Bank of Japan underpins foreign inflows

As the eurozone's great experiment with negative interest rates continues apace, the dynamic of global capital flows has changed dramatically, responding to big shifts in the relationships between the world's main currencies.

While the US dollar is in much the same place relative to the yen as it was at the start of the year, the euro has depreciated by more than a tenth against the Japanese currency. This has confounded an army of forecasters who expected more yen weakness in light of the failure of Abenomics to stoke up Japanese inflation. They also worried that Japan would be exporting deflation via a weaker currency to a eurozone that was struggling with deficient demand.

Mercifully we have all been spared a turn of events that would have been a recipe for much fiercer currency wars than we have experienced so far. The reason is that the attractions of the yen as a funding currency for carry trades has been completely undermined by the European Central Bank's move to quantitative easing as well as by all the other pressures that have contributed to negative eurozone bond yields.

The ECB and the Bank of Japan have between them pulled off the remarkable trick of making the bond market of a country where public sector debt reached 226 per cent of gross domestic product last year, look a sound bet to risk averse international investors.

Japanese government bonds saw strong inflows in the first quarter, following a notable flow of capital in the second half of 2014. That has been a perfectly justifiable response to the narrowing of interest rate differentials and lower than expected inflation. But for the foreign investors piling into JGBs the additional spice comes from the fact that the Bank of Japan's bond buying programme conveniently underpins the investment.

At the turn of the year the BoJ believed that foreigners held 9.3 per cent of the total stock of Japanese Treasury bills and JGBs. This is quite a development in a market where the Japanese have traditionally lent to fellow Japanese. In effect the JGB market, hitherto notoriously characterised by home bias, is succumbing to globalisation.

In one sense that is helpful. If an elderly population is saving less in the face of rising bills for demographically inspired social spending it can make sense for foreigners to plug the gap. On the other hand global capital is frisky and fickle, as so many Asian countries discovered to their cost in the financial crisis of 1997-98.

Of course, Japan has a huge stock of external assets and far less external borrowings than the US or the eurozone. That provides a cushion against financial instability. And the low interest rate environment takes the sting out of debt servicing.

The Organisation for Economic Co-operation and Development estimates that the effective interest rate on government debt was the lowest in the OECD at 0.9 per cent in 2014, limiting net interest payments to 1 per cent of GDP, well below the OECD average of 1.6 per cent.

Yet as the OECD's latest country report on Japan points out, the financing of large government deficits at low rates by Japanese savers will not continue indefinitely, leaving Japan vulnerable to rising interest rates.

It adds that a normalisation in the government's effective borrowing rate from the current 0.9 per cent to 3 per cent would, for example, expand the budget deficit from 8.5 per cent of GDP in 2013 to around 13 per cent. That would be a panic-worthy fiscal nightmare in a country where government revenues have been weakened by anaemic growth and public spending on the elderly has proved exceptionally hard to control.

And a fiscal crisis would be compounded by financial instability because of the vulnerability of Japanese banks whose balance sheets are weighed down with JGBs. In December their holdings amounted to 29 per cent of the total stock. In short, it would take very little in the way of market adjustment to put the banks' solvency in question.

It is conceivable, then, that capital inflows could in due course prove to be a Trojan Horse - that wicked European invention - which might then become the trigger for the Japanese bond market spike that everyone rightly fears. The globalisation of capital flows entails volatility and contagion, as well as accommodation. These wayward behaviours are not easily controlled.

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