The Dangers of a Bear Market in Japanese Bonds

Japanese banks and life insurers will be hit hard if the bond market selloff proves to be a sustained affair.
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The crash in Japanese bond prices has been spectacular. The latest slump was precipitated by the Ministry of Finance's announcement on Dec. 22 that its

Trust Fund Bureau

will stop outright purchases of government bonds from January. This matters, since the bureau has been in the habit of buying about 2.5 trillion yen worth of government bonds a year. It will not be buying because its money will be lent to private-sector companies to ease the credit crunch. Meanwhile, fiscal stimulus means the Japanese government plans to sell a record 71 trillion yen in bonds for next fiscal year beginning in April.

The bond market's reaction to this news makes a nonsense of doctrinaire monetarist views that bond markets cannot be affected by supply concerns. The bond market sell-off also has deeply negative medium-term implications for the yen. This is despite the foreign exchange market's initial reaction which has been to push the yen higher because yields on Japanese government bonds are higher. Profits on bond trading have been a major source of Japanese banks' earnings in recent years. With an estimated 2 trillion to 3 trillion yen sitting in yen government bonds in each major bank, Japanese banks will be hit hard if the bear market in bonds proves to be a sustained affair. The same goes for the life insurers, which have about 13% of their total portfolio in yen bonds. The end of the last bull market in a yen-based asset class should in due course accelerate capital flight, the pace of which has slowed in recent months.

Greed & Fear

retains the view that the yen will decline to the 160 yen/$1 level by the end of next year. The catalyst for this event will be nationalization of most of the major Japanese banks at some point in 1999. But for now, expect the yen to remain in its established trading range.

China's Hard Line

Jiang Zemin's

recent speech marking the 20th anniversary of reform was uncompromising in its emphasis that economic reform will not be followed by political reform, a point of view given further emphasis by recent court proceedings in China. The hard Marxist line of the Chinese leadership is worth noting, following a year in which Asia has seen some dramatic political change, most notably the end of


32-year rule in Indonesia.

A year ago the view of the pundit community employed by financial intermediaries was that economic fallout would be followed by political fallout as a consequence of the steep recession engulfing Asia. That view has in large part been proven correct, though it could be argued that it is remarkable that there has not been more political turbulence given the plunge in economic activity. This is a credit to Asia's family-based social culture and the lack of a debilitating welfare dependency. In China, however, the chief development has been the slowdown of the reform process initiated by Premier

Zhu Rongji

, a consequence of the PRC leadership's realization that too proactive a restructuring of the state-owned enterprises and the enfeebled banking system would compound deflationary pressures signaled in falling pricing indices and rising "unofficial" unemployment. Instead, with the export engine slowing fast, the leadership has decided to pump-prime the economy with a public-sector investment spending binge and renewed forced lending by the banking sector. China has also become the only nation in history, as far as

Greed & Fear

is aware, to institute price controls to stop prices from falling.

China's approach is viewed by the consensus as sensible pragmatism, which in many respects it is. The leadership has the luxury to delay structural reform because of its substantial foreign exchange reserves and its closed capital account. Still, overinvestment and politically driven lending were two big causes of the Asian crisis. Whatever the bulls may argue about the quality of investment, these problems are now being compounded by present policies, unless the naive view is taken that bureaucrats make a better of job of allocating capital than markets. The structural problems therefore remain as daunting as ever in China, with the most notable point of vulnerability the continued willingness of the population to place their savings in an extremely suspect banking system.

It is precisely the awareness of these vulnerabilities that makes the leadership so reluctant to brook organized dissent. The commitment to economic reform is likewise qualified. The clear message is that reform is an experiment. If it does not work, or proves to be too costly in social terms, its advocates will be sacrificed. Such has usually tended to be the fate of reformers throughout China's history, which is precisely why the task facing Zhu, this cycle's reformer, are so daunting. Meanwhile, the crackdown on financial spivvery, symbolized by the international trust and investment company bankruptcies, will continue. This meets both the needs of economic reform and the political hard-liners given their distaste for "speculation," which is convenient. It also happens to be the right thing to do.

A Whiff of Change in Malaysia

There is growing evidence that Malaysia is considering relaxing its capital controls on portfolio investment. The most tangible development is the decision to allow Britain's

Blue Circle

to pay for an acquisition of two cement plants in Malaysia by obtaining ringgit via a virtual swap with foreigners holding ringgit in their external accounts in Malaysia. This is the first easing of the controls in any practical sense since they were announced at the end of August.

The at least temporary stabilization of regional currencies provides a clear reason for Malaysia to consider modifying its policy. Political realities also dictate the need for Prime Minister

Mahathir Mohamad

to ponder some sort of face-saving U-turn. For if the capital controls are left to lapse only after one year, the policy will by then be either a proven success or failure depending on whether the money flows out. This clearly represents a political risk for Mahathir. The obvious compromise is to abandon the controls in favour of some sort of exit tax that discourages short-term investment, along the lines of those imposed by both Taiwan and Chile. There will also be a need to get MSCI to include Malaysia back in the indices which will, presumably, require some sort of reassurance that policy will not again be subject to arbitrary change. Those who believe there is policy change afoot should look to accumulate index-linked stocks.

Christopher Wood is the global emerging market strategist for Santander Investment. He is the author of The End of Japan Inc. (Simon & Schuster, 1994). Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy. While he cannot provide investment advice or recommendations, he welcomes your