Saturday, June 01, 2013

China Has a Medium-Sized Financial Anvil It May Want to Share With Japan

“Abenomics” pumps liquidity into the Japanese financial markets through government bond purchases by the Bank of Japan.  The liquidity creates asset inflation, mainly in the stock market at least for now.  

Theory is, the owners of these bubblicious assets feel rich (or, according to the politically less offensive explanation, feel the raw terror that sustained, government-mandated inflation will erode the value of their savings), buy things, trickle down trickle down trickle down.  

Right now it’s too early to see signs that this process is succeeding.  Instead of buying things, canny investors are taking profits off the bubble (“correction”) and then putting their money back in the market on the calculation that the Japanese government isn’t going to stop the liquidity injections just yet.

The other, voodooish side of Abenomics is the theory is that the  increased demand for government bonds thanks to the Bank of Japan intervention will trigger lower interest rates (in bond-speak, lower yields; since the interest payment is fixed, strengthening or weakening demand is reflected in the price of the bond.  Lower yields means higher bond prices).  

The lower yields promised by Abenomics mean Refi! to reduce the carrying cost of Japan’s truly awesome national debt and cheaper money to provide some conventional Keynsian stimulus to the economy through some infrastructure giveaways.  

Instead, bond prices are falling and yields are increasing—an indication that the bond market is fixating on the inflationary implications of Abenomics and the need to boost yields to keep pace, which is indeed a very traditional view of how bonds are supposed to behave in an inflationary environment, especially one in which the stock market has jumped 79%  year to date—and the opposite of the Bank of Japan’s optimistic prediction.

Higher yields—the more obvious consequence of inflation and a major challenge to Abenomics' liquidity strategy—raises the very, very bad specter of more expensive debt service for a country that can ill afford to add fractions of a percentage point to its cost of borrowing--and the prospect of reduced capital and lending power for the Japanese banks that hold massive amounts of Japanese government debt on their balance sheets.

Here’s what the Economist had to say about Japan’s vulnerability to a yield spike (which would translate into a reduction in value of the bonds held by Japanese banks):

The worst scenario is that bond-market volatility could focus attention on Japan’s public debt, which stands at nearly 250% of GDP. Owning so many government bonds, banks are heavily exposed to any rise in yields: an increase of only one percentage point would mean a loss of ¥10 trillion for Japan’s banks overall, according to J.P. Morgan.

The  Abe government is in determined spin mode to assure the markets that the recent gyrations in asset prices are nothing to get worked up about, while also declaring that the bond market’s queasiness is Good News—a sign that the inflationary-expectations gambit is working.

So far, the financial press, while exhibiting caution,  is not very interested in naysaying Abenomics, which is enriching its well-heeled readers through the upwardly spiraling (well, at least until recently) Nikkei.

Today’s interesting development is that China—which is locked in a zero-sum confrontation with Shinzo Abe-- has taken an overt interest in Japan’s government bond market.

The Global Times article excerpted below lets us know that the PRC holds about $200 billion in Japanese government debt (equivalent to two months plus of Bank of Japan Abenomics-related bond purchases) and is “Japan’s largest creditor”.

I leave it to Interested Reader to speculate as to whether this lengthy discussion of a rather boring subject of China’s Japan debt holdings is meant to convey:

1)      That the Chinese government has decided to maintain a sizable position in Japanese government bonds out of sheer stupidity, even though the value of the Japanese yen is plummeting and the US and EU have already bailed on the Jbond because successful Abenomics will, on top of yen depreciation, put a lid on yields and threaten to wipe out any financial benefit a foreign holder could gain from holding Japanese government debt…

2)      The Chinese government is betting that Abenomics will fail and China will reap a nice return as yields spike or…

3)      That the PRC has in its possession a  $200 billion anvil that it can toss to the Japanese financial markets if it decides it would like to see is Abe grappling with a Chinese selloff on top of the yield-spiking factors already roiling Japanese bond prices...

I’m inclined towards 3.  I have a feeling that China has decided that, in the face of US military superiority, Abe’s success in building strategic ties with India as well as China’s other, smaller regional antagonists, and advances in the anti-China Trans Pacific Partnership alliance of Pacific democracies (plus Vietnam and Myanmar) a key weapon for the PRC as it confronts the pivot is that China is a creditor nation—and the US and Japan are debt superpowers.

By Zhao Qian (Global Times)
13:47, May 29, 2013
China maintained its position as Japan's largest creditor by increasing its holdings of Japanese treasury bonds to 20 trillion yen ($196 billion) at the end of 2012, up 14 percent from the previous year, according to data released Tuesday by the Bank of Japan (BOJ).

By contrast, the US reduced its holdings of Japanese treasury bonds last year by 15 percent to 8.6 trillion yen, while the UK, the largest European creditor of Japan, reduced its holdings by 23 percent to 8.87 trillion yen, according to the BOJ data.

"As the total amount of China's foreign reserves has increased quickly, it was reasonable that China increased its holdings (of Japan's treasury bonds) last year amid concerns about the EU debt crisis and the weakening US economy," Zhao Xijun, deputy director of the Finance and Securities Research Institute at Renmin University of China, told the Global Times Tuesday.

"As the largest holder of US treasury bonds, China also needs to diversify its portfolio to balance its foreign exchange reserves investments," Zhao noted.

China's foreign reserves hit $3.31 trillion by the end of 2012, up 4 percent compared with the previous year, according to the People's Bank of China. And the number had risen to $3.44 trillion by the end of the first quarter this year.

Compared with other foreign investment products, "Japanese treasury bonds have always had a relatively stable yield as most of the holders are domestic investors, and the government is unlikely to allow big potential risks," Zhao noted.

The benchmark 10-year yield for Japanese treasury bonds rose to 0.905 percent Tuesday, up 7 basis points from the previous day.

China started to raise its reserves of Japanese treasury bonds substantially in 2011, when its holdings hit a record high of 18 trillion Japanese yen, up 71 percent from the previous year.

Liu Dongliang, a senior analyst at China Merchants Bank, told the Global Times Tuesday that Japanese treasury bonds are still a good investment target due to the lower risk involved, although the recent depreciation of the yen may cause losses for its foreign holders.

Japanese Prime Minister Shinzo Abe has released a series of quantitative easing policies since he took office last December, and has promised to promote further yen depreciation to stimulate the world's third largest economy.

Zhao said the fall in the yen has not only hurt China's interests but also those of other countries like the US, which is unlikely to allow the yen to depreciate continuously in the long term.


Depreciation in the yen has greatly affected China's exports to Japan, even if the country's quantitative easing measures have been effective in aiding the recovery of its domestic economy, Ministry of Commerce spokesman Shen Danyang said on May 16.


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