A world apart
Japan has been in the spotlight after the tragic March 11 earthquake. The sovereign’s debt profile has been deteriorating for years and the ever-growing public debt presents a different kind of crisis. But is the country’s debt pile unsustainable? Atanas Dinov reports.
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The financial markets of Japan (Aa2/AA–/AA) remain strangely undisturbed by the country’s ongoing deflation and the Great Tohoku Earthquake. There is a stark contrast between the relatively positive short-term and pessimistic long-term views on the sovereign’s credit. But all agree there will be no near-term crisis stemming from the sovereign’s debt. The yen capital markets will remain active.
Perhaps what highlights this most clearly is the recent sovereign outlook cut to negative by S&P. Japan, a country with a terrifying demographic outlook, had already been sitting on a pile of public debt worth around 200% of GDP even before the devastating triple disaster, according to OECD.
The earthquake on March 11 heaped more pressure on the sovereign and S&P was not out on a limb in lowering the outlook on Japan’s AA– long-term rating to negative on April 27. The earthquake, it estimates, will increase the fiscal deficits above prior forecasts by a cumulative 3.7% through 2013. It believes this will likely result in a net general government debt of 145% by 2013, compared to a previous estimate of 137%.
While the Tohoku region accounts for roughly 8% of Japan’s overall economic output, the government estimates damages from the earthquake will come in at a somewhat conservative ¥15trn (US$182.8bn) to ¥20trn – larger than the circa ¥10trn 1995 Kobe earthquake. S&P has a more pessimistic cost-estimate, ranging from ¥20trn to ¥50trn.
The clean-up associated with Fukushima Dai-Ichi nuclear power plant and the eventual government backing for the operator Tokyo Electric Power – the largest Japanese primary bond issuer – will further undermine the sovereign’s credit. The market expects a government-led bailout to be formally announced, to protect senior bond holders. And Japan faces the prospect of economic disruptions from power shortages, especially during the hot, humid summer.
But not everyone agrees Japan’s debt is out of control. Talk about the central bank underwriting government bonds for the sake of reconstruction financing has been mostly dismissed, with increasing attention being focused on expenditure reductions and tax hikes. In this context, Hideki Nagai, Barclays Capital’s head of JGBs and rates trading, argues that even after considering the entire public liability, the sovereign’s debt is sustainable.
“The situation at which Japan is right now is manageable. For example, while a tax increase is being considered to finance the cost of rebuilding the Tohoku region, that doesn’t help the economy given the state Japan is in,” said Nagai. “It may turn out to be better issuing bonds. But even at an increased JGB issuance, which I don’t think will be especially high because of the earthquake, I still don’t see inflation problems looming for Japan.”
This means JGB yields are likely to trend lower in the short-term. The benchmark 10-year yield was hovering around 1.25% in April, reflecting domestic investors’ relative calmness.
The 10-year interest rate could go to 1.55% by the end of the calendar year but should be around 1.65% by the middle of 2012, said Akito Fukunaga, chief rates strategist at RBS.
The government’s 2011 budget assumes the 10-year yield could go up to around 2%. S&P estimates the deficit will grow at 3.5% more than GDP for the period. If those figures are correct, additional JGB issuance of up to 5% should be relatively easily absorbed, said UBS.
“If a rise up to 2% can be tolerated, then… JGBs up to 5% of GDP (¥20trn–¥25trn) can hypothetically be newly issued,” the bank wrote in a report. “[An] increase in demand for funds of 3.5% of GDP would only push the long-term yield up by 40bp, but we do not think that the rise in the long-term yield to 1.6%–1.7% would lead to a major fiscal crisis.”
Meanwhile the sovereign CDS, mostly pushed by foreign players, moved out 2bp on the day of the outlook cut. But at 79bp, it only returned to where it was before March 11.
“I don’t think anyone cares about fundamentals at the moment, the bond market is driven by technicals right now because there is more-than-ever liquidity in the system. Part of it is the BoJ’s money but even more important is that there is real money out there buying stuff,” said one Tokyo-based trader. “For all the fundamentals looking bad, the technicals are killing it.”
Massive internal liquidity
Apart from the looming fiscal year-end in March, the BoJ’s primary concern in the immediate aftermath of the earthquake was maintaining stability. On March 14 it gave the economy a massive ¥15trn liquidity injection, pushing JGB prices higher. The cash-flush Japanese banks, which enjoy a strong deposit base, accepted only ¥9trn, meaning the BoJ’s increased the total amount of its asset purchase program by ¥5trn to ¥40trn.
Having finalised a ¥92.41trn 2011 budget, the Japanese government added an emergency, supplementary one of ¥4trn. JGB issuance will not increase for nowbuta secondsupplementary budget,expected to be around ¥10trn, is expected to be voted on around July.
However, Japan has some significant advantages. It remains the largest external global creditor nation and enjoys strong support from its domestic public institutions. The market has also received a boost from a massive ¥6.3trn JGB net redemption in early March.
The earthquake shut down the primary credit market about 10 trading days earlier than the usual year-end close. Corporate spreads took the biggest hit. Investors were uncertain about the future of Tokyo Electric Power Company’s credit – a significant concern for a company that represents roughly 8.5% of all outstanding domestic corporate debt. Local accounts therefore realigned their investment strategies in March and early April in favour of the quasi-sovereign municipalities and the Zaito agencies, according to one Japanese fund manager.
The highest grade muni issuer, Tokyo Metropolitan Government, set a new benchmark at the end of March, raising ¥40bn 1.38%10-year money through a Dutch auction. Paying a 10bp higher spread compared to its February outing, Tokyo printed at a price of just 15bp over JGBs.
The primary market reopened for the new financial year in the second week of April. Eying the flight to the quality of the already 5bp tighter munis,policy-based Development Bank of Japan and Japan Finance Corp soon followed. Tasked withchannelingfunds for the rebuilding, quasi-sovereign agencies will be at the forefront of such financing.
DBJ, which is now likely to shelve its own privatisation plan, hit the market with a ¥60bn trade and received a strong backing from the domestic investors. The deal came out equally split into a ¥30bn 0.46% three-year tranche and a ¥30bn 0.711% five-year piece. Both priced at the tight end of the JGBs plus 13bp–17bp guidance ranges.
The funding cost also went up for the quasi-sovereign sector. Compared with DBJ’s last deal in October, the new tranches came out 3bp and 4bp wider respectively for the same tenors. Still, in the recovering market sentiment, secondary levels have been tightening. Outstanding DBJ paper was somewhat tighter than the reoffer, at plus 11bp–12bp at the time.
Two weeks later, JFC came out with a jumbo ¥125bn deal: a ¥60bn 0.31% two-year tranche priced at JGBs plus 11bp; a ¥50bn 0.591% five-year at plus 10bp; and a ¥15bn 2.157% 20-year at plus 14bp.
Meanwhile, JFC, Japan Expressway Holding and Debt Repayment Agency have had their government-guaranteed issuance increased together by ¥680bn as part of the supplementary budget.
The government will cut ¥50.1bn of Official Development Assistance loans as part of its first supplementary budget. But this reduction does not signal an abandonment of its foreign interests in favour of an internal focus. The yen market remains open to foreign SSA and corporate borrowers. This will further develop the primary market, both cross-border and domestic.
Japan International Cooperation Agency, a provider of official development assistance to emerging market nations, has announced plans to issue the inaugural retail-targeted Zaito bondsin the latter part of 2011.
Meanwhile, Japan Bank for International Cooperation will also resume its guarantee mechanism for EM sovereign fundraising through Samurai issuance, in line with its mandate to provide trade and development financing to enhance Japanese strategic and diplomatic interests.
Uruguay will show that issuance of JBIC-guaranteed Samurais remains an alternative fundraising route for developing countries. Demand among domestic investors is piping-hot, with a delegation from Uruguay set to conduct its Japan roadshow during the week of May 16.
“The emphasis placed by JBIC has shifted on these deals from the guarantee being more of a support mechanism to now becoming an opener to help issuers, who are more likely to return in the future on stand-alone basis, access the Japanese market, as was the case with Mexico and Turkey,” said one DCM banker.