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"The Next Quake Is Close"
With funds pouring out of Japanese stocks and into bonds, analysts fear another huge bubble is on the verge of collapse

By George Wehrfritz
NEWSWEEK INTERNATIONAL

June 9 issue — The form it will take is hard to forecast—an oil-price spike, perhaps—but a shock is bound to expose Japan’s bond market as a huge bubble, says John Alkire, chief investment officer at Morgan Stanley Asset & Investment Trust Management in Tokyo. “I don’t know the date of the earthquake, but I sure think it’s close.”

A GROWING CADRE of Japan analysts predict upheaval in the world’s second largest bond market. Investors, who saw no limit for Japanese stocks in the late 1980s, now seem to see no limit for bonds. Since the 1989 stock- market crash, money has moved from stocks into the perceived haven of Japanese Government Bonds in amounts so excessive, it now puts the entire public-sector financial system at “high risk,” warns PHP Research Institute, a Tokyo think tank. “There’s a danger that the price of JGBs could collapse at any moment.”
The problem is that the Japanese are making a dangerous wager against Japan. To buy a 10-year government bond at current interest rates (0.595 percent) is to assume that the economy will deliver negative growth until 2013—a run of stagnation unprecedented in modern economic history. Should Japan recover, all bondholders will suffer, but the biggest worry is Japan’s weak banks. At the end of 2002 they held 31.4 percent of all JGBs in circulation, and could be driven under by a sudden price collapse. “Once anyone wants out, it’s a disaster,” says Akio Mikuni, president of Mikuni and Co., which rates bonds. “Nobody will support the market then. It will be like NASDAQ in 2000.”
The difference is that the government is at risk, too. Japan’s $8 trillion national debt is now a staggering 151 percent of GDP. Most has been amassed since 1994, when the government began issuing bonds to pay for huge pave-and-build stimulus packages. The share of the budget funded by bonds has since risen from 20 to 45 percent, and is likely to increase so long as Tokyo and local governments continue to sell bonds to finance deficits. This habit of paying old loans with new ones can only continue if interest rates stay near zero. A rise to 1 percent in JGB yields would double Tokyo’s cost of raising new capital, a rise to 2 percent would quadruple it and so on. No major industrial country has ever maintained bond yields below 3 percent indefinitely, so many experts predict a 2 to 4 percent correction. PHP Research forecasts that bondholders will lose a total of .450 trillion ($3.9 trillion) for each percentage-point rise in interest rates.
After banks, the main JGB holders are insurance companies, pension funds and the Bank of Japan. All are at risk, though Michael Petit, a managing director at Standard & Poor’s in Tokyo, calls collapse scenarios “excessively dramatic.” He cites Tokyo’s May 17 rescue of Resona Holdings with $17 billion in public funds. To save Japan’s fifth largest bank “with so few ripples is quite amazing,” he says.

Others have a darker read on the Resona bailout, which has been called a “soft nationalization.” Engineered by Financial Services Agency chief Heizo Takenaka, it could not have succeeded without approval from the Ministry of Finance and the Bank of Japan—powerful agencies that bickered publicly during past bank failures. Their agreement reveals “a consensus that Resona not be allowed to upset the bond market,” says a Japanese financial official who asks not to be named. In other words, they united only to prevent a shock that could burst the JGB bubble. How encouraging is that?

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With Hideko Takayama in Tokyo

© 2003 Newsweek, Inc.

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