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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.
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 (light-blue line), despite a prolonged period of ultra-low yields, reflecting both risk aversion among pension boards and a lack of in-house operational expertise.
Foreign investors also worry that heightened domestic or international volatility could force Japanese pension funds into a fire sale of their foreign assets, but that concern ignores the critical role of these foreign assets in a typical Japanese pension portfolio. For instance, Japanese public pension funds invest roughly 25% each in domestic and foreign bonds as well as domestic and foreign equities. Given that these foreign holdings are such a crucial part of their strategic portfolio allocation, it is unlikely that Japanese pension funds will sell these foreign bonds outright for the time being. Instead, any future fund flows are likely to occur through rebalancing activity between each cohort of their target allocations.
In summary, the Japanese pension sector is unlikely to face a systemic crisis as seen recently in the UK given key differences between both systems, most notably valuation methodology and derivatives usage. This is not to say that the sector is immune to the potential market stress that may accompany Japan’s exit from QE. However, any uptick in volatility is expected to be temporary and far from a systemic shock.
Bank of Japan policy shift: Waiting for the other shoe to drop?Continue reading
Bank of Japan policy shift: Waiting for the other shoe to drop?
Client Portfolio Manager Jitu Naidu and Investment Director Masahiko Loo share their take on the consensus view that Japan has reached several key inflection points.