Unyielding Fortitude: Japan’s Trillions in Foreign Investments Stand Firm Amidst BOJ Rumbles

By Vidya Ranganathan

SINGAPORE, March 18 (Reuters) – As the Bank of Japan contemplates a seismic shift in monetary policy, market analysts caution that a more substantial effort will be necessary to upend the approximately $3 trillion of yen that Japanese investors have deployed in global bond markets and yen-related transactions.

For years, Japanese investors have sought refuge abroad, seeking returns superior to the paltry gains available in their homeland due to the BOJ’s protracted campaign against deflation.

The BOJ might be on the brink of transforming this narrative. Increasing wages and heightened business activities indicate the end of stagnation, potentially obviating the necessity for the BOJ to persist with negative short-term rates.

The optimism around enhanced growth has attracted foreign capital into Japanese stocks (.N225) and propelled yen bond yields upwards.

Simultaneously, attention has shifted to the $2.4 trillion worth of foreign debt held collectively by Japan’s life insurance firms, pension funds, banks, and trust companies, sparking debates on the probable repatriation of these investments.

However, with these investments fetching yen investors over 5% returns, analysts suggest that even a modest 10 to 20 basis points increase by the BOJ in its rates is unlikely to prompt a significant reaction.

“I honestly don’t think it will have a big impact on flows,” remarked Alex Etra, a senior strategist at analytics firm Exante Data.

According to data from the Ministry of Finance as of the end of December, Japan’s total foreign portfolio investments stood at 628.45 trillion yen ($4.2 trillion), with more than half allocated to interest-sensitive debt instruments, predominantly long-term in nature.

Commencing its quantitative and qualitative easing (QQE) program back in May 2013, the BOJ has overseen Japanese investment in foreign debt surge by about 89 trillion yen over the subsequent years, with pension funds, including the enormous Government Pension Investment Fund (GPIF), accounting for nearly 60% of this growth.

Etra from Exante underscores that Japanese pension funds commonly refrain from hedging their overseas bond holdings against currency risks, with the returns on foreign bonds proving alluring, especially when translated into yen.

The Hedge Conundrum

“I’m not a huge believer of that repatriation story,” expressed Gareth Berry, currency and rates strategist at Macquarie Bank.

Reflecting on historical data over the past two decades, Berry highlighted the scant evidence of substantial repatriation even during the Global Financial Crisis in 2008.

In contrast to pension funds, Japan’s major banks and life insurance entities typically opt to hedge their foreign bond exposures to safeguard against potential risks to their deposits and other yen liabilities.

Flow data indicates a gradual reduction in foreign debt holdings among this investor class, which includes institutions like Japan Post Bank (7182.T) and the Norinchukin Bank.

Nomura strategist Jin Moteki postulated that entities such as insurance firms will only repatriate foreign investments if attractive yields ensue at home in Japanese government bonds (JGBs).

Moteki projected that significant repatriation might only transpire if 20-year JGB yields touch the 2% mark, implying a roughly 50 basis points increment in longer-term yields. Nomura envisions the BOJ elevating the overnight rate to 0.25% by October.

“In our assessment, the potential repatriation prompted by the conclusion of YCC is anticipated to hover around 45 trillion yen at most. We also anticipate Japanese life insurance companies to emerge as the principal players in the repatriation process,” Moteki asserted.

Besides, a scenario where short-term yen rates swell simultaneously with a rate reduction by the Fed could lower hedging costs, rendering FX-hedged investments in U.S. Treasuries more enticing.

Responses from Japan Post Bank, Norinchukin, and the GPIF were unavailable in response to Reuters’ inquiries on their investment strategies.

Carry Trades and Volatility

The repercussions of the BOJ’s departure from negative rates on the intricate realm of FX carry trades pivot greatly on the signals regarding rate trajectory that the BOJ transmits, rather than merely the initial rate increase.

For decades, the yen has remained the go-to funding currency for trades where investors borrow zero-cost yen to swap for higher-yielding dollars. Although immensely profitable, these short-term trades are highly susceptible to minimal changes in interest and exchange rates.

A 3-month dollar-yen carry trade yielded 7% annually in December, but the return has since dwindled to 5%, triggered by the ascension of both the yen and Japanese yields.

Estimating the magnitude of such trades remains challenging. Japan’s collective short-term lending to foreigners amounts to roughly $500 billion, providing a rough barometer of outstanding carry trades.

The ‘carry’ aspect in these transactions could dissipate swiftly if the market begins pricing in elevated short- and mid-term yields.

James Malcolm, currency strategist at UBS in London, highlighted that a mere 10 basis points shift in the interest rate differential between the dollar and yen has historically led to a 1% fluctuation in the dollar-yen rate over the past few years.

“When there’s a substantial carry trade accumulation, the risk looms that minor adjustments may trigger a domino effect, causing significant FX movements by generating self-propagating dynamics,” Malcolm cautioned.

($1 = 149.0200 yen)

Foreign bond purchases by Japanese investors: A segment breakdown https://reut.rs/3VdMH2k

(Additional reporting by Rae Wee and Tom Westbrook in Singapore, Ritsuko Shimizu and Makiko Yamazaki in Tokyo; Graphics by Patturaja Murugaboopathy; Editing by Lincoln Feast.)

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