Japan has a long history of taking good business ideas and improving on them. Electronics, automobiles, computers, you name it. Japanese policy makers have taken things a step further -- making bigger and better financial bubbles.
The first hint came in the late 1980's, when the nation's stock bubble burst. Nearly a dozen years later, the world's second-largest economy is still dealing with the fallout of deflated equity and property values. The phenomenon made Japan the poster child of modern bubble economics and, to this day, left Tokyo with persistent asset and price deflation.
Those challenges may be complicated by Japan's other bubble -- its bond market. Tokyo's attempts to revitalize the economy have focused on government spending financed by bonds. Today, Japan's debt is a third larger that its entire economy, leaving it with a debt-to-gross-domestic-product ratio that seems more appropriate for an emerging nation than an industrialized one.
Even with Japan's staggering debt load, its government bond yields are among the lowest in the world. Japan's current 10-year bond is yielding 1.4 percent, and that's after a big sell-off. To some observers, this defies the traditional laws of supply and demand and constitutes a bubble in Japanese fixed-income assets.
Consider that in the US, which is enjoying a budget surplus, the corresponding 10-year issue is yielding 5.13 percent.
Germany's offers a 4.96 percent rate, while Australia's is at 6.03 percent and the United Kingdom's 5.06 percent.
True, Japan is beset by recession, while other industrial nations aren't. And with even the most optimistic of analysts agreeing there's little hope of a Japanese recovery this year, one might expect lower bond yields. But many observers are hard- pressed to find a reasonable explanation for sub-2 percent yields.
The most plausible one is more demand than supply. Japanese households are sitting on massive savings, and there are few appealing investment choices, least of all stocks. Not surprisingly, households like to hold bonds. Trouble is, Japan's bond market may be a sleeping -- and potentially destabilizing -- threat to the nation's economic stability.
Eisuke Sakakibara, Japan's vice finance minister in charge of international affairs from 1997 to 1999, warns that the bond market is a "bubble waiting to collapse." His concerns come from the unique goings on in the Japanese bond market, and the risk that the laws of supply and demand will reassert themselves.
Even Japan's former finance minister, Kiichi Miyazawa, said in March -- when he still was finance minister -- that the nation's finances are "close to collapse." Some of the world's largest bond investors harbor similar concerns. Lee Thomas, a fund manager at Pacific Investment Management Company in Newport Beach, California, the world's largest bond manager, thinks of Japan's debt market as a "bubble that's going to burst someday." Even though Tokyo has issued so many bonds that it lost its triple-A credit rating, Japan's yields remain bafflingly low. The market's performance in the face of massive debt issuance has observers wondering if the bond rally is the next bubble that will burst.
Admittedly, this all seems a bit far-fetched. Japan is a wealthy nation that enjoys vast pools of household savings, one of the world's most liquid currencies and a central bank that could maintain liquidity at all times. Yet some observers wonder if a ripple or two in Japan's financial situation could touch off a tidal wave of panic.
The risk was the unlikely subject of a best-selling novel earlier in the year. The book, Nihon Kokusai, or Japanese Government Bonds, tells the story of fixed-income traders who decide to boycott a government bond auction. The action leads to soaring Japanese rates, a freefall in the yen and the stock market, and nail-biting in Washington. White House officials fret Japanese investors will sell their massive holdings of US Treasuries to cover losses.
The book became an unlikely topic of countless television talk shows and stimulated discussion among Japanese voters about risks posed by the bond market. While its author, former bond trader Main Kohda, concedes her book is sensational, she also asserts that its premise -- a meltdown in Japan's bond market -- is quite plausible.
The problem, she asserts, is the incestuous relationship between the government and Japan's banks. The intimacy manifests itself in low bond yields. The government wants low borrowing costs, while banks don't want to upset politicians by bidding up rates.
Perhaps Prime Minister Junichiro Koizumi has read Kohda's book. His first pledge was to cap new debt sales below 30 trillion yen in the fiscal year that begins April 1, 2002. While his Liberal Democratic Party seems content with issuing more debt, Koizumi understands that doing so could raise Japan's borrowing costs. That would not only destabilize the economy and send stocks lower, but hamper the Bank of Japan's efforts to stimulate demand.
Hence the wave of panic shooting through Japan's bond market now that Koizumi may be relaxing plans to limit bond sales. The economy is back in recession and the Nikkei 225 stock average this week hit a 16-year low. The turn of events puts the spotlight on banks; falling stocks reduce the value of their equity investments and, in turn, hinder their ability to write off bad loans.
Cognizant of this point, Koizumi's finance minister said Tokyo should consider "comprehensive or powerful measures" if things deteriorate further. To analysts, that means more spending financed by bonds. Since Japan already has the biggest government bond market in the world, more debt issuance may not sit well with global investors.
Up until now, that would've been fine, considering that, unlike US debt, domestic investors hold the vast majority of Japanese bonds. But what if investors suddenly panic over Japan's finances? Say, because of another rating downgrade? Or if consumers lose faith in Tokyo's ability to keep bond yields from surging and costing them some of their coveted savings? No one knows how all this will play out. All we do know is that Japan may have perfected the art of creating financial bubbles.
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