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Japan’s economic conditions have become a significant concern for those in the investment industry as the country faces the perfect storm of economic conditions to batter its conservative fiscal policy.
Until last year, the yen offered a smaller return on investment due to lower interest payments, which meant that the currency was less attractive to foreign investors. Because Japan’s financial sector is heavily entwined with other countries – and is the world’s largest creditor, with trillions of assets held abroad – if it lags financially, it could drag others down with it.
"The ten-year treasury is a pricing benchmark, the action
reverberated through the market.”
In the aftermath of Covid-19 and the energy crisis, the Bank of Japan (BoJ) did not raise rates quickly like other countries did. However, to counter this lack of attractiveness, the BoJ altered the interest rate on the ten-year bond – which is widely used for borrowing across its broader economy – that it had previously capped at -0.25%. This change led to a mass buying scheme up to 0.5%.
“Since, like most countries, the ten-year treasury is a pricing benchmark, the action reverberated through the market,” said Sean Egan, Principal at credit rating agency Egan Jones. “A flurry of foreign exchange options trades occurred, as the market looked for protection against downward moves in the yen/dollar spot rate. The rate fell from 136.91 on December 19 to 132.33 the following day, after the announcement that the central bank would adjust its long-standing yield curve control measure – an indication that a rate rise might be on its way.”
The yen has since fallen against the US dollar partly as a result, and the bank has remained out of sync with the global market. For instance, The US Federal Reserve raised the fed funds rate by 50 basis points to 4.25%-4.5% during its last monetary policy meeting of 2022, which pushed borrowing costs to the highest level since 2007, in line with market expectations.
The annual inflation rate in Japan increased to 4.0% in December 2022 from 3.8% a month earlier – which means the highest reading since January 1991, amid high prices of imported raw commodities and persistent yen weakness. Japan’s economy is expected to grow by 1.1% in 2023.
“Any departure from the policy configuration will need to be validated by
sustained improvement in domestic macro dynamics."
Some market participants have accused the BoJ of doing too little. “December’s tweak by the BoJ was not a prelude to monetary tightening and makes virtually no difference for the real economy in the foreseeable future,” said TS Lombard’s UK Economist, Konstantinos Venetis.
“Any departure from the policy configuration will need to be validated by sustained improvement in domestic macro dynamics. The BoJ’s aim is ‘sustainably achieving the 2% inflation target', and this hinges on a lasting pick-up in wage growth. While things are looking more promising on this front, there is still a long way to go.”
He says further policy adjustments are more likely to be made after the 2023 spring wage negotiations and following a formal policy review under the new BoJ governor when current boss Haruhiko Kuroda’s term expires in April.
Japan is home to several of the world’s largest insurance firms – such as Sompo, Nippon Life, Dai-Ichi Life, Tokio Marine & Nichido, Maiji Yasuda Life, and Mitsui Sumitomo.
The Japanese life insurance market was valued at $272.2 billion in 2021 and could be spared much of the malaise that affects the Japanese economy. In its Japanese Insurance Outlook 2023 report, Fitch Ratings said that it believed Japanese life insurers could generate overall stable earnings even after considering the negative impact of Covid-19 – and that capitalisation is likely to remain at healthy levels over the near future.
“The investment spread has increased as a portion of total earnings, at slightly more than 50%, due partly to the temporarily negative impact on underwriting profits from Covid-19,” it added. “Earnings from profitable protection-type insurance underwriting such as health insurance and death protection, which are quite stable and much more profitable than in most other jurisdictions outside Japan, still represent the major part of life insurers' total earnings.”
Fitch expects Japanese life insurers’ positive investment spread to continue to expand due mainly to several factors that are likely to continue in 2023: for example, the rise in coupon income from insurers' foreign bond portfolios due to the yen’s depreciation versus the US dollar.
“Japanese insurers and other financial institutions have turned net
sellers of foreign bonds over the last year.”
“The biggest risk for Japanese insurers stems from volatility in financial markets, while they will benefit from rising Japanese yen bond yields and the yen’s depreciation versus the US dollar,” said Teruki Morinaga, Director, at Fitch Ratings.
The second factor is that traditional life insurers’ average guaranteed yield is likely to continue to decline, which will be positive for their investment spread. This is a secular trend, because policies with high guaranteed yields – which were sold decades ago – are likely to expire over the next ten years or more. As a result, most life insurers’ investment spreads are likely to be maintained or continue to improve moderately.
“Japanese insurers and other financial institutions have turned net sellers of foreign bonds over the last year,” said Venetis. “In part, this is because of maturity mismatches in their balance sheets: the more pronounced the inversion in the US Treasury curve, the higher the pressure to sell assets in order to cover short-term debt obligations.”
He also noted that as the majority of Japanese insurers’ foreign bond investments are FX-hedged, the sharp increases in the cost of hedging during 2022 are an additional factor behind the propensity to sell foreign bonds.
The Japanese economy was predicted to have a difficult 2023 despite the estimated growth. As of September 2022, Japanese public debt is estimated to be approximately $9.2 trillion, or 266% of GDP – which is the highest of any developed nation. The BoJ holds 43.3% of this debt, a key factor.
“A 1% increase in Japan’s funding cost would cost 12.8 trillion yen and increase its deficit from 48 trillion yen to approximately 60 trillion yen,” said Egan, when asked how the situation could affect investments and overall fiscal policy. “An indication of the sorry situation is the portion Japanese debt service as a percentage of tax revenues, which as of 2010 was at 60%.”
Fitch said that Japanese life insurers are reducing their exposure to currency-hedged foreign bonds because the currency-hedging costs versus the US dollar have risen substantially over the past few months. “Instead, they are steadily increasing their positions of super-long Japanese government bonds,” which are affected by the interest rate rise.
“The medium-term impact, if we assume a change in the
BoJ’s monetary policy, [is] of more concern."
“In addition, their larger positions in super-long government bonds will result in reduced asset-liability management duration mismatch, which is favourable for Japanese insurers as they try to cope with the new economic value-based regulatory regime in Japan from 2025,” they added.
In its November 2022 Japan Life Insurance outlook, UBS said the key points for its sector assessment also listed the near-term impact of higher US interest rates on earnings capability – but also noted that the focus should be on medium-term growth opportunities. “The medium-term impact, if we assume a change in the BoJ’s monetary policy, [is] of more concern."
It also listed the long-term growth potential in protection insurance for longer lifespans (the third-category insurance field). “We identify a risk of a decline in near-term earnings, although this appears to be priced in based on the low valuation multiples.”
