Deflation in Japan keeps yields low
23 August 2002
In his Bloomberg article "S&P Warning Doesn't Rate for Japan Investors" on 21 August, William Pesek Jr. raised the question of why Standard & Poor's warning of a possible downgrade in the credit rating for Japan has failed to push up Japanese bond yields. Pesek suggested that investors may have become indifferent to Japan's deteriorating credit rating, but warned that "the day of reckoning can't be put off indefinitely".
"What concerns investors is the gap between Japanese yields and those elsewhere," he wrote. "The U.S., a triple-A-rated economy, needs to offer 10-year investors 4.18 percent, while Japan offers 1.23 percent."
Pesek warned that Japan's bond market is the "financial equivalent of a pressure cooker that could explode… The big concern, credit raters have said over the last year, is deflation, which raises the inflation-adjusted value of debt. Since there's no end in sight to Japan's falling-price trend, its debt load is set to rise." He then went on to add: "Against that backdrop, it's hard to find a reasonable explanation for sub-2 percent yields in Japan."
How odd. I always thought that deflation -- or a falling-price trend -- is the reason for low yields. Earlier, he mentioned that the US offered higher yields. But then, the US economy is still experiencing inflation, not deflation.
However, that is not to say that Pesek's concern is unwarranted. The low yields leave bond investors vulnerable to a reversal from deflation to inflation. As Pesek wrote: "If things get dicey, Tokyo could always monetize its debt. And in the current deflationary environment, the Bank of Japan can print lots of yen." And Pesek asks: "What if more ratings downgrades spook investors? What if life insurance companies or households lose faith in Tokyo's ability to cap bond yields?" Any of these could be a catalyst for yields to rise and bond prices to fall.
On the other hand, if Morgan Stanley's Andy Xie is correct, bond investors in Japan may have little to fear. On 22 August, he wrote in the Global Economic Forum: "East Asia appears to be winning the deflation battle for market shares in global trade. The demand increase in response to lower prices is finally exceeding the value reduction on existing demand from lower prices. The main factor for the current success is the redistribution of the production chain to China, which allows Asian producers to cut prices more aggressively than before, in our view."
However, he adds: "We believe it is only a matter of time before more of the production value chain shifts into China. East Asia's deflation strategy in winning trade would have serious consequences for the global economy. The current debate on deflation or low inflation for the global economy could have been decided already, without major shifts in monetary policy among three major central banks. The current trend points to a further decline in the relative price between tradable and non-tradable goods in OECD economies. The decline could be sufficiently large to pull OECD economies into deflation, in our view."
And that is a view that Japanese bond investors probably hold too.
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