top of page

Japan’s Christmas bombshell risks setting off another European credit crunch - Telegraph - 22.12.22

The Bank of Japan has gone from a bad but stable equilibrium to an unstable equilibrium says Ambrose Evans-Pritchard.


Japan is the world’s top creditor with $3.6 trillion (£3 trillion) of net assets overseas. It is the marginal buyer of British, eurozone, and American debt, and a central pillar of the international bond market.


In good times, the constant flow of investment via the yen "carry trade" is like a global ATM machine for needy debtors. When the flows reverse and the Japanese repatriate their money – as they did in late 2007 and 2008 – it can lead very quickly to a systemic credit crunch and a financial chain-reaction.


“Ultra-easy monetary policy in Japan has been holding down yields in the rest of the world, but the tectonic plates are now moving,” said Mark Dowding from BlueBay Asset Management.


Western bonds markets suffered instant contagion this week after the Bank of Japan (BoJ) lifted its cap on 10-year yields from 25 to 50 basis points, setting off convulsions in the country’s domestic bond market. This may be the first taste of what may become a wholesale Japanese retreat from the world markets.


The Japanese stopped buying western bonds months ago. NatWest Markets estimates that they sold €33bn of debt from the eurozone’s big four since April, and have sold $136bn of US debt since late last year. Liz Truss chose a bad moment to test market appetite for fiscal hooliganism.


The Japanese still own fat chunks of 9pc of the West’s sovereign debt markets: notably France at 9pc ($237bn), the UK 7pc ($138bn), the US 6pc ($1,320bn), and Germany 5pc ($98bn), among others.


NatWest's Giles Gale and Joann Spadigan say Japan’s fixed-income investors can now eke out a better return at home than they can from buying gilts, US Treasuries, Bunds, or French and Australian bonds, when adjusted for currency hedge costs. The logic of the carry trade is that it will now go into reverse.

“With clearly better yields at home Japanese may start to sell foreign holdings more aggressively,” they said. Furthermore, Europeans and Americans may switch to buying Japanese debt.


The financial world was caught off guard by the Bank of Japan’s bombshell. It should not have been. Japanese inflation reached a 40-year high of 3.6pc in October. The BoJ’s policy of yield curve control has pushed its bond portfolio to untenable levels near 120pc of GDP. The bank had been under pressure from the Kishida government to stabilise the yen and to restore normality to the bond market (be careful what you wish for).


“We could see it coming, but it was a nice Christmas present,” said Mr Dowding. BlueBay had large short positions on Japanese bonds.


“They couldn’t announce it in advance because that would have been an invitation to speculators. It is a bit like running a fixed exchange regime,” he said.


Markets are already testing the new 0.5pc cap, with swap contracts now pricing in 0.8pc. The Bank of Japan has gone from a bad but stable equilibrium to an unstable equilibrium. “The genie is out of the bottle,” said Mr Dowding.


It was not a pure policy “pivot”. Governor Haruhiko Kuroda said the move was intended chiefly to repair a broken bond market and should not be misread as tightening. Markets have drawn their own conclusion.


“Every big central bank is now withdrawing liquidity at the same time. It is going to make it much more difficult for Europe as it faces really big refinancing demands next year,” said Marc Ostwald, a bond veteran at ADM.


“Germany is borrowing almost half a trillion euros next year and this is going to crowd out the lending market. I am worried about a wave of corporate defaults,” he said.

Britain is on fiscal probation and squarely in the firing line. Yields on 10-year gilts jumped 13 basis points in the two trading days after the Japanese shock.


The events of the last week vindicate the Sunak-Hunt strategy of fiscal retrenchment. Procyclical austerity into the teeth of recession is not to my macroeconomic taste, but there are moments when it is too dangerous to defy creditors.


Europe too is in the firing line, with the added complication of a dysfunctional monetary union. NatWest Markets says the eurozone must finance over €1.3 trillion of sovereign debt in 2023 as energy bail-outs drag on and Germany’s deficit balloons to 4.5pc of GDP. That is €340bn more than last year.


The AAA stalwarts such as Germany or The Netherlands will have no trouble borrowing – yields may fall as recession bites harder – but it is a different story for Club Med debtors. The surge in bond issuance hits just as the ECB launches quantitative tightening and adds another €15bn a month to bond supply.


Worse yet, the ECB has turned ferociously hawkish, signalling a “terminal” interest rate of 3.5pc. This implies a rise in Italian bond yields to circa 6pc, which is courting fate for a country with a public debt ratio near 150pc of GDP.


A southern European bond crisis is the dog that has not barked in this tightening cycle. Markets may have been lulled into a false sense of security, firstly because the ECB has skewed its bond redemptions away from Bunds and into Italian bonds (now played out), and secondly because the ECB has conjured a backstop of sorts with its “anti-spread” tool (TPI).


The TPI is a mirage. It cannot be used unless the eurozone is under extreme stress, otherwise it would be a fiscal rescue in violation of the Maastricht Treaty. The legal details have to be resolved, and the tool appears incompatible with past rulings by the German constitutional court.


Christine Lagarde, the ECB’s president, implicitly admitted this last week that there is a problem when she urged Italy to ratify the EU’s normal rescue fund (ESM), an entirely different animal. Not a single euro of this fund can be lent without the assent of the German Bundestag and under strict conditions. It amounts to a “Greek” fiscal occupation by EU commissars and that is why it has been rejected furiously by the Italian political Right.


Citigroup said France too could suffer from this week’s fall-out, given the scale of Japanese debt holdings and the country’s chronic fiscal deficit.


The Japanese gorged on a quarter trillion euros of French public debt before the pandemic because it offered core eurozone status with 25 basis points of extra yield over Bunds. It was a reasonable calculus. France has always been the beating heart of the Europe project.


However, the risk spread has since widened to 52 points. French political control over the ECB policy-making machinery is slipping away. In October, President Emmanuel Macron rebuked unnamed monetary hawks on the governing council for responding to an imported inflation shock by throttling internal demand. The ECB ignored him.

France’s total public and private debt has risen by 70 percentage points to 351pc of GDP over the last decade (BIS data), compared to 276pc for Italy, and 271pc for the UK.


S&P Global put the country on negative watch this month, warning of “rising risks to France’s public finances” and lack of structural reform. It said the debt ratio will still be 111pc of GDP in 2025.


For whatever reason, the Japanese have been running down their French bond portfolio at a rapid clip. The pace of liquidation is now likely to accelerate.


France has great strategic depth and will muddle through whatever happens but the real cost of fiscal insouciance is rising fast.


The UK has already learned the hard way that there is no margin for political and economic error when the global credit spigot dries up. The eurozone will have its lesson in 2023.



Business Briefing newsletter

Our daily digest packed with news and analysis


For this article in pdf, please click here:

Japan’s Christmas bombshell risks setting off another European credit crunch – by Ambrose
.
Download • 145KB

The Bank of Japan has been under pressure from the Kishida government to stabilise the yen Credit: Anadolu Agency

42 views0 comments

Comments


bottom of page