Takeshi Kimura, president of consulting firm KPMG Financial Co., says he periodically receives calls from overseas investors who ask one chilling question.
“What is the probability of the Japanese government freezing savings accounts or declaring a state of emergency?”
Hedge fund managers are toying with a series of theoretical questions. How far off is capital flight? And if the yen plunges, what is the possibility of the finance minister shutting down the Tokyo foreign-exchange market, just when the opportunity for profit is brightest?
A “Sell Japan” order — involving a massive selling of the yen, stocks and government bonds — may seem far-fetched. Japan is the world’s largest donor nation. The Japanese hold 1.4 quadrillion yen in financial assets, and the economy has the world’s highest foreign reserves, $400 billion.
But analysts worldwide worry that Japan may be in the same boat as Argentina, which defaulted on its public debt and devalued the peso in January.
They wonder what it would take for Japan to do the same.
Japan’s public debt — that of the national as well as local governments — officially is climbing to 668 trillion yen.
International credit-rating agencies downgraded Japan’s sovereign debt last year, citing spreading deflation and slow progress in structural reforms.
Among the Group of Seven industrialized nations, Japanese government bonds are rated at the same level as Italy’s, and only a peg away from debtors that include Chile and Hungary.
The ratings could well fall one more notch, given the state of the economy. That would increase the risk that prices of government bonds may fall and damage banks’ massive bond portfolios.
Indeed, this may have already begun. The benchmark 10-year government bond yields stood at 1.480 percent Thursday. Since January, falling bond prices have pushed the yield up above 1.400 percent, which it last hit in April, threatening to cut the value of banks’ bond portfolios.
The nation’s banks hold 67 trillion yen in government bonds, which account for 9 percent of their total assets. A fall in bond prices hurts banks under a new rule that forces them to subtract 60 percent of those losses from their capital.
“Everyone knows that the bond market is acting abnormally,” said Seichiro Saito, a professor of economics at Rikkyo University. “You could say bonds have not fallen yet because financial markets are paralyzed.”
Each time bond prices fall, speculation about foreign institutional investors selling Japan grips the market.
But hemmed in between their problem loans and a slumping market, banks continue to play a game of chicken, increasing their bond holdings while warily eyeing other institutional investors. That delicate balance could collapse with an accelerated yen weakening and downgrading of government bonds.
The dollar stood at 132.92 yen at 5 p.m. Thursday, a 9 percent increase from three months ago. Economists’ forecasts for the next two weeks place the dollar between 128 yen to as much as 138 yen. The yen’s weakening trend could accelerate if the bad-loan problem grows or if the gap in economic prospects for Japan and the U.S. widens. A rise in U.S. interest rates will make the dollar more attractive and may weaken the yen.
This is not unrealistic, and the situation becomes more ominous when taking into account domestic pressures on the yen as well:
The trade surplus is shrinking at a rapid pace. Unemployment is at a record high 5.6 percent as the number of bankruptcies rises and companies shift production overseas. Consumer prices fell 0.7 percent in December and have fallen for three consecutive years. Economists say official forecasts of zero growth for fiscal 2002 are overly optimistic.
If these factors weigh on the yen, a weakening currency could trigger capital flight.
Here’s how it might begin:
Foreign investors decide the yen is in permanent decline and pull more funds out of the stock market.
In an attempt to lure this capital back, interest rates are jacked up.
But this only damages the banking system, which holds 67 trillion yen worth of government bonds (as interest rates rise, bond prices fall, and banks buy bonds in hope of selling them at a higher price).
With the lenders weakened, corporate balance sheets erode and more of their loans sour, putting still more pressure on banks.
Meanwhile, Japan’s ultralow interest rates, which are designed to allow sick corporations to breath easier, is wreaking havoc with the insurance industry.
Life insurers are already looking to foreign markets. They are collectively considering halving annual yields on group insurance policies to 0.75 percent as they struggle to manage funds because of ultra-low interest rates.
Tomonori Asatomi, general manager of pension fund investments at Yasuda Mutual Life Insurance Co., said 1.5 percent may not seem like much, “But if you can find anywhere in Japan where we can put our money to make these rates, please be my guest.
“Foreign markets are extremely attractive.”
Individual depositors may feel the same way. They were putting a record 10.58 trillion yen into foreign currency-denominated accounts as of Sept. 30, up 29 percent from a year earlier.
The ramifications are chilling. If 1 percent of the 1.4 quadrillion yen in personal financial assets out of yen-denominated accounts, it would account for 14 trillion yen — more than Japan’s trade surplus in one year.
“You saw what happened when MMFs (money market funds) fell below par value,” said Atsushi Miyanoya, head of the BOJ’s Financial Coordination Division. If a bank fails and depositors don’t get their full deposits back, or if the yen takes a drastic slide, “there’s no way to tell what could happen,” he said.
In December, investors fled from money management funds, shifting over 3 trillion yen, when the low-risk funds fell below their par value.
Private-sector moves are not the only factor pushing the yen down. Neighboring countries, including China and South Korea, which may lose their export competitiveness because of a weaker yen, suspect Japan’s monetary authorities are deliberately trying to weaken the currency.
A weaker yen enables Japanese exporters to receive more yen from sales denominated in dollars.
The BOJ is suspected of having a motive. Short-term interest rates are effectively at zero, leaving no room for cuts. And because teetering banks have all but stopped taking credit risks, the banks’ efforts to expand broad money have been ineffective.
BOJ chief Masaru Hayami has flatly denied radical measures, such as the central bank buying land or equity to create inflationary expectations. This leaves the exchange rate as one of its few remaining policy options, although the Finance Ministry has the authority to decide on any currency intervention.
Hayami, however, stressed earlier this week that Japan should not push the yen weaker as a measure to bolster its economy. The Finance Ministry, for its part, since last year has categorically denied Japan has deliberately encouraged a weak yen.
In any event, the yen would need to weaken further to help Japan out of recession. According to HSBC Securities, a 10 percent depreciation to the 146 yen to 150 yen range would add only half a percentage point to gross domestic product growth over two years.
Some market watchers nonetheless argue that a greatly weakened yen — if taken far enough — would not only boost the economy, but help solve bad-loan problems by prompting inflation — a complete reversal of the current deflation.
Takeshi Fujimaki, a former Tokyo chief of U.S. investment bank JP Morgan, said the BOJ should purchase U.S. government bonds and push the exchange rate down to 200 yen to the dollar.
The move would cause inflation by raising prices of imported goods, like gasoline, he said. And land prices would also rise as foreigners buy cheaper Japanese land — some of which would be taken as loan collateral by banks. The move would help banks get rid of their problem loans as they sell land at higher prices, he reckoned.
Other analysts brush aside excessive pessimism.
“Japan is no Argentina,” said Michael Petit, chief credit officer for the Asia-Pacific region at Standard & Poor’s Tokyo. “We see many problems,” including fiscal debt that will grow to 175 percent of GDP within five years unless drastic action is taken, he said.
“But many things will have to happen this year before foreigners or Japanese decide to sell Japan.”