Why Japan is an unexpected threat to financial stability

In a crisis, the ability of banks to fund their dollar lending would be in question

John Plender 

© Reuters

The reversal of globalisation is by now in full swing in goods markets but nothing remotely comparable is happening to capital flows.

Indeed, it is impossible to understand US monetary policy or the gyrations of the Treasury market without considering the distorting impact of central bank asset-buying in Europe and Japan.

To American or British investors, a yield on 10-year Treasuries of just under three per cent looks pretty threadbare by historical standards. However, to yield-starved investors in Frankfurt or Tokyo, it looks more of a gift horse.

Minimal or zero yields on Japanese government bonds have caused a huge exodus of capital into US Treasuries. You can see it most graphically in the latest annual report of Japan Post Bank, the biggest deposit taker in the world.

Between 2007 and the end of March of this year, its holdings of JGBs declined from 88 per cent of its overall portfolio to just over 30 per cent.

At the same time, its investments in foreign securities went from 0.1 per cent to 28.5 per cent, now amounting to ¥58tn ($521bn). That is scarcely peanuts and a great deal of it went towards financing the US government.

Adding to the flow is the fact that investors in Japan can lock in a yield pick-up over JGBs even after full currency hedging.

Stuart Graham of Autonomous Research calculates that, using three-month rolling hedges, 10-year Treasuries at a yield of 2.95 per cent offer a 34 basis points pick-up over JGBs yielding nine basis points.

Those kind of opportunities do not come along often in today’s markets. It took the world’s most extreme quantitative easing programme to throw up this serendipitous free lunch.

What are the wider consequences of this extraordinary degree of integration in global capital markets?

One is that the yield curve — the difference between short- and long-term Treasury rates — may prove to be less reliable as a predictor of recession. More crucially, cross-border capital flows complicate judgments about monetary policy.

The US Federal Reserve has been busy raising interest rates and has embarked on quantitative tightening whereby it shrinks its swollen balance sheet.

Yet because short- to medium-term Treasury yields are below the rate of inflation, they are negative in real terms.

This suggests that monetary policy is still stimulative, which looks inappropriate when the economy is growing at above its underlying trend rate, unemployment is at its lowest level for half a century and fiscal policy is in galloping expansion mode under Donald Trump.

Another snag is that cross-border bank lending is adding fuel to a US credit cycle that is already well advanced.

The latest Fed Senior Loan Officer survey showed further easing of lending standards in the commercial and industrial loan category. This reflects intensifying competition in which the Japanese banks are playing a notable part.

As well as operating in a low-growth domestic market, their profits have been squeezed by QE, so they have had to look overseas to plug the gap.

Once again, Japan Post Bank is interesting. It is proposing to build its strategic investment portfolio from a level of ¥1.6tn to ¥8.5tn with much of the money going into credit markets. This dash for yield at a relatively late stage in the cycle looks racy. Other Japanese banks are following suit.

These frothy symptoms carry an echo of events before the great financial crisis. The decline in lending standards probably has further to go.

But, as yet, there is no real-estate bubble, which is how financial crises so often come about in developed world economies. That is good news.

The longer-term worry is about Japan. After the bursting of the Japanese bubble in 1990, the country’s banking crises had little external impact. The JGB market, though huge, was and remains, largely about Japanese savers lending to the Japanese government.

In effect, it was a financially closed economy where a post-bubble collapse of both the stock market and the property market left the rest of the world largely untouched.

With the growth of Japan’s capital exports and the Japanese banks’ shift into foreign markets, the country has become a factor not only in US and European monetary policy but a potential threat to financial stability.

In a financial crisis, the banks’ ability to fund their dollar lending would be in question. Note, too, that the history of banking is littered with cases of lenders running into trouble after taking big risks in novel territory.

From a US perspective, the key point is that the pattern of Treasury yields is heavily distorted. When the great central banking experiments in Europe and Japan come to an end, investors in US Treasuries will surely be burnt.

Sanctions reach far beyond Russia’s oligarchs

Struggles for mid-size groups illustrate broader effects of US and EU penalties

Henry Foy

The harshest curbs against Russia were designed to totally sever targets from the international banking system © Bloomberg

When officials at the US Treasury were mulling which Russians they should hit with sanctions to punish Moscow for its alleged meddling in the 2016 US election, it is unlikely that GV Gold featured in their conversations.

A mid-ranking gold producer that has spent two decades slowly building up a foothold in the country’s vast mining industry, it is not owned by oligarchs and has no major political connections. In many ways, it is an example of an enterprise that critics of Russia’s economy often say does not exist in a country portrayed as being dominated by kleptocrats, state-controlled behemoths and shady tycoons with friends in high places.

It has nevertheless become an unwitting victim of a western sanctions regime now entering its fifth year, and a prime example of the collateral damage inflicted across vast swaths of the economy. “The company is nothing to do with all this. But it is their reality all the same,” said a person close to GV Gold’s management. “But what can you do?”

First levied in 2014 after Moscow’s annexation of Crimea, US and EU sanctions cut off some major Russian energy and defence companies from certain western technologies and long-term financing. Various new restrictions have been introduced in the years since, but the harshest curbs, levied in April of this year, were designed to totally sever the targets from the international banking system. The broadside had immediate, powerful effects. A small group of oligarchs lost $7.5bn in four days. Most prominently, metals and energy tycoon Oleg Deripaska saw the value of his aluminium businesses, Rusal and EN+, plummet.

But as GV Gold’s experience shows, the real impact has been felt far wider. The sanctions could not have come at a worse time. The company was days from announcing a deal to acquire a rival, Kamchatka Gold — an acquisition that had been worked on for almost 12 months and was set to roughly double its size. The catch was that Kamchatka was ultimately owned by Viktor Vekselberg, an oligarch who was hit by the same sanctions as Mr Deripaska. The deal was ripped up.

At the same time, the pall that the sanctions cast over the Russian investment climate forced GV Gold to postpone an initial public offering. “The market, due to the change in the geopolitical situation and the blowback from the sanctions list, simply closed for small-sized, low liquidity IPOs,” said a person briefed on the company’s strategy. “Theoretically they are ready for a listing at two months’ notice. But this is not a near-term likelihood.”

GV Gold’s deal to buy rival Kamchatka was shelved as the group was ultimately owned oligarch Viktor Vekselberg © Reuters

GV Gold is not alone. IBS, an IT services provider, had already announced its IPO when the sanctions were announced, forcing it to postpone the plans. Moscow bankers say only the bold or the desperate would push ahead with listings in the current climate. That leaves companies such as GV Gold and IBS in a bind. The gold producer, which is 18 per cent-owned by US fund manager BlackRock, has increased its production by some 35 per cent over the past two years to become Russia’s seventh-largest, but reckons organic growth will flatten from next year.

Based in Russia’s Far East, a 2017 stake sale and the IPO plans pegged its value at $650m-$750m. Longstanding shareholders who have built the company over two decades are looking to cash out. Small-scale acquisitions of other Russian gold assets are being considered, two people involved in the talks told the Financial Times, as the company attempts to gain scale that would allow it to compete with the country’s two market leaders, Polyus and Polymetal.

Short of that, the people said that an option to sell the entire company to one of those major players was not completely out of the question, given the market conditions. “It’s not plan A, but maybe plan D or E,” said one of the people.

In contrast to that uncertainty, sectors directly targeted by sanctions are powering ahead. Russia’s oil and gas output is at a 30-year high, gas exports to Europe are at record levels, and the oil and gas index on the Moscow stock exchange has never been higher. Mr Deripaska’s companies are negotiating with Washington for some form of waiver to allow it to continue doing business. Prominent oligarchs and political figures may be the headline victims, but look to the broader damage on Russia’s mid-sized companies to see the long-term effect.

In Turkey, a Test to the Limits of Presidential Power

The central bank has decided not to raise interest rates.

By Xander Snyder

Turkey’s central bank met on Tuesday for the first time since President Recep Tayyip Erdogan was re-elected with enhanced executive powers. Though many expected the bank to raise interest rates to prop up the struggling lira, it decided instead to leave rates unchanged, causing the currency to fall once again – this time by 4 percent relative to the dollar before recovering slightly. Erdogan has long supported cutting interest rates to encourage borrowing and boost investment. And his new powers, which include appointments to the central bank, give him even more influence in this regard. But the bank’s decision not to cut rates puts into question how much power the president really has over monetary policy.

Specifically, Erdogan's new powers enable to appoint the central bank governor. (Previously, the president, prime minister and deputy prime minister jointly appointed the central bank governor, but under Turkey’s new executive presidential system, the post of prime minister no longer exists.) The six other members of the board of governors are elected by the bank’s general assembly. But he had already decreased the term limit for the governor from five years to four years and eliminated the requirement that deputy governors must have a decade of experience before being appointed.

This has naturally raised questions about the bank’s independence. Politicians often push for loose monetary policies that decrease interest rates to make borrowing cheap and to spur investment and economic growth. The downside is that low interest rates increase debt and raise inflation, which can decrease the value of the country’s currency. But the economic benefits often materialize faster than the drawbacks, so politicians are somewhat predisposed to support low rates. The independence of a central bank is meant to ensure that decisions made by the bank aren’t driven by short-term political interests.

Erdogan has long advocated for low interest rates, even though it could further weaken an already weak currency. While Turkey has experienced high economic growth rates (7.4 percent in the first quarter of 2018, the most recent figure available from the government’s statistical agency), it has also experiences high levels of inflation (over 15 percent in June). A cheaper lira means staple goods, especially those that are imported, become more expensive for Turkish consumers. And the declining lira is even more concerning given the increasing dependency of the Turkish economy on external debt (that is, debt denominated in currencies other than the lira). Turkey’s central bank responded earlier this year by raising rates by 5 percent in total, bringing its benchmark rate to 17.75 percent, but the currency has continued to plummet.

The markets have, therefore, viewed Tuesday’s meeting as a litmus test for Erdogan’s new powers over the central bank. Financial analysts claimed that an increase in interest rates would be an indication that the central bank has maintained some of its independence and that a decrease (or even holding at current rates) would be a sign that Erdogan is now dictating monetary policy.

This framing is useful but not comprehensive. It ignores the fact that the fundamentals of Turkey’s economy haven’t changed, and Erdogan faces the same set of bad choices that he did before the recent snap elections.

If interest rates go up, they might slow the fall of the lira, but they could also imperil the credit-fueled growth that has been a lynchpin of Erdogan’s economic policies. If interest rates go down, GDP growth might continue to climb, but inflation would also go up and the lira would fall. So while the 2017 referendum on presidential powers and the recent snap elections have indeed given Erdogan sweeping new powers, they’re not enough to change Turkey’s economic reality.

Erdogan knows that keeping rates low isn’t a long-term solution, regardless of what he says publicly. It’s a useful political tactic in the run-up to an election, but having secured a new five-year term that arguably makes him the most powerful leader in Turkey since Mustafa Kemal Ataturk, he will be more willing to make difficult decisions. Even if Erdogan did have complete control over the central bank, at this early stage in his new term, he may well be willing to take steps that stabilize the lira, even if they hurt GDP growth, in the hopes that he could make necessary structural reforms before the next election takes place.

Slower growth is, for the time being, politically tolerable for Erdogan. A run on the lira that could lead to a currency crisis would threaten the Turkish financial system itself.

Darts Are Beating the Ira Sohn Investing Pros

By Spencer Jakab

Top 5 dart picks in blue, top 5 Sohn picks in red

“Nothing new ever occurs in the business of speculating. What’s happened in the past will happen again and again and again.”

Bond king Jeffrey Gundlach’s comments three months ago at the Sohn Conference in New York, which raises money for charity by inviting investing legends to share their stock tips with the masses, were more accurate than he could have imagined. Once again, investors would have been better off picking companies by throwing darts at stock tables than listening to Wall Street’s geniuses.

Mr. Gundlach’s suggestion to short the shares of Facebook and to go long on an exchange-traded fund of oil and gas explorers, for example, would have lagged behind an S&P 500 Index fund by 24 percentage points through Monday’s close.

Jeffrey Gundlach of DoubleLine Capital at the Sohn Conference in New York on April 23.
Jeffrey Gundlach of DoubleLine Capital at the Sohn Conference in New York on April 23. Photo: Reuters

At the time of the conference, Heard on the Street columnists took on the stock pickers by throwing darts to create a portfolio of 10 stocks to go up against the 12 stocks picked by the Sohn speakers. Three months later, the darts have prevailed. The Heard team’s 10 picks, eight long and two short, have returned 7.23% on average. The combined performance of 12 picks by Sohn attendees has been slightly negative, lagging behind the S&P 500 by more than 6 percentage points.

Burton Malkiel did perhaps more than anyone to popularize the notion that investing expertise is overrated in his classic book “A Random Walk Down Wall Street.” Despite some overwhelming evidence before and after the book’s publication and the rise of passive index funds, the Sohn Conference is closely followed and attended by thousands of paying investment professionals.

The top pick from the darts was railcar leasing company GATX , up 27% in the past three months. The leader from the experts was a recommendation from venture capitalist and former Facebook executive Chamath Palihapitiya to buy Box . Yet, while Box was up a solid 16%, it lagged behind three dart picks.

We will update this every three months until the next Sohn conference. Maybe the Heard on the Street team will be invited to throw its darts on stage next year.

IMF Executive Board Concludes 2018 Article IV Consultation with Peru

On July 9, 2018, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation[1] with Peru.

Peru has been one of the top performers in Latin America since the turn of the century. Robust growth has helped close the income gap with the largest regional economies and reduce poverty significantly, while inflation has remained low. Sound macroeconomic and structural reforms have played an indispensable role in this. 

After a difficult 2017, the economy is recovering. Extreme weather caused by El Niño and spillovers from the Odebrecht investigation led to subpar growth in 2017, and the poverty ratio increased. While high commodity prices are currently supporting investment and broader economic activity, domestic headwinds have continued. The Odebrecht case led to the resignation of President Kuczynski. The authorities have also been facing the challenge of rebuilding infrastructure damaged by El Niño. In the face of this, the new Cabinet has moved quickly to implement various measures and receive special legislative powers from Congress to speed up the reconstruction and implement needed reforms. Recent indicators suggest a pickup in economic activity. 

Against this backdrop, growth in 2018 is expected to increase to 3.7 percent, supported by countercyclical fiscal and monetary stimulus. In 2019–20, the recovery of private domestic demand is expected to push growth above 4 percent, even as gradual fiscal consolidation takes place. In the medium term, growth is projected to converge to its potential of 4 percent.

Headline inflation is expected to gradually increase to the center of the central bank target range of 1–3 percent by end-2018.

Executive Board Assessment[2]

Executive Directors commended the authorities for implementing sound macroeconomic policies and key structural reforms over the past two decades, which have helped keep inflation low, raise incomes and reduce poverty. While medium‑term risks are tilted to the downside, high copper prices and reduced political uncertainty create a window of opportunity for addressing remaining challenges and increasing potential growth. 

Directors agreed that the fiscal policy stance should remain countercyclical in 2018. Given the negative output gap, Directors supported the authorities’ objective to expand public investment to meet the significant reconstruction needs after the flooding and landslides, while also stressing the importance of increasing implementation capacity of subnational governments. 

Directors welcomed the commitment to medium‑term fiscal consolidation, under the fiscal responsibility framework. They supported the focus on revenue mobilization through strengthening tax policy and administration, and streamlining current expenditures to help free up space for much needed public investment. 

Directors considered that the accommodative monetary policy stance remains appropriate and that monetary policy should remain data dependent. While the central bank has improved the communication of its policy guidance, it could consider further enhancements in this area. Directors underscored that exchange rate flexibility is an important shock absorber, and foreign exchange interventions should continue to be two‑sided and limited to addressing disorderly market conditions. 

Directors observed that the financial sector remains sound and resilient to severe macroeconomic shocks, as shown by the stress tests, thanks to a robust supervisory framework, although high concentration, off‑balance sheet positions, and common exposures call for continued monitoring of risks and for increasing capital surcharges for systemically‑important banks. Directors welcomed the reduction in financial dollarization, but stressed the importance of taking steps to reduce it further.

Directors recommended further improvement of the macroprudential framework, including by giving enhanced mandates for macroprudential policy to the central bank and the financial supervisor. 

Directors underscored the need for continued structural reforms to tackle the long‑standing challenge of high informality and low productivity. Directors called for further efforts to strengthen governance, improve education, increase labor market flexibility, and enhance financial deepening and inclusion. They highlighted the importance of reforming the pension system to enhance social protection and reduce inequities.

Peru : Financial System Stability Assessment

Peru’s financial system has developed and become more resilient since the previous FSAP in 2011, but some challenges remain. Peru’s main vulnerabilities are external, especially related to growth in trading partners (due to reliance on commodity exports), and exchange rate depreciation (due to significant dollarization), which were confirmed by the Growth-at-Risk (GaR) analysis. Peru is also vulnerable to domestic headwinds, related to uncertainty and spillovers from the ongoing Lava Jato investigation. The banking sector remains highly concentrated, with the four largest banks accounting for 83 percent of total private banking sector assets. These top four banks are all classified as domestic-systemically important banks (D-SIBs) and hence are subject to elevated supervision. The mission’s stress-test analysis showed that the banking system is largely resilient to adverse shocks, largely because of banks’ initial strong capital buffers and profitability. In the adverse scenario, all large banks experience credit losses, but initial high capital and profitability help them remain above the minimum regulatory capital adequacy ratio (CAR) threshold of 10 percent, while, for a few small banks, the CARs fall below the regulatory threshold.
The overall banking system’s profits decline substantially in the adverse scenario, with some banks facing losses, but the aggregate capital shortfall for these banks is modest. The interconnectedness/contagion analysis showed that the joint probability of distress across all banks has fallen since the post-global financial crisis peak level it reached in 2010. However, shocks that affect credit exposures, which are strongly correlated among large banks, have the potential to become systemic events, since the banking system is concentrated.

Peru Selected Indicators Table
Social Indicators       
Life expectancy at birth (years)74.274.474.774.9
Infant mortality (per thousand live births)13.512.912.411.9
Adult literacy rate93.893.794.294.2
Poverty rate (total) 1/23.922.721.820.721.7
Unemployment rate5.
Production and prices       
Real GDP5.
Real domestic demand7.
Real domestic demand (contribution to GDP)
Consumption (contribution to GDP)
Investment (contribution to GDP)3.0-0.9-0.7-1.0-
Net Exports (contribution to GDP)-
Output gap (percent of potential GDP)1.7-0.2-0.9-0.6-1.1-1.1-0.8
Consumer prices (end of period)
Consumer prices (period average)
External sector       
Terms of trade (deterioration -)-5.2-5.4-6.4-
Real effective exchange rate (depreciation -)-0.2-1.60.8-2.41.4n.a.n.a.
Money and credit 2/ 3/       
Broad money15.39.511.
Net credit to the private sector18.313.
Public sector       
NFPS revenue27.727.724.923.223.023.423.9
NFPS primary expenditure25.726.925.924.624.925.425.2
NFPS primary balance2.00.8-1.0-1.4-1.9-2.0-1.3
NFPS overall balance0.9-0.3-2.0-2.5-3.1-3.3-2.7
NFPS structural primary balance 4/0.7-0.3-0.5-1.1-1.5-1.7-1.1
External sector       
External current account balance-4.6-4.4-4.8-2.7-1.3-1.7-1.8
Gross reserves       
 In billions of U.S. dollars65.762.461.561.763.763.764.2
 Percent of short-term external debt 5/536534523450312478454
 Percent of foreign currency deposits at banks274258224230225220222
Total external debt 6/29.934.
Gross non-financial public sector debt 7/19.920.623.924.425.326.627.6
Savings and investment       
Gross domestic investment25.824.924.122.621.421.922.6
 Public sector (incl. repayment certificates)
 Private sector (incl. inventories)20.119.319.117.816.917.117.6
National savings21.220.519.319.920.220.220.8
 Public sector7.
 Private sector14.214.515.617.
Memorandum items       
Nominal GDP (S/. billions)548.2576.5612.7659.7701.8749.0796.9
GDP per capita (in US$)6,6556,5866,1686,2086,7627,1987,533

Sources: National authorities; UNDP Human Development Indicators; and Fund staff estimates/projections.

1/ Defined as the percentage of households with total spending below the cost of a basic consumption basket.

2/ Corresponds to depository corporations

3/ Foreign currency stocks are valued at end-of-period exchange rates.

4/ Adjusted by the economic cycle and commodity prices, and for non-structural commodity revenue. The latter uses as equilibrium commodity prices a moving average estimate that takes 5 years of historical prices and 3 years of forward prices according to IMF World Economic Outlook.

5/ Short-term debt is defined on a residual maturity basis and includes amortization of medium and long-term debt.

6/ Includes local currency debt held by non-residents and excludes global bonds held by residents.

7/ Includes repayment certificates.

[1] Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board.

[2] At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm.
IMF Communications Department