JGB Downgrade

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

Japanese sovereign debt faces not the issue of the Japanese government
not able or willing to pay its obligations.  It is precisely that both
Japanese debt and currency are freeely traded in the open, largely
unregulated market that credit rating must remain above suspicion of
integrity.  Persistent Japanese government budget deficits will and do
impact the prices of JGB (Japanese Gobernment Bonds).  For the past
three years, ever since the BOJ reduced short term rates to zero,
Japanese banks, as well as a host of
international speculators, have been borrowing cost free funds to invest
in 10 year bonds at about 1.3%. The banks have by now 67 trillion yen
($539 billion) in fixed income securities, doubling their holdings in
February 1999 when the BOJ first introduced its zero interest hyperloose
monetary policy.  The banks have sold roughly 10% of their holdings in
the first half of this fiscal year.

This interest rate spread has allowed Japanese banks to earn profits to
cover some of their losses from distressed loans and equity deflation.
Koizumi's cabinet is not expected to be able to keep its promise to cap
new bond issues to finance further deficits.  Banks, already weaken in
their capital base by asset deflation, cannot sustain a sudden collapse
of the bond market.  Under Bank of International Settlement guidelines
to be introduced in 2005, government debt with a single A standing
carries a 20 per cent risk rating, meaning that holders must set aside
capital reserves to cover 20 per cent of the assets. The latest rating
has dropped from AA+ to AA.  Although the local regulator can still
ignore these guidelines, it
would be a serious blow to Japan and its banks' international standing.

There is open political pressure for the BOJ to adopt a reflation
target. Ironically, the bank lobby is most among the most vocal in this
pressure group.  The banks have been selling the JGB holdings as a risk
management move. There is also political pressure to depreciate the yen
to the 150-160 range.  Yet a 148 yen will trigger region wide
competitive currency depreciation, including China's RMB.

With Japan caught in a liquidity trap, zero interest has had the effect
of pushing on a credit string domestically.  But profits are being made
by those who borrow cost free yen to invest in US treasuries, Japanese
deflated real estate and distress debts.   This amounts to a black hole
of unlimited drain on the future of the Japanese economy.  With a
potential yen depreciation, this problem is further exaggerated,
movtiating market participants to borrow yen to invest in instrument
denominated in dollars.  Overseas investors had built up arbitrage
positions between bonds and yen swaps on the assumption swap rates
would not fall below JGB yields. But 10-year swap yields were about 1.3
per cent on Tuesday (Nov. 27), 9.5 basis points below the 10- year cash
JGB yield.  This will prompt liquidation of JGBs against
swaps, leading to serious contagion.

The fact is that Japan, and really the whole world, cannot solve it
financial problems without facing up to the reality that no free market
or regulated markets exist for foreign exchange, credits or even equity
anywhere. Arbitary, secretive and whimiscal intervention on a massive
scale hangs as ever-present threats over the global system of exchange.
Individual self preservation moves and profit incentive will bring the
system crashing down some Tuesday morning.

Henry C.K. Liu