Abenomics describes the plans of Japanese Prime Minister Shinzo Abe to revive growth in the world's third largest economy, which is struggling to find traction under the impact of a strong yen and stubborn deflation.
Following significant pressure from Abe for bolder action, the Bank of Japan in January doubled its inflation target to 2 percent and made an open-ended commitment to buy assets from 2014. The central bank's new governor Haruhiko Kuroda has vowed to do "whatever it takes" to achieve the inflation goal in two years.
Japanese are trying it in despair after more than two decades of unsatisfied reforms.
We will show you that even if Abenomics can achieve its inflation goal, in a longer time frame, it is going to have a major impact on Japanese banks because their holdings of JGBs (Japanese Government Bonds) are enormous.
The What If Abenomics Scenario
The Abe Scenario means that the new mandate of the Bank of Japan is to re-inflate the economy with an inflation target of 2 percent. What we are forgetting is that Japan reached a 2 percent inflation rate in 2008 as shown by the graph below.
And back then, the market was convinced that the inflation spike was temporary; even then, the yield on Japanese bonds with a maturity of 10 years rose from 1.3% to 1.8% as shown by the graph below.
Japan Government Bond 10Y Yields
Chart from Tradingeconomics.com
What if they succeed with their inflation target?
The what if scenario is simple; what can happen if they succeed with the perception of a permanent 2 percent inflation rate?
The most obvious one is that the interest rate will rise according to it by at least 2 percent. But let's stay conservative and say that a permanent rise on the whole interest yield curve of 2 percent will occur quickly.
What can be the consequences for the Japanese banks?
The banks' huge holdings of Japanese government bonds (JGBS) (the biggest concentration of bank bond holdings in the world in percentage of their total assets) - while acting as a key source of their liquidity - also exposed them to considerable interest-rate risk from potential volatility in the JGBs market as shown by the chart below.
Chart and text from IMF.org
JGB market exposures represent one of the central macrofinancial risk factors. This risk reflects the possible impact on public debt sustainability of changes in yields and related effects on investor confidence; the increased role of the private financial sector in covering government borrowing needs; the prospect that ongoing demographic shifts will reduce private saving; and growing household interest in investing abroad.
Interest rate risk sensitivity is especially prevalent in regional banks and insurance companies (JGBs representing about 70 percent of life insurers' securities holdings and 90 percent of insurance cooperatives' securities holdings). In addition, the main public pension schemes, as well as Japan post and banks, also have large JGB exposures as shown by the charts below.
As expected, JGB market exposures constitute one of the central macrofinancial risks for the system. Tests including market yield shocks (i.e., the macro scenario with a 100 basis points shock and the sensitivity test for a larger shock) reduce aggregate capital ratios in the first two years more than other scenarios.
Banks in Japan have larger exposure to domestic sovereign debt than those in any other advanced economy. The BOJ (2012) notes that regional banks in Japan in particular are especially vulnerable to the risks of these large holdings: according to the BOJ, a 100-basis-point increase in interest rates across the yield curve would lead to mark-to-market losses of 20 percent of Tier 1 capital for regional banks and 10 percent for the major banks.
Chart from IMF.org
Chart and text from IMF.org
Japanese banks will face tremendous challenges going forward. A Japanese economy more and more dependent on exports, with more volatility in terms of exchange rate, and especially an increase in interest rate risk, will not position them as a real interesting investment compared to their American peers.