The Problems With Japan's Plan B: The Government Pension Investment Fund's "House Of Bonds"

“So long as public funds ultimately are governed by the government, which is controlled by representatives of the general public, risk tolerance is subject to the general public’s risk tolerance, and the general public’s risk tolerance is not necessarily high. If and when the stock market collapses and performance goes negative for some time, people, the media and politicians will complain loudly… Who exactly is responsible for the future payment of benefits? Those who make the promise today may not be the people to actually deliver on the promise in future decades. It is much easier to make a promise that somebody else is supposed to carry out. Here the future generation is not in a position to sign the contract at all. This is the critical agency problem.

      Yuji Kage, former CIO, Pension Fund Association

Now that the BOJ’s “interventionalism” in the capital markets is increasingly losing steam, as the soaring realized volatility in equity and bond markets squarely puts into question its credibility and its ability to enforce its core mandate (which, according to the Bank of Japan Act “states that the Bank’s monetary policy should be aimed at achieving price stability, thereby contributing to the sound development of the national economy) Japan is left with one wildcard: the Government Pension Investment Fund (GPIF), which as of December 31 held some ¥111.9 trillion in assets, of which ¥67.3 trillion, or 60.1% in Japanese Government Bonds. Perhaps more importantly, the GPIF also held “just” ¥14.5 trillion in domestic stocks, or 12.9% of total, far less than the minimum allocation to bonds (current floor of 59%). 

What the GPIF has going for it is that with a total asset size of just about $1.1 trillion, it is the largest government pension fund in the world. It is almost equal to the size of Korea’s economy, has nearly six times as much assets under management as CALPERS, the biggest US pension fund, and nearly four times as much as Europe’s largest pension plan, Stichting Pensioenfonds ABP of the Netherlands. Which means that the mere whisper of capital reallocation sends assorted asset classes scrambling.

It is this massive potential buying dry powder that has led to numerous hints in the press (first in Bloomberg in February, then in Reuters last week, and then in the Japanese Nikkei this morning all of which have been intended to serve as a – brief – risk-on catalyst) that a capital reallocation in the GPIF is imminent to allow for much more domestic equity buying, now that the threat of the BOJ’s open-ended QE is barely sufficient to avoid a bear market crash in the Nikkei in under two weeks.

There are some problems, however.

The first of which, is that GPIF appears to be a “jack of all trades” when it comes to its potential utility. It was only in March that HSBC wrote in “Japan’s trillion dollar bond rotation” that “there is clearly a bias to shift more public funds into international markets“, and that “Crucially, the GPIF is conducting a review to accelerate divestments in domestic bonds in favour of EM.” Wait, reallocation from domestic bonds into international markets, and specifically bonds? Oh yes, that’s because back then Europe needed backstopping and the mere threat of a Japanese carry trade tsunami was sufficient to send peripheral bond yields plunging to near record lows (despite Europe’s imploding economy).

Fast forward to today, when we now learn that this mythical reallocation from domestic into international bonds has been put on hiatus (PIIGS yields plunging notwithstanding), and has been replaced by a new narrative – one which is suddenly the much more critical, and Abenomics preserving one: reinvesting out of domestic bonds and into domestic stocks, thus providing a backstop to the BOJ. Problem is, cry capital-reallocating wolf enough times, and soon someone will demand to see proof before taking you at your word.

This problem is compounded by another problem: as we wrote several years ago, in 2010, due to the demographic crunch of Japanese society, the GPIF became, for the first time ever, a net asset seller. This can be seen on the charts below.

Worst of all, and as can be very vividly seen on the charts below, not only has the GPIF been consistently leaking assets in the past four years, it has already been actively reallocating away from bonds: in fact, at 60.1% of total assets, the JGB holdings as of December 31 a % of total assets are the lowest they have been in decades (and just above the 59% threshold), while the allocation to domestic stocks has soared from 12.3% in Q3 to 14.5% in Q4: the highest in two years. Just how much dry powder does this pension fund really have before it literally bets the bank on the riskiest of all asset classes, and – in the off chance it bets incorrectly – dooms tens of millions of people to retirement in poverty? So the GPIF needs a reallocation program?  Sounds to us like it needs to invest more into JGBs!

Total GPIF assets:

Relative GPIF assets:

So will the GPIF indeed scramble to reallocate into equities or is this merely the latest bluff in a long series of pseudo-political gambits? Here are some thoughts from HSBC on this issue:

Domestic equities might be an obvious target for the reallocation of assets, especially if the impressive rally in the Nikkei continues. But Japanese investors will be very reluctant to immediately pile into the local stock market. The asset bubble that burst more than 20 years ago left its mark. More than half of households’ USD15trn financial assets were kept in cash as of September 2012 and only 6% in equities, according to BoJ data. Other significant domestic holders of JGBs such as banks and pension funds will also be constrained to match liabilities and meet regulation requirements, implying bond investments, including overseas bonds, are more likely than equity investments.

Well that’s great for Spanish bonds, but does nothing to help what may soon be the next great Japanese equity market bubble. 

But wait, it gets worse.

As we have been showing over the past several weeks, suddenly a far bigger problem that has emerged for Japan is not what happens to the Nikkei, but whether it suffers an out of control collapse in its bond market, and sees a rapid, vicious and sharp sell off in the JGB complex as nearly happened on May 23, the day when the the Nikkei225 crashed. It is this that is the biggest structural threat to Abenomics, not whether or not Mrs. Watanabe will have generated enough money daytrading to avoid the 20% price surge in McDonalds.

So if indeed the GPIF does reallocate into equities (a very big if considering its multi-functional usage depending on the dry-powder threat need du jour), it will have to sell JGBs. Even more than it has sold so far. Which will then precipitate yet another rout in the JGB market, from where we go into such issues as the “VaR shock” we described two weeks ago (a topic the FT caught up with today), and all too real capital losses for Japanese banks who mark JGBs on a MTM basis.

Here is what HSBC had to say on this issue:

There is also an asymmetric risk to JGB yields in the very long term (ie beyond the next couple of years), making diversification compelling on a risk-adjusted basis. If official policies in Japan begin to bite and inflation rises on a more sustainable basis, this would place pressure on interest rates and materially reduce the value of JGBs held by banks. Yet, given the scale of such holdings, reducing exposure to JGBs would be difficult. Japanese financial institutions hold a substantial amount of JGBs. According to the BIS, Japanese banks hold 90% of their tier 1 capital in JGBs. Japan’s largest bank, Bank of Tokyo-Mitsubishi, has already acknowledged that reducing its USD485bn holdings of JGBs would be disruptive for the markets

Wait, what? Let’s read more from the FT, shall we:

Nobuyuki Hirano, chief executive of Bank of Tokyo-Mitsubishi, admitted that the bank’s Y40tn ($485bn) holdings of Japanese government bonds were a major risk but said he was powerless to do much about it.…The risk facing Japanese banks from their vast holdings of government bonds has been underlined by the chief executive of the country’s largest bank who said it would struggle to reduce its exposure.

Well that’s not good: if the largest Japanese bank can’t handle what may soon be concerted selling by one of the largest single holders of JGBs, who can? And what can be done then?

Oh, that’s right: this is where Kuroda’s plea to please not sell bonds, just to buy stocks comes into play. The problem is only the BOJ can come up with money out of thin air, for everyone else buying something, means selling something else first. So unfortunately unless the BOJ wishes to further increase its QE, which will be needed to absorb all the selling without a surge in yields (something Kyle Bass warned about last week), a move which however would further break the connection between bonds and inflation expectations, and further destabilize the equity, FX and bond markets.

So in short: Japan’s Plan B is not only not a panacea, but it is a House of Bonds Cards that would not survive an even modest gust of wind, and an even more modest contemplation into its true internal dynamics. We would urge Messrs Abe and Kuroda to come up with a fall back plan to the fall back plan before it, once again, becomes too late.

Finally, for those who just can’t get enough, we recommend the following piece by James Shinn for Institutional Investor which should explain all lingering questions about what really goes on at Japan’s Plan B.


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