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Japan Towards Credit Crunch Relief Currencies Foreign Holdings of US Agencies and the Dollar View GEF Archive

		The Global Economics Team

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The centerpiece of the government’s JPY11.7 trillion all-round package of emergency stimulus is JPY9.1 trillion in assistance for SME (small and medium-size enterprise) funding. This includes some subsidies effectively for certain industries that are hit by high fuel costs, but the market impact of the package lies in the financing assistance. It is unclear whether the measures will have the desired effect, but we can hope that this will bring some relief for the small businesses, where banks have adopted somewhat of a tougher credit stance under a system of shared responsibility for lending risk introduced last October.

Expecting Banks’ Credit Stance to Ease

The content of the funding relief in the Cabinet Office’s press release is 1) smoother financing for the SMEs and mom-and-pop businesses, 2) introduction of a new credit guarantee system (which offers emergency guarantees in the event of sharp rises in raw materials prices, for example), and 3) a strengthened safety net for loan access. The first measure demands that financial institutions (upon request) provide SMEs and small firms with easier access to loans, and calls for the FSA to improve its investigative response to further the mediating function of the financial system. This part simply exhorts further effort, and may not in itself improve efficiency.

By contrast, the second measure calls for extending the system of credit guarantees to the SMEs and small firms. The credit guarantee system is known as ‘maruho’, and banks, etc. have so far been lending to the SMEs in a proactive manner on the understanding that the loans are covered by the credit guarantee corporations (CGCs). Involvement of guarantors means additional fees for the business borrower, but the access to a relatively easily available and inexpensive public guarantee has led to extensive use of the system by the SMEs and small firms.

The credit guarantee system already covers some special provisions for firms in deteriorating business sectors, and the new emergency guarantees in the event of sharp rises in raw material prices represent another example. The new system comes alongside a number of safety net guarantees and appears to be premised on 100% loan backing. This should do something to ease the credit stance of banks towards small businesses, which has tightened somewhat since the implementation last October of a system of shared responsibility for lending risk (lowering the risk exposure of the CGC to 80% of the loan; more later).

However, the measures above are far removed from the money provided without meaningful oversight by the Obuchi administration in 1998-99 (as discussed later) – there is a credit review at the CGC and bank that needs to be passed. Measure (3) is an extension of the function of systemic lending by government-affiliated SME-financing institutions such as the Japan Finance Corporation for Small and Medium Enterprises, and does not represent free money either.

So this time the financing assistance takes careful account of moral hazard, and is a response to the observed increase in bankruptcies at the SMEs and small businesses which have been denied credit.

This Is Not the Special Guarantee System of the Past

It’s worth running over the differences between these recent measures and the special guarantees provided by the Obuchi government. The JPY30 trillion guarantee system in 1998 was replete with moral hazard, as banks supplied loans backed by credit corporation guarantees without any check (free money) to the SMEs and small businesses. This did a lot to alleviate the credit crunch. Small business owners with no use for special funding were said to have taken out loans and spent the money on IT stocks and golf club memberships, stoking the 1999 IT bubble. However, to the extent that such policy response is effective, it also involves moral hazard. The special guarantee system ultimately added to the fiscal burden, as the government lost money on investments due to a sharp rise in bankruptcies of SME debtors covered under the guarantee.

Shared Responsibility System and a Safety Net Guarantee

The above lesson led to a system of shared responsibility implemented last October, which is the antithesis of the earlier approach. As the name implies, the lending risk under the new system is shared, with 80% shouldered by the CGC and 20% by the bank, which provides a safeguard against moral hazard. But at the same time, this has prompted banks to be cautious when lending to small businesses even under acceptable conditions, and this may have influenced the funding situation of these smaller firms (see Credit Crunch Coming, January 7, 2008).

So alongside this new system created to ease funding problems, the new economic package also brings a wider range of safety net guarantees of different types.

Safety net guarantees lie outside the shared responsibility system, and have been used, as the name says, to provide a safety net for the SMEs that cannot access CGC-backed loans. Originally, about 70 sectors were designated as eligible for credit support based on criteria such as sales performance, but the number has almost doubled in the wake of the errant policy-induced housing shock that followed last year’s revision of the Building Standards Law. The eligibility of a debtor is decided by the external criterion of whether it is included in the specified industries and whether sales are down more than 5%Y for the latest three months, but the number of industries covered could rise as the recession deepens.

In this case, we think that the credit guarantee system might not differ much in effect from the 100% guarantee that pre-dated the shared responsibility system. It cannot be completely denied that a policy backlash may have had something to do with it, but the timing of the introduction of this shared responsibility system coincided closely with the peak of the economy and, regardless of the merits or otherwise of the system, was unfortunate from the timing perspective.

Where We Differ from the Market’s View

The JPY400 billion in government spending to tackle tight funding conditions will be invested in the government-affiliated financial institution that underwrites reinsurance in the credit guarantee system (specifically SME public financing corporations such the Japan Finance Corporation for Small and Medium Enterprises, to be reconstituted in October as the Japan Policy Finance Corporation). If there is a 5% delinquency rate, this implies that the lending framework covered by economic policy will expand to JPY8 trillion, but this JPY400 billion need not lead directly to JGB issuance. This is because it is not essential to use cash to provide this funding in the initial phase. What could happen is that the government provides financial contribution or delivery bonds to this institution, and then when a loan actually turns sour, the finance corporation for the SMEs would cash in the bond received at the time it pays out on reinsurance. This is just speculation on our part, however. The fiscal authorities appear to be considering using construction bonds instead to avoid issuing more deficit-financing bonds, but this seems logically inconsistent, in our view.

It is also arguable whether this JPY400 billion sum can be counted as part of the ‘real water’ of the package (the amount that contributes directly to incremental demand). The JPY8 trillion framework of guaranteed loans created assumes that banks will actually lend this amount, and even if they do, the loans will not necessarily directly increase demand (GDP).

Policy and Market Implications

The market is voicing concern about deterioration in supply and demand stemming from extra JGB issuance. In fact, the downturn in the economy will inevitably lead to a shortfall in tax revenues for F3/09, and even if the supplementary budget does not incorporate additional issuance, the second supplementary budget expected around year-end would need to do so, in our view. Also the government has made a clear commitment to a fixed amount of tax cut during F3/09, separate from its economic measures; however if, as we think possible, it decides to fund its spending with financial contribution or delivery bonds rather than deficit-financing or construction bonds, increased issuance in the near term at least could be avoided.

If the system works and banks relax their credit stance, this might apply a brake to the current upswing in bankruptcies caused by funding problems. Since credit worries are an element dampening the stock market now, this could have a market impact. However, it is questionable how far the credit guarantee system can respond to real estate lending, given that this increase in funding-related bankruptcies is heavily skewed toward sectors like real estate to start with.

Risks

Policy effects and fiscal discipline are contradictory. Obuchi’s government in 1998 implemented an extreme system of special loan guarantees, which had a huge impact because there was effectively no accompanying oversight, but did damage to Japan’s fiscal base. What’s different this time is that there are credit checks by the CGCs and banks, but this may dilute the stimulus effect correspondingly, in our view.

The resignation of PM Fukuda has also thrown the political situation into a state of flux and created the risk that a snap election could be held without a supplementary budget in place. But our main scenario is for an LDP leadership election on September 22, nomination of a new PM and formation of a new cabinet at an extraordinary session on September 24, and then priority given to passing the supplementary budget through the lower house in mid-October. Since this supplementary budget would automatically take effect 30 days after the Lower House approval, regardless of the Upper House’s stance, the budget could be in place around mid-November, by our estimation.

There is also a real possibility that if the LDP succeeds in lifting its support ratings amid the LDP leadership election fever, it could dissolve the lower house immediately after passing the supplementary budget. In that event, the general election could be held on November 23, and the second supplementary budget would be a matter for the new administration. The scale of the income tax cuts which the government has announced separately would then depend on the make-up of the next administration.

Currencies
Foreign Holdings of US Agencies and the Dollar
September 08, 2008

By Stephen Jen | London

Summary and Conclusions

The US GSE turmoil has global implications, because of the large agency holdings by foreign central banks.  Our view is that most foreign central banks will likely avoid investing more in US agencies in the months ahead, but will increase their buying of US Treasuries instead.  This uncomfortable substitution is only possible because the US still commands the most liquid and deep financial markets in the world and, in times of global turmoil, the dollar is still the currency to hold, especially for EM (emerging market) central banks.  Also, the fact that the world is still experiencing aggregate excess savings should help fill US financing needs.  However, over the long run, we believe that the US – both the public and private sectors – will need to fundamentally reform and restructure in order to continue to attract foreign capital. 

Some Basic Facts about Foreign Agency Holdings

According to latest US Treasury data (see Preliminary Annual Reports on US Holdings of Foreign Assets and Foreign Holdings of US Assets, August 29, 2008), foreigners demonstrated a huge appetite for USD assets in 2007.  Total foreign holdings of long-term USD securities increased from US$7.8 trillion in 2006 to US$9.8 trillion in 2007, with US$1.3 trillion of this annual increase from increased foreign holdings of US long-term debt securities, including US Treasuries, agencies, agency ABS and corporate bonds.  Foreigners are dominant in some of these markets.  For example, some 57% of the marketable Treasury securities are held by foreign investors. 

Foreign investors’ appetite for US agencies – both straight agency debt and agency-backed ABS (also called agency pass-throughs) – has risen sharply.  (Fannie Mae and Freddie Mac (F&F) are government-sponsored enterprises (GSEs) with two main activities.  First, they securitise mortgages by converting conforming mortgage loans into tradable mortgage-backed securities (MBS).  Second, they have an ‘investment portfolio’ business, whereby they issue AAA rated agency debt to finance the holding of MBS or other assets.  The latter is a ‘carry trade’, capitalising on the then-implicit government guarantee.  One key part of the policy discussion regarding F&F is whether their second activity is justified.)   Of close to US$7.5 trillion in outstanding US agency debt and agency-backed ABS, some US$1.54 trillion (according to Fed flow of funds data, June 2008) is held outside the US, with China, Japan and AXJ being the largest holders of these securities, with US$985 billion of this latter figure held by foreign central banks. (The share of total US long-term securities held by foreign investors has more than doubled since 1994 (from 7.9% of the US$16 trillion in securities back then to 18.8% of the US$49 trillion outstanding as of 2007).  We illustrate how the geographical composition of foreign holdings of long-term agency debt has changed in the past five years.  While there is no clear breakdown between holdings by the central banks and the rest of the economies, our guess is that, for Asia, most of these assets could be held by central banks, though state-owned enterprises and private banks also have some agency holdings. 

We have the following thoughts:

•           Thought 1.  Central banks have been stunned by the recent developments.  Asian central banks are among the largest holders of these securities.  China (both public and private sectors), for example, has US$376 billion of long-term agency debt, in addition to US$467 billion of long-term Treasury holdings, according to the US Treasury data.  Japan has US$229 billion of agency debt and US$553 billion of long-term US Treasuries.  Given that these are survey data, these are likely to be underestimates of the real figures.  For example, China and Japan’s official reserves are US$1.8 trillion and US$1.0 trillion, respectively.  If we assume that 65% of China’s reserves and 90% of Japan’s reserves are held in USD, the corresponding USD holdings for China and Japan should be US$1,160 billion and US$900 billion, respectively, which exceed the reported total countries’ holdings of long-term US debt by 40% and 15%, respectively.  Specifically, China and Japan could have more US Treasury and agency debt holdings than captured by the Treasury data, or the difference is held in short-term (less than one year in maturity) assets.  In any case, paper losses on these holdings are substantial, and Asian central banks may not be too pleased about the volatility in the agency debt market.  While the US has domestic reasons to sort out the GSEs, this ‘customer complaint’ may also help to pressure the US to reform the GSEs.  (Incidentally, with the explicit government guarantee on the agency debt, this may actually be the time for Asian central banks to buy more agencies.) 

•           Thought 2.  Foreign central banks still love the US Treasuries, though.   While most non-US central banks have ceased, for the time being, to buy new agency debt products, they have substituted their appetite for USD assets with US Treasuries.  We illustrate the almost full offset between these two assets in recent weeks. 

•           Thought 3.  Excess savings in the world make it easy for the US to get external financing.   We have written in the past (see The Burgeoning Global Savings Glut & Risky Assets, January 8, 2008) that the pace of the compression in the US savings-investment (S-I) deficit is faster than the pace of compression of the S-I surpluses of the rest of the world.  This, we argued, was why the global real long-term interest rate remains low.  The US non-oil trade deficit shrank from 4.4% of GDP in 2005 to 3.0% of GDP in 2Q08; oil trade now accounts for close to half of the US overall trade deficit.  However, with oil prices being better contained, the improvement in the US external balance should become more evident.  At the same time, the oil-exporting countries and Asian exporters continue to run outsized external surpluses.  Normalisation of the US C/A deficit has helped the US fill its external financing needs. 

•           Thought 4.  Central bank ‘liquidity problems’ in interventions.  In recent years, some central banks have been quite actively diversifying out of the US Treasuries and into agency debt and agency-guaranteed MBS.  The soft conditions in the agency debt market suggest that many central banks may wish to hold these securities to maturity, rather than being forced to realise the losses by selling them into a soft market.  But now that the AXJ currencies are under pressure, Asian central banks are being challenged to stabilise their currencies through intervention.  The question is whether some of these central banks have enough reserves in the right underlying asset, i.e., do they have too much exposure to agency debt for them to intervene effectively?  Without going into specifics here, our view is that this ‘liquidity issue’ may be legitimate for at least one central bank in Asia.  It is not that they will run out of USD reserves held in Treasuries soon, but rather that these holdings are a much smaller fraction of their overall official reserves and have a greater need to be conserved than many may think.  Suspecting this vulnerability, speculators and domestic corporates could become more aggressive in testing the central banks’ resolve by pushing the USD higher. 

Bottom Line

Though not happy with the market volatility, foreign central banks are likely to be tolerant of the developments of the US GSEs.   Foreign central banks and large banks have essentially stopped buying new agency debt, but are not selling them, either.  Instead, they have increased their buying of US Treasuries.  Depending on the resolution and reforms of the GSEs, this may or may not remain an asset foreign central banks find attractive.  In any case, for the time being, we believe that the dollar will remain supported as foreign financing will remain ample, even if foreign central banks have stopped buying agency debt.

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