quite a lot of alarmist comment on Japan’s current account surplus. I can see why this is, because Japan did post a trade deficit last year, and some of the forces that pushed Japan into this trade deficit are still in place, notably the need to import more fossil fuels to offset the closure of the nuclear energy facilities.

But even if you have a negative view on the trade deficit — and I’m not sure that I do — it is hard to make the argument that the current account will go into deficit any time soon. Income flows from abroad are visible, substantial and reliable, so the argument that the current account surplus is going to recede any time soon is wrong. I agree that if you could make that argument it would be negative for the bond market, because Japan’s excess savings are a function of the current account surplus.

EUROWEEK: Frances, would you agree that Japan’s current account surplus makes up for the size of its external debt?

Frances Hudson, Standard Life: It does for now. My concern is that Japan is in a transitional phase. We’ve had decades of corporate deleveraging but there are signs that that is coming to an end. That is being compensated for by the government stepping in and boosting spending.

Alex was positive about the prospects for the current account surplus. But I think that is problematical, given that Japan now has to import a good deal more LNG and oil because of the changes in its energy strategy since last year’s earthquake and tsunami. Although Japan has recently decided to restart a couple of its reactors, nuclear power has gone from an average of about 25% of annual electricity generation to about 0.3%. That is a big fall, and we obviously won’t see all the capacity coming back on-stream given the risk considerations for certain reactors. So I don’t see the current account position being as strong going forward.

The fact that companies are now starting to invest again is positive on the equity side. But in the past these companies have been very strong buyers of Japanese government bonds and if that bid were to dry up, the government will have to increase its buying, be it through the rinban or the asset purchasing programme at the shorter end.

In terms of the demographics, Japan has done very well in compensating for the drag arising from the loss of labour input that Sumi-san mentioned, by increasing its productivity. But the prospects for keeping this going indefinitely are not good.

Also on the demographic side, normally with an aging population you would expect to see more inflation as people run down their savings and consume more. In Japan that hasn’t happened to date, because of the very strong propensity to save. That propensity may also be diminishing.

There are plenty of positives in Japan, but I have a slightly different view of how it will evolve to some of the others around the table, maybe because I’m a thematic strategist looking at the very long term.

EUROWEEK: You raised a couple of points that I’d like to ask Sumi-san about. First, what is the latest news on Japan’s energy policy and what impact will this have on the trade surplus or deficit over the long term? Second, is there a concern that Japan’s adverse demographics will lead to a sharp fall in savings?

Sumi, Ministry of Finance: After the earthquake we physically lost two nuclear power plants. The remaining plants were also shut down as a safety precaution. So by early this year we were producing all our electricity without any contribution from nuclear power.

We recently posted our first trade deficit for many years, which reflected the disruption in exports due to the tsunami and the floods in Thailand, which is an important assembly centre for the Japanese automobile industry and for its exports to the rest of the world. The increased fuel bill arising from increased coal and gas imports also contributed to the tiny negative balance in our trade account.

But helped by the strong income account inflow, which derives from our net foreign asset position which are by far the largest in the world, we were able to maintain our current account surplus. These foreign net assets equate to about 50% of GDP, so if we ran a persistent 2% current account deficit it would take about 50 years to deplete these assets.

Japan has sufficient savings to cover the entire debt of our nation, plus that of a few other countries. So if Japan were to lose its current account surplus, what would happen to these other countries’ debt?

I accept that the issue of Japan’s current account surplus may have been slightly exaggerated as a reason for the stability of the JGB market. But the small trade deficit I mentioned is inclusive of the entire fuel bill for the last year. It also covers the one-off disruption to exports. So we are naturally assuming that this deficit will turn back into a surplus in the coming years. It will also be supported by these income receipts of 2% of GDP which keep flowing in from our outstanding stock of foreign assets. This will mitigate any possible impact from shrinkage in the trade account.

So we are confident that our external position will remain strong. We’re not claiming that we can see what will happen in the future, but it is reasonable to predict that we will maintain a solid current account surplus over the coming years, even if it is not as strong as it used to be.

It’s also important to point out that Japanese trade is not overly concentrated on China. Our trade is divided almost equally between the US, China, non-China Asia and the rest of the world. There has been a ripple effect from the European situation, and Japan prospers when the rest of the world prospers. In that sense we can be described as a high beta country from a global trade perspective.

To answer your question about savings, Japan’s public sector has accumulated a lot of debt. But I have compared the development of Japan’s debt to GDP ratio over the last 30 years with the rise in private and public sector debt in the US, the UK and the Eurozone over recent years, and they are remarkably similar.

Since the Japanese bubble burst at the start of the 1990s we’ve seen an increase in public sector debt and a corresponding decline in private sector debt. By letting automatic stabilisers work, as well as implementing tax cuts and fiscal stimulus measures, we helped our private sector to deleverage.

My point is that we have accumulated debt not because we went on an extravagant spending spree. When the Japanese bubble burst, the international community asked the government to increase expenditure because we were running a current account surplus. The G7 communiqué repeatedly asked for the expansion of the Japanese fiscal stimulus and for tax cuts. It was the implementation of these polices that led to our debt.

However, even allowing for this dis-saving by the government, on a net-net basis we have still been running a domestic savings surplus for almost the entire period since the bubble burst. That has corresponded with our current account surplus on the external side of between 2% and 4% every year.

Some famous investors are reported to have said that they have turned Japanese, implying that this was negative. But I think that turning Japanese may not be such a bad thing. And I wonder how many countries are fortunate enough to be able to turn Japanese, because Japan is one of the few countries in the world that has consistently maintained a robust external position and exceptionally strong national savings.

Rose, Schroders: I agree. Japan still has an excess of domestic household and corporate savings, which are funnelled through banks. The result is that the loan to deposit ratio among Japanese banks is about 70%. So to assess how long Japan’s debt can be sustained, you have to take a view on how long those excess savings will stay in place. Most of the forecasts I’ve seen don’t assume that those excess savings will be unwound to the point that it would cause a bond market rout.

Scicluna, Daiwa Capital Markets: I’d like to pick up on a couple of points Sumi-san made, starting with the strength of the current account and the net investment income situation being so healthy. I would strongly endorse that view.

The point about the exceptional trade situation that we’ve had since the earthquake needs to be underscored. Yet net investment income has still been three times the size of the monthly average trade deficit. Looking ahead, the modelling that the Daiwa economists in Tokyo have been doing calculates that far from decreasing, by 2020 the annual current account surplus will have increased to about ¥20tr or more.

There is obviously a range of uncertainties surrounding that calculation. But the assumptions underpinning it on factors such as the exchange rate and the oil price are relatively conservative. It is only if we get a significant number of adverse external events that we would shift to a position where the current account surplus turns into a deficit. These would include events such as another massive oil price shock, or a significant hollowing-out of Japanese industry with its investments abroad so severely mismanaged that the return on those investments becomes negligible or even negative.

We don’t think events such as these are likely and we are confident that the current account position will remain relatively comfortable and a source of strength. The international net wealth position that Sumi-san mentioned is also positive for the economy and for the JGB market.

So too is the fact that Japan has its own currency which doesn’t just mean it can print money to fund the debt if necessary. It also means that the Japanese investors who hold all this wealth have an automatic preference for domestic securities because they want to avoid incurring foreign exchange risk. So we believe the JGB market will remain stable and well supported.

The credit ratings agencies’ actions which have recently placed Japan on a par with certain Eurozone member states that don’t even have their own currency makes an absolute mockery of the ratings methodology.

I would also echo the point Sumi-san made about countries turning Japanese. If countries such as the UK, the US and a number of Eurozone economies can do as well as Japan has done over the past 20 years they will have done very well indeed. Some of the similarities between these countries and Japan are compelling, but arguably many of the structural weaknesses they face are a lot more grave than those Japan has faced over the past two decades.

Again, we come back to the international beauty contest Alex alluded to. A few years ago everybody wondered why people would want to buy JGBs when yields were so low. Now all sovereigns of any substance have equally low yields and the relative attractiveness of JGBs in the current environment is very strong. So rather than scrabbling around for arguments about why to buy JGBs, it’s more appropriate to ask why investors should not buy them.

EUROWEEK: Foreign holdings of JGBs are rising, aren’t they?

Sumi, Ministry of Finance: Yes. Foreign investors now account for 6% of the market. Including short term securities the share is over 8%.

Although their total holdings are in the single digits, foreign institutions tend to trade the market more actively than the Japanese, who are generally buy and hold investors. So in the secondary market, foreigners’ share of the total trading volume is between 15% and 20%, while in the derivatives or futures market their participation is 35%-40%. So foreign investors do have a strong influence in determining pricing levels in the JGB market, although their share of secondary market trading is still recovering from the decline after the Lehman shock.

We wholeheartedly welcome this participation by foreign investors because it increases the integrity of the yield curve and enhances liquidity.

Rose, Schroders: It is easy to see why, with yields so low, the JGB market has not been attractive to foreign investors. Although foreign investors have been buying JGBs recently, the data I look at shows only a small increase in their total holdings between 2006 and 2011. But these things are all relative. The JGB market is seen as an attractive temporary refuge, which is what is bringing foreign money in to the market.

Historically, other markets looked far more attractive on a relative basis because their yields were far higher. But there has been a convergence in recent months, and although Japanese yields are still unbelievably low, they are no longer as unattractive on a relative value basis as they may have been in the past. It’s interesting that the CDS market is now saying that the default risk on Japanese bonds is lower than on German Bunds.

Taylor, Lombard Street: On the issue of ownership of JGBs, the banks are big holders. But looking the flow of funds data they have become net sellers over the last three quarters. In its Financial Stability Report the Bank of Japan started to express concern about the magnitude of banks’ holdings.

While I agree about the stability of the JGB market, one slight concern would be what the implications are if the banks started to offload significant amounts of JGBs. If at the same time life insurance companies and pension funds also start selling because of demographics, who will be taking up the slack and buying JGBs?

I agree with the argument that the current account will stay in surplus, meaning that net domestic savings will be sufficient to generate the buyers, but it may be that those buyers will require a higher yield.

Sumi, Ministry of Finance: Japanese megabanks tend to be more active in the market than regional banks. Since pricing has risen recently it may be that some of these banks will look to realise some capital gains through sales. That’s natural. But I don’t see much evidence of an exit from the market by the banks. They tend to be opportunistic in responding to price movements in the secondary market.

We’re grateful to the Japanese banks for holding such a large proportion of our debt. But at the same time, the number of decision-makers in the banking sector has become smaller, because of the M&A we’ve seen in the industry, and their business models tend to be quite similar. So I can understand why there may be some apprehension about the potential for herding among the banks. In 2003 we experienced the so-called VAR shock, where all investors moved in the same direction because they all used the same value-at-risk computer programmes. Those programme trades all generated sell orders at the same time.

The banks have learned the lesson of that shock and have all come up with their own versions. But this is one reason why we are so committed to developing our investor relations activities. We have employed a famous group of singers and the sumo champion to help market JGBs to retail investors. Households as well as foreign investors are the two frontiers we are exploring in order to encourage more diversification of ownership.

There is ¥1,400tr of Japanese household financial wealth, of which 60% is invested in bank deposits. Individuals deposit their money in banks, and because corporates are deleveraging, banks have relatively limited options for lending their money. So they have little choice but to buy JGBs.

Our strategy is to disintermediate this process by going direct to households and encouraging them to buy the retail version of JGBs, meaning that banks don’t have to pay deposit insurance.

EUROWEEK: Wasn’t there also a promotional campaign which said beautiful young women would be attracted to single men who invested in JGBs?

Sumi, Ministry of Finance: In this marketing business, no publicity is bad publicity. The idea of that marketing programme was that young men looking to marry nice girls should make the case that they are financially secure and in that respect buying JGBs has merits.

We welcome foreign and retail participation because the correlation between their behaviour and bank investors is small or negative.

Foreign investors can be more volatile but in a different way to the Japanese domestic accounts. By having investors who think and act in a different way, we create more of a two-way market.

Rea, Capital Economics: Coming back to Michael’s point, if the banks are the largest holders of JGBs they are probably the largest sellers to the Bank of Japan’s asset purchase programme as well.

They would then have greater resources to lend out, which in many respects would be a good thing.

Sumi, Ministry of Finance: We are quite grateful to the Bank of Japan for its asset purchase programme which increases liquidity. But we’re not dependent on the BoJ’s programme for our issuance. Nor do we want to be seen to be dependent on it. We try to remain completely independent from any discussion about the BoJ increasing its purchases of JGBs. How the BoJ sets about increasing the money supply is completely its decision.

Takahashi, Capula: Some people may not be completely familiar with the BoJ’s asset purchase programme. Under this programme the bank uses its balance sheet to buy various financial assets such as corporate bonds, REITs and ETFs – not just JGBs. Also it is important to emphasise that the programme includes both the outright buying operation and a repo operation.

The rinban programme absorbs all maturities up to 30 years as well as linkers, whereas the APP is focused on the one to three year maturities. The current monthly purchase amount is ¥2.1tr. On the expectation of further easing the APP has pushed down the three year yield to 0.10% and the five year yields to 0.20%.

In addition, the rinban target is the flow size of ¥21.6tr JGBs per year. On the other hand, the target of the APP programme, which originally started in October 2010, is now the asset size of ¥29tr JGBs on the bank’s balance sheet. There are maturing JGBs of ¥1.2tr in Q1 and Q2 2013 in the programme and that is why the bank will need to purchase more than ¥6.2tr for the term in order to achieve the final asset target of ¥29tr in the end of June 2013.

EUROWEEK: Chris mentioned the ratings and the fact that they make a mockery of the entire ratings methodology. To what extent do the ratings matter to Japan, given that so much of the debt is held by domestic investors?

Scicluna, Daiwa: Does it matter for the JGB market? No. These ratings decisions have tended to have a temporary impact on the currency, which has lasted for about half an hour before being reversed. But the ratings downgrades have had an impact on some investors for whom such ratings can dictate whether or not they are allowed to participate in the market.

EUROWEEK: Frances, does the rating matter to you?

Hudson, Standard Life:
My team is global multi-asset absolute return, so no, it does not matter. But for other parts of Standard Life which invest on behalf of pension funds and other institutions with benchmark restrictions it does make a difference.

Where I’ve seen the biggest impact hasn’t been on the government bond side but on the money markets, where even a warning of a possible downgrade can force people on triple-A mandates to act. That then becomes a self-fulfilling prophecy, because it forces yields up, which is ludicrous.

Scicluna, Daiwa Capital Markets: The most recent Fitch announcement was an absolute absurdity to the extent that when it was made it took Japan’s rating to just one notch above Spain, which was on the verge of losing market access and requiring a bail-out. This was absolutely ridiculous because it is impossible to see Japan being put in that position.

Rea, Capital Economics: Japan’s own credit ratings agency still rates Japan very highly. I’m not sure how much of an impact these ratings have on investors within Japan and whether they carry more weight than external agencies’ ratings.

Sumi, Ministry of Finance: Standard regulation under the Basel II regime is that if it is your own country’s sovereign security that is automatically risk-free, i.e. the risk weight is zero. For other countries’ sovereign debt which rate lower than double-A banks have to assign a 20% risk weight to government securities under the standardised method of risk weighting.

Through that process, ratings do have an impact on smaller investors and on banks which use the so-called standardised method of assessment which are usually smaller banks. Larger and more sophisticated investors have confidence in their own research capability and the ratings agencies are often not on a par with these investors. These larger investors don’t generally care about ratings, but for compliance reasons some of the more heavily regulated investors may have some limitations on what they can invest in.

But I don’t think ratings methodologies for the sovereigns have yet been established very well. Government securities are of course an instrument governments use to borrow, but at the same time they are also important assets for investors. And as Takahashi-san pointed out, Japanese investors have ¥253tr, or more than $3tr, worth of foreign assets. In other words, Japanese investors may opt to return to the domestic market. If that is the case, they will need more Japanese assets.

Japanese life insurance companies have been quite successful in selling private pension policies to customers in the private sector. They promise a certain absolute return to their clients after the policyholder’s retirement. In order to cover their liability for making good on that promise, these life insurance companies need very long dated fixed income securities.

The Japanese government is the only possible provider of such securities. So we are very comfortable with demand for 20 year bonds because life insurance companies reduce their risk when they buy 20 year JGBs by shortening the gap between their assets and liabilities.

Government securities don’t exist in a vacuum, but within a network of financial commitments and agreements, and each investor has to manage its own liabilities. They need to cater to their cashflow and other needs and identify the assets that suit them best. By coming up with the products that are most suitable for liability-driven investment clients, we think JGBs can be a way of helping life insurance companies to reduce their own risk. That’s a win-win situation for us and the investor.

I certainly agree with Chris that JGBs, and also US Treasuries, German Bunds and UK Gilts, each have a unique position in their markets. In order to hold risk-free US dollar-denominated securities you have to go to the Treasuries market. The same can be said of Gilts in the sterling market.

But in the case of the euro you don’t need to go to Italy or Spain or Greece to buy a risk-free euro-denominated security. No offence to their sovereignty, but purely from the perspective of investors, these countries’ government bonds aren’t exactly the same as the traditional sovereign bonds. They have similar features as municipal bonds.

When agencies are rating US treasuries, UK Gilts or JGBs, all of which are issued in their own independent currencies, their methodologies have vast room for improvement.

Hudson, Standard Life: If the Japanese government is successful in achieving inflation, would the Ministry of Finance look again at issuing inflation-linked bonds?

Sumi, Ministry of Finance: Yes, we are considering the reintroduction of linkers. We originally started issuing inflation-linked bonds back in 2004, but during the market’s infancy it was hit by the Lehman crisis when breakeven inflation went into negative territory. For the government, if breakeven inflation is negative it makes no sense to issue linkers, because it’s cheaper to borrow in fixed rate format.

So we stopped issuing linkers soon after the Lehman shock. However, now the breakeven inflation has wandered back into positive territory for the past few months, which is why we are considering their reintroduction.

It’s unlikely that any country with its own currency will go directly into default. It will print money first, and then inflation will follow. But inflation-linkers provide protection against that eventuality. Our decision to go back into the linker market is not a function of this worst-case scenario. But investors who have a very bearish or pessimistic view may find some value in the linker market.

Scicluna, Daiwa Capital Markets: Would you consider a floor?

Sumi, Ministry of Finance: When we first introduced linkers we didn’t have any deflation floor. This time we plan to offer anti-deflation protection at the time of redemption. Therefore the interest payment may fall, say, to 90% of the nominal, depending on the CPI movement. But the redemption is always 100% or more.

We talked earlier about how foreigners’ holdings in the JGB market are rising. Based on anecdotal or sampling evidence we believe Asian central banks have been some of the biggest buyers of JGBs.

Those countries that are consistently running current account surpluses have accumulated foreign exchange reserves predominantly invested in US dollars. But if you run a current account surplus the US government may pressurise you to allow your currency to appreciate. So for Asian surplus currencies, having those reserves in US dollars alone means they are exposed to the risk of US dollar depreciation versus their own currency.

This is why they started diversifying a few years ago into the euro. But at the moment they’re having some second thoughts about the euro, and the Japanese yen is emerging as a natural third currency to diversify into.

We welcome the interest that has been shown in the JGB market by some of these Asian central banks. They are very long term investors but they don’t like being exposed to inflation risk. So we are hopeful that inflation-linked bonds meet the demands of such investors.

Takahashi, Capula: On the subject of foreign holdings of JGBs, in March, non-residents sold a net ¥3.1tr, but in April on a net basis they bought ¥1.6tr, and in May, another ¥1.6tr. So while the decisive factor in the JGB market is the strong demand from domestic investors and the strong commitment by the BoJ, non-residents are also helping to support the market.

One important point about the inflation-linked market is that we haven’t seen the development of a linker repo market. So when the Ministry of Finance reintroduces linkers we need to think about a repo market which is such an important source of liquidity.

Rea, Capital Economics: Going back to what Chris was saying about Daiwa’s expectation that the current account surplus will increase between now and 2020, I have a question for Frances. As a long term strategist, do you have a similar view on the outlook for Japan’s current account?

Hudson, Standard Life: I think long-term trends are changing. Japan has this phenomenal wealth stored up, and traditionally the JGB market has been very well supported. But the counter to that is that Japanese investors and pension funds have less than 10% of their assets in equities. If deleveraging in the corporate sector is indeed coming to an end, then the likelihood is that Japanese institutions will start to invest in equities again and exporting more capital. So yes, I think we will see some of the imbalances shrinking over time.

Scicluna, Daiwa Capital Markets: Coming back to the global beauty contest question, Japanese equities will hold significant attractions as and when global sentiment improves once more.

It would be appropriate for Japanese companies to invest more abroad, reflecting the fact that the size of Japan’s economy will continue to decline relative to the size of the total Asian and global economy. So Japan should look to invest more overseas. It’s just a question of how well Japanese companies manage that investment. At the moment we don’t have excessive concerns about their ability to do so efficiently.

Sumi, Ministry of Finance: If I sounded over-confident or complacent earlier about the current account surplus that was not my intention. I have focused on what we have accumulated in the past. But Frances is absolutely right when she says we are in a transitional phase.

We don’t want Japan’s deflationary environment to last forever. Our challenge as we go back into an environment of modest inflation and rising nominal interest rates will be to manage the transition that will occur as a result. At the moment we are confident that JGBs are 100% solid, but looking ahead to an environment of modest growth and inflation we will have to adjust to the new reality. That can’t be done overnight. This is why we are putting so much energy into the tax and social security system reform.

02 Jul 2012