April 17, 2017    10 minute read

Two Decades Of Deflation: Impact On The Japanese Financial System

A Mighty Island    April 17, 2017    10 minute read

Two Decades Of Deflation: Impact On The Japanese Financial System

Having gone through two major recession during the past 50 years (the oil shock of 1973 and the market crash fueled by the burst of a real estate bubble in the 1990’s), Japan’s financial system showcased resilience in the recent financial crisis of 2007-2009, in spite of the contractionary effects of the global deleveraging that affected the demand for the country’s exports.

This is particularly impressive, given that exports account for 17.9% of Japan’s GDP, and that 90% of them consist of highly income-elastic goods (i.e. industrial supplies, capital goods, and consumer durables). Furthermore, Japan’s financial system has been extremely flexible throughout the years. This was evidenced by the proactive regulations adopted in the aftermath of the 1990s crisis, and, more recently, after UK’s EU referendum, which led the Bank of Japan (BOJ) to introduce quantitative and qualitative easing (QQE) in September 2016 in addition to its negative interest rates policy implemented to fight deflation and boost consumption.

However, in spite of active easing factors such as deflation prompted by tight monetary conditions, the BOJ’s failure to create a sustained increase in broad money combined with unfavourable demographics, and falling asset prices has remained a large challenge for the health of the Japanese financial system since the 1990s.

Given the BOJ’s regulations, characterised by the imposition of negative interest rates and a zero yield target for the ten-year government bond, aimed at increasing borrowing, stimulating economic activity, and pushing the price levels up, banks have played an important role in intermediating funds to facilitate monetary easing.

Going Down

In light of recent policies, it is important to highlight that even before negative rates came into effect in February 2016, the net profit of commercial banks has declined 16% in the final quarter of 2015.

The combination of negative rates and shrinking bank profits resulted in interest rate spreads further decreasing (by 8% for big banks and 15% for regional banks, according to S&P estimates), thus threatening the stability of the financial system, especially given that Japanese banks have been historically less profitable than their American and Asian counterparts.

On the other hand, negative rates have had some positive side effects on the banking system as they caused increased investment in Japanese government bonds, which drove up the bond prices. This price increase benefited the Japanese banks that held large amounts of government bonds and could convert the increases in bond prices to profits to offset the effects of negative rates.

Further Problems

It is important to note that excessive competition among banks paired with the declining population could further erode the banks’ profit basis, weaken their financial intermediation function, and incentivize banks to take excessive risks to make up for the lost profits, thus introducing systemic risk in the financial system.

Therefore, from a macroprudential perspective, the Japanese financial system needs to strengthen its ability to respond to risks in areas where higher risks are taken, such as in overseas business and market investments, by ensuring the existence of a strong financial base and the establishment of a cohesive action plan to follow in case of an economic shock.

Main Challenges

Currently, Japan must fight a battle against inflationary expectations: more than two decades of deflation have galvanised deflationary expectations and prevented inflation. Many economists thereby suggest that Japan take radical steps towards driving inflation in order to change deep-rooted expectations.

Furthermore, Japan’s economy has been marked by the declining population growth and price levels for the last two decades. In order to contain the rising debt levels, the Japanese government’s primary focus is on increasing spending.

In January 2016 the BOJ decided to set negative interest rates in order to boost consumption. This move weakened the yen and favoured the exporters.

Other Factors

However, the Japanese interest rates are exposed to international shocks. After Donald Trump got elected, a sell-off ensued in the international bond markets as investors expected policy changes that would increase the price level. As a result, interest rates went up in the bond markets. The Japanese bonds followed suit, and the interest rate became positive again by November.

Besides the expectation and demographics problem, there are several risks associated with the Japanese financial system that may come from outside the finance sector but do heavily impact the system. The first factor is related to the confidence of the international investors’ community. The IMF has cast doubts over the ability of the Japanese economy to sustain its fiscal policy in the long-run and keep its revenue in line with its spending. In April, Fitch downgraded the sovereign debt rating of Japanese bonds from AA- to A+ (same at Malta).

The rating agency noted that it had concerns about the rising public sector debts. It also pointed out that recent gains in corporate profits might be due to devalued yen and may not be sustainable in the long run.

Second, the Japanese government still runs a fiscal deficit of about 5.2% of its GDP. Given the debt-to-GDP ratio of 220%, the Japanese government should be running surpluses to pay off its crippling debt.

The Main Figures

This deficit is expected to remain at this level until 2017, according to the Euler Hermes country report, and this raises serious questions about the strategy being adopted by the Japanese government to eliminate its debt burden.

Another risk factor worth considering is that Japan is heavily exposed to natural disasters as the country gets about 1500 earthquakes every year.

An earthquake in 2011 took a toll of ¥25trn on the infrastructure. Such events put additional constraints on government spending. Finally, the Japanese economy is highly sensitive to interest rate fluctuations.

As of 2015, it had ¥1057trn in debt and ¥56trn of tax revenue. This means that even 1% increase in the tax rate can soak up about a fifth of the annual revenue and increase the fiscal deficit to GDP ratio by 2.2 percentage points, which poses an immense interest rate risk to the Japanese government if it is to keep servicing its debt and avoid a default.

Solutions

  • Basel Implementation

In order to ensure the stability of the financial system, the BOJ and the Japanese government opted for implementing more stringent regulations. Thus, Japan has become the foremost country to adopt the post-2009 recession global standards laid out by Basel 2.5 and 3.

  • Stress testing

In addition to increasing capital requirements, the Financial Services Administration (FSA) implemented more stringent stress tests which the BOJ continues to conduct and report semi-annually on at a macro level. Additionally, all deposit-taking institutions must conduct their own stress testing and report these results to the FSA for review.

If banks cannot withstand the prescribed stress scenarios, the FSA mandates capital increases and improvements in risk management. The current scenarios for semi-annual macro stress testing are as follows:

  • A tail event scenario whereby economic and financial developments at home and abroad deteriorate to a level comparable to that seen during the Lehman shock;
  • A tailored event involving widening of foreign currency funding premiums by 50bps, a 200bps widening in term premiums for US interest rates, and constrained availability of foreign currency funding.

The BOJ’s October 2016 report on the financial system found that financial institutions could withstand a tail event comparable to the Lehman shock and would, in aggregate, maintain capital adequacy ratios above current required levels.

Additionally, the BOJ found that the system had a sufficient liquidity buffer and withstood the prescribed tailored event, even in the case where Japanese institutions cannot avoid disposing of foreign currency-denominated assets.

  • Over the Counter Derivatives

Japan has also followed other G20 countries in coming down on OTC derivatives which were a contributing factor in the recent crisis. Primarily, the response of regulation has been to shine light on and unwind these opaque and highly connected securities. Japanese authorities addressed these concerns through various amendments to the Financial Instruments and Exchange Act. These mandate that certain OTC derivatives be cleared through a central clearing party, require data reporting to the FSA either directly or through trade repositories, and the use of electronic trading platforms.

In practice, however, the efficacy of these clearing requirements should be called into question due to the numerous and vague exemptions which allow many institutions to avoid these requirements altogether.

Reporting requirements, on the other hand, apply to a vast variety of OTC derivative transactions with limited exemptions and have been published in aggregated reports since May 2014. Here, the main concern is that foreign blocking statutes may hinder reporting in international transactions.

  • Financial Policies Monitor

In September 2015 the FSA established the Financial Policies Monitor (FPM) with the stated purpose of receiving “candid opinions and suggestions concerning financial policies and to reflect these in the FSA’s financial policies” due in large part to concerns that institutions will not give honest feedback when face-to-face with an FSA official.

Not only does this have the potential to improve regulatory efficiency, but it reflects an open and proactive approach to financial regulation which is reflected in Japan’s regulatory success.

Ahead of the Times

Given Japan’s extended struggle with inflation, the country’s regulatory environment is and has been, in many respect ahead of the times. For this reason, its financial system remained healthy through the crisis relative to the systems in the US and Europe.

Not only has Japan promptly incorporated the new global standards that took form following the 2007-2009 crisis, but it also brings regulatory discipline borne through the painful crisis of the 90s. Nonetheless, Japan must be wary of the limitations of its own regulatory tools (i.e. stress tests, capital requirements, etc.) as well as the existence of exemptions which may allow for regulatory arbitrage.

Conclusion

Overall, in spite of deflation, the Japanese financial institutions have been exhibiting high capital adequacy ratios relative to the risks undertaken. The systemically important institutions (such as the Mizuho Financial Group, the bank of Tokyo-Mitsubishi and financial services company Sumimoto Mitsui Banking Corporation) have all shown signs of strength manifested through passing the regulatory stress-testing procedures and exhibiting sufficient funding and currency liquidity.

Another sign of the Japanese financial system’s strength is the fact that the volume of interbank loans has been slowly recovering from the sharp decline after the introduction of negative interest rates. This resulted from the BOJ’s open market operations of buying large amounts of government bonds to extend excess liquidity to banks.

Although it might seem irrational for banks to lend to each other in an environment where money today is worth more than money tomorrow, lenders with large amounts of surplus reserves are charged -0.1% rates by the BOJ, which pushes banks to lend their surplus out at a smaller negative interest rate in the repo market.

The BOJ thus keeps up a functioning money market, which is key to ensuring that lenders have ready access to liquidity. The operational money market provides hope of a broader-based revival of Japan’s financial systems should rates normalise in the future.

This view is supported by Tomo Kinoshita, a chief market economist at Nomura Securities in Tokyo, who believes that transaction volumes in the money market will revive after the BOJ exits from the current expansionary policy. However, Kinoshita is realistic, as he is not expecting to see that outcome for several more years, given the slim chances that the central bank will be able to reach its 2% inflation target.

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