(The opinions expressed here are those of the author, a columnist for Reuters.)
ORLANDO, Florida – The Bank of Japan is taking a more cautious approach to reducing its balance sheet, meaning Japanese capital invested overseas is less likely to be coming home anytime soon.
In the face of heightened economic uncertainty and recent volatility at the long end of the Japanese Government Bond curve, the BOJ announced on Tuesday that it will halve the rate of its balance sheet rundown in fiscal year 2026 to 200 billion yen a quarter.
The central bank began gradually shrinking its bloated balance sheet 18 months ago and last August began an even more gradual interest rate-raising cycle, representing a historic shift after years of maintaining ultra-low and even negative nominal rates.
All else being equal, this modest tightening would be expected to narrow the yield gap between Japanese and foreign bonds, making JGBs more attractive to domestic and foreign investors while also strengthening the yen.
So why hasn’t Japanese capital been coming home? In part, because Japan’s real interest rates and bond yields remain deeply negative, and the latest BOJ move suggests this is likely to remain the case for the foreseeable future.
The prospect of Japanese real returns staying deeply negative is enhanced by current inflation dynamics. Inflation in Japan is the highest in two years by some measures and may prove sticky if Middle East tensions continue to put upward pressure on oil prices. Japan imports around 90% of its energy and almost all of its oil.
Japan’s yield curve could also potentially flatten from its recent historically steep levels if the BOJ’s decision caps or lowers long-end yields. And the curve will flatten further if the BOJ continues to ‘normalize’ interest rates – something BOJ Governor Kazuo Ueda insists is still on the table, although markets think the central bank is on hold until next year.
MARKET MUSCLE
Either way, a flatter yield curve won’t be particularly appealing to Japanese investors who may be considering pulling money out of U.S. or European markets. And there is a lot of money to repatriate, meaning even marginal shifts in Japanese investors’ positioning could be meaningful.
While Japan is no longer the world’s largest creditor nation, having recently lost the crown to Germany after holding it for more than three decades, it still has plenty of financial muscle with a net $3.5 trillion in overseas stocks and bonds, the highest total ever.
Analysts at Deutsche Bank estimate that Japanese life insurers and pension funds hold more than $2 trillion in foreign assets, around 30% of their total assets.
What would prompt Japanese investors to repatriate? In a deep dive on the topic last month, JP Morgan analysts said several stars would have to align, namely a sustainable rise in long-term Japanese interest rates, an improvement in the country’s public finances, and steady yen appreciation against the dollar.
That’s a tall order. But if this were to materialize, and banks and other depositary institutions reverted to pre-‘Abenomics’ asset allocation ratios of 82% domestic bonds and 13% foreign securities, repatriation flows from these institutions alone could amount to as much as 70 trillion yen. That’s just under $500 billion at current exchange rates.
That’s not JP Morgan’s base case though, certainly not in the near term. But over the long term, they think some reversal of the flow of capital from JGBs into U.S. bonds over the last decade or more is “plausible”.
The BOJ’s decision on Tuesday probably makes the prospect of any significant capital shift less plausible, though, at least for now.
(The opinions expressed here are those of the author, a columnist for Reuters)
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(By Jamie McGeever)
