After a prolonged period of quantitative easing (QE), there are tentative signs that Japan may finally join other developed economies in reversing course. The journey towards normalisation is, however, fraught with danger as highlighted by the UK’s example, when inappropriate polices caused a sharp sell-off in sterling and UK government bonds (gilts) that threatened the stability of its pensions system. Could Japan, with a debt-to-GDP ratio of close to 250% and a still fragile economy, be the next country to experience such an event given rapidly rising yields?
The most obvious counterargument is that the Bank of Japan (BOJ) is acutely aware of the risks to financial stability and will only proceed very gradually towards normalisation. In practice, this may be hard to achieve as illustrated by the markets’ reaction to the BOJ’s only limited relaxation of its yield curve control programme at the end of 2022. A scenario whereby the BOJ is forced into a much faster-than-intended exit of its QE programme should not be discounted. On the face of it, such a forced exit could pose a systemic challenge to the Japanese pension system, which would be similar to what occurred in the UK but with even more far-reaching consequences given Japan’s status as the world’s largest net creditor.
While there are some parallels between both countries’ pensions systems and policy dilemmas, there is no simple read-across. On balance, the risk of Japan experiencing something akin to the UK pension crisis appears moderately low, due to differences in valuation methodology and leverage across both pension systems.
Differences in pension sectors
Discount rate — In Japan, the valuation of defined benefit pension fund liabilities is based on a constant discount rate, whereas in the UK it is based on a market-consistent discount rate at the time of the valuation. As such, the value of UK pension fund liabilities can swing dramatically when long-term interest rates move, whereas those of its Japanese peers remain largely stable.
Usage of leverage — Over the years, UK pension funds have faced significant pressure to reduce potentially volatile interest-rate-risk exposure through liability-driven investment (LDI) strategies. The weak funding position of many schemes meant, however, that implementing these hedges involved significant amounts of leverage (as high as three times), using repos and swaps. The sharp jump in UK gilt yields triggered by the UK’s mini-budget caused these swap positions to move into the red. Schemes were forced to sell their liquid assets to cover the ensuing margin calls, creating a vicious cycle that was only stopped by the Bank of England’s intervention. By contrast, Japanese pension funds usually do not rely on derivatives-based LDI strategies, meaning they do not face the risk of unexpected liquidity calls.
Overall, pension funds in Japan tend to have limited leverage. Figure 1 provides a high-level overview of the type and total amount of assets held by Japanese pension funds. It illustrates that Japanese pension funds have historically not been heavy users of derivatives (black line), despite a prolonged period of ultra-low yields, reflecting both risk aversion among pension boards and a lack of in-house operational expertise.