After the fall: Rebuilding in the post-crisis world
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Large Japanese banks could be susceptible to a global economic downturn after having ramped up their exposure to risky assets in international capital markets, economists said, while noting the country's diverging path from the more cautious global banking environment.
Total outstanding cross-border claims of Japanese banks reached $4.7 trillion in the first quarter, a rise of some $2 trillion since the subprime crisis of 2008, according to the Bank for International Settlements. The country's banking sector is now the largest provider of foreign funding, having stepped into the breach left as European banks reduced their own exposure following the global financial crisis.
Japan's largest, and most globally focused, banks — Mitsubishi UFJ Financial Group Inc., Mizuho Financial Group Inc. and Sumitomo Mitsui Financial Group Inc. — saw margins squeezed in their first fiscal quarter ended June 30, with net interest margins well below 1%.
The Bank of Japan's policy of zero-to-negative interest rates and compressed 10-year bond yields have "driven Japanese banks to expand their foreign activities aggressively," Freya Beamish, chief Asia economist at Pantheon Macroeconomics, said in an interview, with the result being that "banks with non-local currency balance sheets are less stable than those operating in yen."
During the run-up to the financial crisis, Japan largely stayed in the background as European banks' lending surged, reaching 36% of world GDP in the first quarter of 2008. But, while Beamish noted that Japanese banks' foreign currency balance sheets are not as stretched as those of European banks before the crisis, "it is deteriorating, and the changing nature of the global financial system means that the old measures of stability likely do not capture the risks."
As a percentage of GDP, Japanese banks' holdings of nonfinancial corporate sector debt are at their highest since 2000, climbing to 109% in the fourth quarter of 2017, according to the BIS.
In late July, Japan's central bank sought to improve the profitability of domestic financial institutions by reducing the proportion of the financial institutions' deposits that are subject to negative interest rates. But Kaori Nishizawa, a director at Fitch Ratings, said the low interest rate environment remained a key challenge for the bigger Japanese banks already generally isolated from negative rates. "Less than 1% of the ¥11.5 trillion negative interest rate deposits at BOJ — which could reduce to around ¥5 trillion — are from major and regional banks, while 73% are from trust and custodial banks and the remainder from foreign banks, as per end-June data."
Japan's liquidity ratio — high-quality assets divided by estimated funding outflows over a short stress period — was below 100% in 2017, "suggesting it doesn't have the liquid assets to meet funding strains," Beamish said.
An International Monetary Fund research paper published in June on how Japanese banks have been reacting to negative interest rates concluded that the increased risk portfolio "does not presently appear to be a significant concern," even suggesting the BoJ would be happy to encourage risk-taking by what it considered "an overly timid financial system." But Beamish pointed to Japanese banking's "heavy reliance" on swap market funding as a concern, given that swap markets are more volatile than other short-term funding sources such as traditional interbank markets.
She noted that regulatory changes since the financial crisis have contributed to a squeeze on U.S. banks' ability to supply dollar swaps. As a result, entities such as hedge funds and sovereign wealth funds have stepped in and now account for 70% of the supply of foreign currency derivatives to Japanese financial institutions. These entities tend to be known as fair-weather suppliers, meaning liquidity is now even more prone to dry up in times of stress.
The threat is that banks are unable to roll over their short-term dollar funding if pension funds or life insurance firms decide they can achieve better returns elsewhere. This would result in banks having to sell dollar assets and possibly even yen assets to repay loans. "At the very least, if funding pressures escalate, this will force Japanese banks to pull back on dollar lending, damaging global liquidity," she said.
Exposure to China
Lending to emerging-market economies has grown sharply, according to the BIS, surging to $4 trillion in the fourth quarter of 2017, with China alone accounting for 24% of total demand. "After the global financial crisis, European banks gradually pulled back from ASEAN. Asian banks, led by Japanese banks and Singapore's banks, have filled in the gap," wrote Li Wenlong and Simon Liu Xinyi, economists at the ASEAN Macroeconomic Research Office.
The bulk of Chinese corporate debt is not risky, according to the two economists, but there are certain sectors in which credit has built up while profitability and repayment capacities have declined. They said said this applied to sectors at the heart of the country's investment-led growth model, such as state-owned enterprises in steel, mining, utility, transport and manufacturing, as well as some private firms in real estate and construction.
In a June discussion paper on corporate debt, consultancy McKinsey Global Institute wrote that some 30% to 35% of corporate debt in China is associated with construction and real estate. "Credit risks from highly leveraged Chinese corporates can increasingly spill over to foreign investors following the recent opening up of China's debt market," according to McKinsey's research arm.
The Chinese government's crackdown on banks to recognize nonperforming loans added risk to the highly leveraged sectors, destabilizing the banks most exposed to them. Beamish said the highly levered Chinese companies are among those that sought offshore financing after finding a loophole in government rules last year.
Chinese dollar debt issuance spiked last year as authorities cracked down on the country's shadow banking sector. Bonds with maturities of less than one year did not require issuance approval and so cash-hungry companies took advantage of that, despite clear signals from the Federal Reserve that interest rates would rise, making it more expensive to refinance maturing debt. A spate of defaults contributed to recent decisions by the Chinese government to encourage onshore lending once more and slow its crackdown on the shadow banking sector, which has long serviced the construction and real estate sectors.
The level of Chinese debt held by Japanese banks is not easy to gauge, but at this stage, S&P Global Ratings says exposure to Chinese debt is not a key credit factor in assessing Japanese bank creditworthiness.
Marcel Thieliant, senior Japan economist at consultancy Capital Economics, said the international exposure would be to the bigger Japanese banks whereas regional groups are more concerned about shrinking population and potential decline in the number of domestic businesses requiring financial services.
"From a quick look at the international claims data, this doesn't seem to be a major issue. Claims on developing countries in Asia only account for 6% of all foreign claims of Japanese banks," Thieliant said.
But Beamish said the BoJ's decision to ease the pressure on its banking system is partly a recognition of potential systemic problems. "The potential is for Chinese financial fragilities to leak abroad through Japan, and possibly Canada. Then we could start to see this sort of financial multiplier effects, which is why it's important to move to damage control."
As of Sept. 7, US$1 was equivalent to ¥111.16.
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