Anthony Rowley: US monetary policy portends return of the dreaded ‘Japan premium’

The term “Japan premium” sounds rather like a superior brew of Japanese ale. But it actually came into use more than 20 years ago to describe something rather less intoxicating — the punishingly high cost that Japan’s banks had to pay if they wanted to buy dollars in overseas markets.

There are fears now that the Japan premium could reappear as U.S. interest rates begin to rise. This could squeeze Japanese banks, which are lending heavily in dollars and other currencies that they have to buy, borrow or swap.

The Bank of Japan’s historically low interest rate policy has sent banks rushing offshore in search of profitable lending opportunities that they are denied at home. But it is hard for them to find takers for yen loans outside Japan because the yen is seen by many as a “volatile” currency.

Offshore lending works well as long as the cost of funding remains stable. That has been the case during the recent long period of low volatility in financial markets. But it could be a different story as interest rates start rising and currency market volatility returns.

The Japan premium tends to occur in times of crisis, arising out of domestic factors or events that cause a repatriation of dollar funds to the U.S. It first emerged in 1995 when, as the Federal Reserve Bank of San Francisco noted in a paper, many Japanese banks were facing financial difficulties from losses on equity holdings and property investments following the collapse of Japan’s “bubble economy.” Until the crisis abated, overseas lenders required a premium to lend dollars to the troubled Japanese banks.

In 2001, the Japan premium re-emerged amid the financial stress created in the U.S. by the popping of the so-called dot-com bubble, which led to corporate collapses in the information technology sector and prompted U.S. investors to withdraw liquidity from the international interbank market.

To be sure, the size of the premium did not appear all that large. According to the San Francisco Fed, it never exceeded 0.05% to 0.07% (depending upon banks involved) during the 2001 episode. But relative to the size of funds involved — billions of dollars — the amounts were very large.

Recently, there has been a chorus of warnings that Japanese banks are again courting the risk of getting into trouble with overseas lending, as well as sailing too close to the wind in terms of the thin margins they accept at home as a result of fierce lending competition.

The most recent of these alerts appeared in the International Monetary Fund’s Financial System Stability Assessment on Japan in July. This noted that Japanese banks are borrowing or buying dollars heavily in interbank or currency-swap markets to fund aggressive overseas lending.

They are also turning to securities markets to acquire dollars via bond issues. “Heightened international activities have increased reliance on potentially volatile wholesale foreign currency funding” to finance the growth of banks’ overseas balance sheets, the IMF said.

BLACK BOX Bank of Japan Gov. Haruhiko Kuroda had earlier voiced concern over the growing exposure of Japanese banks to foreign currency funds — especially from what he termed the “black box” area of the currency swaps market — at a time of rising interest rates.

BOJ Deputy Gov. Hiroshi Nakaso also warned that the cost of dollar funds could spike if the BOJ and the U.S. Fed continue to diverge in their approach to monetary policy. “Under monetary policy divergence, the U.S. dollar-funding premium in the currency swap market could easily spike higher,” Nakaso said.

Between 30% and 40% of total assets at Japan’s three biggest banks — Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group, and Mizuho Financial Group — are now represented by overseas loans, made by overseas branches or in foreign currency loans from Japan, according to the IMF.

The increase in recent years has been “dramatic,” according to BOJ sources. The bulk of these loans are from the megabanks, although Japan’s myriad regional banks have also been shifting focus to overseas borrowers in the face of sluggish demand in the stagnant Japanese economy.

Foreign currency loans by the three megabanks more than doubled from around 30 trillion yen in 2010 (about $369 billion at the time) to more than 70 trillion yen in 2016, according to the BOJ. Regional bank foreign-currency loans more than tripled to around 3 trillion yen.

If all this suggests that Japanese banks are behaving incautiously it also points to the failure of Japanese monetary authorities to foresee and accept the consequences of financial globalization. In the past, there had been talk of “internationalizing” the yen, but little action was taken.

Yen internationalization was a popular topic of discussion in Japanese official and academic circles in the 1980s and 1990s, when the future role of the Japanese currency in Asia was seen by some as similar to that of the German deutsche mark, then a regional “reference” currency for Europe.

In 1998, in the aftermath of the Asian financial crisis, a subcommittee of the Japan Finance Ministry’s Council on Foreign Exchange, headed by prominent academic Takatoshi Ito, published a report aimed at stirring debate on how to win wider international acceptance for the yen.

The report argued that Asia would benefit from easier access to the yen as an alternative monetary anchor to the dollar. It could contribute to diversification of risk among central banks and international investors, it was suggested.

Another reason for internationalizing the yen was that the 1990s banking crisis in Japan had driven up the cost of dollars for Japanese banks. If foreign loans were denominated in yen, they would not face this problem and their capital would not be hit by exchange rate fluctuations.

But like a previous finance ministry report on the issue in 1985, the 1998 version was destined to gather dust on shelves as contrary arguments said it was more important for Japan to retain control over its domestic money supply and monetary policy than to cater to the needs of banks.

OTHER WAYS Apart from exercising stricter surveillance over banks’ overseas lending, the BOJ is seeking to help in other ways. It has announced a series of direct currency swap agreements with Southeast Asian central banks, to avert a liquidity crunch involving Japanese banks overseas. But the fact that the IMF raised concerns as recently as August, after holding consultations with the BOJ, suggests that the Japanese central bank’s measures may not be sufficient to contain possible future problems.

Meanwhile, the banks are expanding their overseas presence at a faster rate than they are growing at home. For example, Bank of Tokyo-Mitsubishi UFJ, a unit of MUFG, plans to acquire banks in the U.S. as it strives to become one of the world’s leading commercial lenders.

MUFG led the charge by taking control of Thailand’s Bank of Ayudhya in 2013. Such moves will help Japanese banks acquire a dollar funding base overseas, but some fear that Japanese banks may be paying over the odds for foreign acquisitions at a time when other foreign banks are withdrawing.

The chances of the Japan premium reappearing are very real given that Japanese banks’ exposure to dollar loans has been growing faster than banks have been able to increase their sources of dollar funding via overseas acquisitions. The squeeze this time is likely to be felt not just by the megabanks but also by Japan’s regional banks.

The timing of such a squeeze will depend upon how far and how fast the U.S. Fed raises dollar interest rates. But the fact that overseas lending by Japanese banks is continuing to increase even as interest rates trend upward indicates that the potential size of the problem is increasing rather than diminishing.

Anthony Rowley is a Tokyo-based journalist who has been covering the Japanese economy and politics since 1993. He is a former business editor and international finance editor of the Far Eastern Economic Review, and a former Tokyo correspondent of the Singapore Business Times.

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