## _wp11292

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---

### I. Introduction
- Despite gross public debt rising to over 200 percent of GDP, 10-year JGB yields remained around 1.0–1.2 percent after the March 2011 earthquake.
- Auctions since the earthquake were met with steady demand across key maturities from banks and life insurers.
- Key medium-term concern: market capacity to absorb new debt likely to diminish as population aging reduces household saving and risk appetite; without significant policy adjustment, the stock of gross public debt could exceed household financial assets in around 10 years.

### II. Near-term Domestic and External Risks
- Domestic risks:
  - Decline in supply of funds for financing JGBs as private spending for reconstruction picks up.
  - Increase in market volatility could induce banks to shorten maturities or reduce JGB exposures.
- External risks:
  - High correlation between JGB yields and other sovereign debts implies that a sudden rise in global risk premia could spill over into the JGB market.
- Potential outcome: sustained rise in yields, worsening public debt dynamics, and risks to financial stability.

### III. Decline in Fund Supply — Structure and Quantities
- Non-financial sectors’ balance (end-2010):
  - Financial assets held by private corporate and household sectors: ¥2,275 trillion (450 percent of GDP).
  - Excess of assets over liabilities: ¥840 trillion (about 170 percent of GDP).
- Domestic financing share: nearly 95 percent of the stock of JGBs financed domestically.
- Household deposits since 2000: increased by ¥40 trillion (8 percent of GDP).
- Corporate loans since 2000: declined by about ¥100 trillion (20 percent of GDP).
- Bank of Japan JGB purchases: currently at ¥21.6 trillion per year on a gross basis.
- Household financial assets currently at 300 percent of GDP.
- Corporate financial surpluses in 2010: 7 percent of GDP.

### IV. Demand Function Estimation — Impact of Loans and Deposits
- Estimated equation: govtsec = β1 loans + β2 deposits + β3 control variables, where govtsec = banks’ holdings of central government securities (JGBs and FBs), loans = bank loans, deposits = corporate + household deposits (all in percent of GDP).
- Granger causality:
  - Decline in loans leads to an increase in govtsec (first differences: hypothesis that loans do not Granger-cause govtsec rejected at the 1 percent level; reverse causality not rejected at the 10 percent level).
- Regression findings (sample period: Q4 1997-; dependent variable: banks’ holdings of central government securities):
  - A 1 percent of GDP increase in loans reduces banks’ holdings of central government securities by 0.3–0.6 percent of GDP.
  - A 1 percent of GDP decline in deposits cuts banks’ holdings by 0.5–0.9 percent of GDP.
  - Table 1 (selected estimates):
    - loans coefficient examples: -0.56; -0.35; -0.42.
    - deposits coefficient examples: 0.86; 0.67; 0.51.
    - Num of obs: 53; R-squared: 0.75, 0.86, 0.96, 0.97 across specifications.
- Interpretation and scenarios:
  - If corporate net repayment and deposit accumulation cease and corporate financial surpluses decline by 4 percent of GDP, banks’ net government security purchases could fall by 1–3 percent of GDP, compared with annual net government debt issuances around 10 percent of GDP.
  - A decline in corporate surpluses does not necessarily raise JGB yields if it is accompanied by stronger domestic demand and higher tax revenues that reduce fiscal deficits (historical precedent 2003–07: yields stayed below 2 percent).
  - Corporate overseas expansion could reduce corporate surpluses held in bank deposits; outward M&A reached 3 trillion yen (0.6 percent of GDP) in first six months of 2011.
  - Projected fiscal deficit narrowing may be limited: authorities’ plan narrows overall fiscal deficits by only 3 percent of GDP over next 5–6 years versus 5½ percent of GDP in 2003–07.
  - Household portfolio shifts: if households’ net purchases of securities (excluding government securities) and shares return to 2 percent of GDP (2007 level), banks’ purchases of government securities could fall by 1½–2 percent of GDP through slower deposit accumulation.
- Historical yield sensitivity:
  - Historical data suggest immediate impact on yields from a decline in corporate financial surpluses even to zero would be at most about 10 basis points.
  - Yields’ response could be nonlinear and larger once public debt exceeds certain thresholds.

### V. Market Volatility — Banks’ Exposures and Triggers for Unwinding
- Banks’ JGB holdings increase since mid-2008: ¥40 trillion (8 percent of GDP); outstanding JGB holdings rose to ¥150 trillion (more than 15 percent of banks’ total assets).
- Average maturity of banks’ JGB holdings shortened to about 2 years in FY2010 (from 3.2 years in 2002–03); regional banks hold longer maturity JGBs (~3½ years).
- Potential triggers for a JGB unwind:
  - Further shortening of maturities in response to higher interest rate risk and volatility.
  - Banks’ risk management thresholds (VaR-type models): example of June 2003 ‘VaR shock’ when 10-year JGB yields more than tripled over three months.
- Returns context:
  - Average annual returns: JGBs provided higher returns than alternative investments for Japanese investors during certain periods; nominal returns from U.S. Treasuries in yen terms were negative at times due to yen appreciation and narrowing interest differentials.
- Risks to the JGB market and domestic channels:
  - Banks’ JGB holdings are significantly larger than 10 years ago despite strengthened risk management and inclusion of qualitative assessment in VaR models.
  - Rating downgrade risk: a further rating downgrade or a series of weak JGB auctions that push up yield volatility could induce banks to reduce duration of JGB holdings or sell JGBs to limit losses.
  - Rollover risk:
    - Government’s annual financing requirement now amounts to about 55 percent of GDP (including financing bills)—the highest among advanced economies.
    - Average maturity of JGBs is still around 5½-6 years (including financing bills).
    - Authors’ estimates: average maturity rose from 4.7 years at end-FY2005 (March 2006) to 5.8 years at end-FY2010.
  - Historical episode: the “VaR shock” — rise in volatility increased risk measures in banks’ internal VaR models and led to one-sided selling by banks.

### VI. Global Spillovers and Market Linkages
- Sensitivity to global risks:
  - Correlation between 10-year JGB returns and U.S. Treasuries ranges from 0.37 to 0.58.
  - Correlation coefficients for entire sample (Jan 2000 - May 2011): 10-year US Treasury yields 0.58; 10-year German bond yields 0.37; average yields of adv. countries 0.49.
  - Before Jan 2008: US 0.61, Germany 0.19, average 0.44. After Lehman crisis: US 0.62, Germany 0.87, average 0.75.
- Foreign participation and derivatives:
  - Foreign ownership of JGBs is low at 5 percent of total outstanding, but foreign investors hold about one-third of outstanding JGB futures contracts.
  - Distress sell-offs in the futures market could affect the JGB cash market given close arbitrage links.
  - Overseas financial distress could lead to a rise in global yields, amplifying pressures on JGB yields through derivatives markets.
- Empirical causality:
  - Granger-causality tests show movements in global yields generally precede those of JGBs; reverse causality from JGB yields to global yields is not statistically significant.

### VII. Quantified Sensitivities from Regressions and Volatility Effects
- Regression results (Sample period: Jan 2006 - May 2011; dependent variable: 10-year JGB yields):
  - Coefficients (first lags; standard errors in parentheses):
    - 10-year U.S. Treasury yields: 0.16 (0.01)
    - 10-year German sovereign bond yields: 0.10 (0.02)
    - Implied volatility of JGBs: 0.05 (0.00)
    - Equity returns (Nikkei): -0.07 (0.03)
    - Term premium: 0.14 (0.05)
  - Interpretation examples:
    - A one percentage point increase in U.S. Treasury yields could increase JGB yields by nearly 15 basis points.
    - A rise in implied volatility similar to what took place after the Lehman crisis could push up JGB yields by more than 40 basis points, holding other variables constant.
  - Post-crisis: JGB yields were more closely driven by U.S. Treasury yields after the global financial crisis.
- Sovereign CDS spillovers:
  - A one-percentage rise in the composite CDS spreads in advanced countries could raise Japan’s CDS spreads by 30 basis points.
  - Sample period May 2009 - June 2011 regressions (dependent variable: 5-year Sovereign CDS for Japan) show coefficients on 5-year sovereign CDS spreads (advanced countries) of 0.49 (0.07) to 0.30 (0.09) across specifications.
  - Global equity returns and implied volatility also correlate with Japan’s CDS spreads.

### VIII. Banking System Exposure and Interest Rate Risk
- Banks hold a large amount of JGBs (more than 15 percent of total assets, excluding Japan Post Bank).
- BOJ estimates for FY2010:
  - A 100 basis point increase in interest rates across all maturities increased the value of interest rate risk (including from loans) by around ¥500 billion at major banks and about ¥400 billion at regional banks.
  - The total value of interest rate risk corresponds to 10 percent of major banks’ tier-1 capital and more than 30 percent of regional banks’ tier-1 capital.
- Probability-based distress model results:
  - Potential impact from a hypothetical sovereign distress event on Japanese financial institutions has significantly risen compared to pre-global financial crisis periods.
  - Drivers include higher JGB holdings in the financial system and higher sensitivity of market investors to linkages between sovereign risk and financial institution distress.

### IX. Fiscal Vulnerability and Scenario Implications
- Medium-term finance capacity concern: without policy adjustment, gross public debt could exceed household financial assets in around 10 years.
- Quantitative reference points:
  - Gross public debt: over 200 percent of GDP.
  - Household financial assets: 300 percent of GDP.
  - Annual BOJ gross JGB purchases: ¥21.6 trillion.
  - Banks’ increased JGB holdings since mid-2008: ¥40 trillion.
  - Banks’ outstanding JGB holdings: ¥150 trillion (>15 percent of total assets).
  - Corporate outward M&A in first six months of 2011: 3 trillion yen (0.6 percent of GDP).
  - Corporate financial surpluses in 2010: 7 percent of GDP.
  - Potential reduction in banks’ net government security purchases from a 4 percent of GDP decline in corporate surpluses: 1–3 percent of GDP.
  - Annual net government debt issuances in recent years: 10 percent of GDP.
- Fiscal sustainability under yield shock:
  - If sovereign yields rise by 100 basis points over the next 5 years, the net debt-to-GDP ratio would remain at high levels over the long term, even after a 10 percentage points of GDP adjustment in the structural fiscal balance between 2010-20.
  - Scenario assumptions referenced:
    - Yields hike by 100 basis points gradually over 5 years between 2011-16.
    - Nominal interest rate growth differential assumed to converge to 225 basis points over the long term (125 basis points pre-global financial crisis average since 2000 + 100 basis points).
    - 10 percentage points of GDP improvement of the structural primary balance assumed between 2010-20 in the adjustment scenario.

### X. Policy Recommendations and Conclusions
- Stabilizing and reducing public debt is critical to maintaining confidence in the JGB market because factors holding down JGB yields could diminish over time.
- To limit risks from declining fund supply, higher market volatility, and global spillovers:
  - Fiscal policy should aim to reduce public debt quickly.
  - Given limited scope for expenditure cuts, fiscal adjustment should take a balanced approach that involves both raising revenue and curbing expenditure growth.
  - Lengthening maturities of JGBs would lock in low interest rates and reduce rollover risks.

*Source: IMF working paper content (text and tables provided).*

### References .............................................................................................................

### _wp11292 - References

### I. Introduction
- Despite gross public debt rising to over 200 percent of GDP, 10-year JGB yields remained around 1.0–1.2 percent after the March 2011 earthquake.
- Auctions since the earthquake were met with steady demand across key maturities from banks and life insurers.
- Key medium-term concern: market capacity to absorb new debt likely to diminish as population aging reduces household saving and risk appetite; without significant policy adjustment, the stock of gross public debt could exceed household financial assets in around 10 years.

### II. Near-term Domestic and External Risks
- Domestic risks:
  - Decline in supply of funds for financing JGBs as private spending for reconstruction picks up.
  - Increase in market volatility could induce banks to shorten maturities or reduce JGB exposures.
- External risks:
  - High correlation between JGB yields and other sovereign debts implies that a sudden rise in global risk premia could spill over into the JGB market.
- Potential outcome: sustained rise in yields, worsening public debt dynamics, and risks to financial stability.

### III. Decline in Fund Supply — Structure and Quantities
- Non-financial sectors’ balance (end-2010):
  - Financial assets held by private corporate and household sectors: ¥2,275 trillion (450 percent of GDP).
  - Excess of assets over liabilities: ¥840 trillion (about 170 percent of GDP).
- Domestic financing share: nearly 95 percent of the stock of JGBs financed domestically.
- Household deposits since 2000: increased by ¥40 trillion (8 percent of GDP).
- Corporate loans since 2000: declined by about ¥100 trillion (20 percent of GDP).
- Bank of Japan JGB purchases: currently at ¥21.6 trillion per year on a gross basis.
- Household financial assets currently at 300 percent of GDP.
- Corporate financial surpluses in 2010: 7 percent of GDP.

### IV. Demand Function Estimation — Impact of Loans and Deposits
- Estimated equation: govtsec = β1 loans + β2 deposits + β3 control variables, where govtsec = banks’ holdings of central government securities (JGBs and FBs), loans = bank loans, deposits = corporate + household deposits (all in percent of GDP).
- Granger causality: decline in loans leads to an increase in govtsec (first differences: hypothesis that loans do not Granger-cause govtsec rejected at the 1 percent level; reverse causality not rejected at the 10 percent level).
- Regression findings (sample period: Q4 1997-; dependent variable: banks’ holdings of central government securities):
  - A 1 percent of GDP increase in loans reduces banks’ holdings of central government securities by 0.3–0.6 percent of GDP.
  - A 1 percent of GDP decline in deposits cuts banks’ holdings by 0.5–0.9 percent of GDP.
  - Table 1 (selected estimates):
    - loans coefficient examples: -0.56; -0.35; -0.42 (standard errors shown in table).
    - deposits coefficient examples: 0.86; 0.67; 0.51 (standard errors shown in table).
    - Num of obs: 53; R-squared: 0.75, 0.86, 0.96, 0.97 across specifications.
- Interpretation:
  - If corporate net repayment and deposit accumulation cease and corporate financial surpluses decline by 4 percent of GDP, banks’ net government security purchases could fall by 1–3 percent of GDP, compared with annual net government debt issuances around 10 percent of GDP.
  - A decline in corporate surpluses does not necessarily raise JGB yields if it is accompanied by stronger domestic demand and higher tax revenues that reduce fiscal deficits (historical precedent 2003–07: yields stayed below 2 percent).
- Risks to the “good” scenario:
  - Corporate overseas expansion could reduce corporate surpluses held in bank deposits; outward M&A reached 3 trillion yen (0.6 percent of GDP) in first six months of 2011.
  - Projected fiscal deficit narrowing may be limited: authorities’ plan narrows overall fiscal deficits by only 3 percent of GDP over next 5–6 years versus 5½ percent of GDP in 2003–07.
  - Household portfolio shifts: if households’ net purchases of securities (excluding government securities) and shares return to 2 percent of GDP (2007 level), banks’ purchases of government securities could fall by 1½–2 percent of GDP through slower deposit accumulation.
- Historical yield sensitivity:
  - Historical data suggest immediate impact on yields from a decline in corporate financial surpluses even to zero would be at most about 10 basis points.
  - Caveat: yields’ response could be nonlinear and larger once public debt exceeds certain thresholds.

### V. Market Volatility — Banks’ Exposures and Triggers for Unwinding
- Banks’ JGB holdings increase since mid-2008: ¥40 trillion (8 percent of GDP); outstanding JGB holdings rose to ¥150 trillion (more than 15 percent of banks’ total assets).
- Average maturity of banks’ JGB holdings shortened to about 2 years in FY2010 (from 3.2 years in 2002–03); regional banks hold longer maturity JGBs (~3½ years).
- Potential triggers for a JGB unwind:
  - Further shortening of maturities in response to higher interest rate risk and volatility.
  - Banks’ risk management thresholds (VaR-type models): example of June 2003 ‘VaR shock’ when 10-year JGB yields more than tripled over three months.
- Returns context:
  - Average annual returns: JGBs provided higher returns than alternative investments for Japanese investors during certain periods; nominal returns from U.S. Treasuries in yen terms were negative at times due to yen appreciation and narrowing interest differentials.

### VI. Implications and Scenarios
- Medium-term finance capacity concern: without policy adjustment, gross public debt could exceed household financial assets in around 10 years.
- Near-term scenario:
  - Moderate declines in corporate/household surpluses likely to exert modest upward pressure on yields (historical estimate: up to about 10 basis points).
  - Nonlinear risk: once debt crosses thresholds, funding shocks could produce larger yield responses and financial stability risks.
- Quantitative reference points:
  - Gross public debt: over 200 percent of GDP.
  - Household financial assets: 300 percent of GDP.
  - Annual BOJ gross JGB purchases: ¥21.6 trillion.
  - Banks’ increased JGB holdings since mid-2008: ¥40 trillion.
  - Banks’ outstanding JGB holdings: ¥150 trillion (>15 percent of total assets).
  - Corporate outward M&A in first six months of 2011: 3 trillion yen (0.6 percent of GDP).
  - Corporate financial surpluses in 2010: 7 percent of GDP.
  - Potential reduction in banks’ net government security purchases from a 4 percent of GDP decline in corporate surpluses: 1–3 percent of GDP.
  - Annual net government debt issuances in recent years: 10 percent of GDP.

*Source: IMF working paper content (text and tables provided).*

### 0.5 percent to 1.6 percent (Figure 4).

### _wp11292 - 0.5 percent to 1.6 percent (Figure 4).

### Risks to the JGB market and domestic channels
- Banks’ JGB holdings are significantly larger than 10 years ago despite strengthened risk management and inclusion of qualitative assessment in VaR models.
- Rating downgrade risk:
  - A further rating downgrade or a series of weak JGB auctions that push up yield volatility could induce banks to reduce duration of JGB holdings or sell JGBs to limit losses.
  - Such bank actions could lead foreign investors to unwind positions in the futures and swaps markets.
- Rollover risk:
  - Government’s annual financing requirement now amounts to about 55 percent of GDP (including financing bills)—the highest among advanced economies.
  - Average maturity of JGBs is still around 5½-6 years (including financing bills) despite recent lengthening.
  - Authors’ estimates: average maturity rose from 4.7 years at end-FY2005 (March 2006) to 5.8 years at end-FY2010.
  - Large amounts of bonds to be rolled over mean increases in uncertainty over supply and demand could disrupt absorption of new issuances and push up JGB yields.
- Historical episode: the “VaR shock” (Bank of Japan, 2010) — rise in volatility increased risk measures in banks’ internal VaR models and led to one-sided selling by banks.

### Global spillovers and market linkages
- Sensitivity to global risks:
  - JGB yields are sensitive to global risks such as investors’ risk appetite.
  - Correlation between 10-year JGB returns and U.S. Treasuries ranges from 0.37 to 0.58 (Table 2).
  - Correlation coefficients for entire sample (Jan 2000 - May 2011): 10-year US Treasury yields 0.58; 10-year German bond yields 0.37; average yields of adv. countries 0.49.
  - Before Jan 2008: US 0.61, Germany 0.19, average 0.44. After Lehman crisis: US 0.62, Germany 0.87, average 0.75.
- Foreign participation and derivatives:
  - Foreign ownership of JGBs is low at 5 percent of total outstanding, but foreign investors hold about one-third of outstanding JGB futures contracts.
  - Distress sell-offs in the futures market could affect the JGB cash market given close arbitrage links.
  - Overseas financial distress could lead to a rise in global yields, amplifying pressures on JGB yields through derivatives markets.
- Empirical causality:
  - Granger-causality tests show movements in global yields generally precede those of JGBs; reverse causality from JGB yields to global yields is not statistically significant.

### Quantified sensitivities from regressions and volatility effects
- Regression results (Sample period: Jan 2006 - May 2011; dependent variable: 10-year JGB yields):
  - Coefficients (first lags; standard errors in parentheses):
    - 10-year U.S. Treasury yields: 0.16 (0.01)
    - 10-year German sovereign bond yields: 0.10 (0.02)
    - Implied volatility of JGBs: 0.05 (0.00)
    - Equity returns (Nikkei): -0.07 (0.03)
    - Term premium: 0.14 (0.05)
  - Interpretation examples:
    - A one percentage point increase in U.S. Treasury yields could increase JGB yields by nearly 15 basis points.
    - A rise in implied volatility similar to what took place after the Lehman crisis could push up JGB yields by more than 40 basis points, holding other variables constant.
  - Post-crisis: JGB yields were more closely driven by U.S. Treasury yields after the global financial crisis.
- Sovereign CDS spillovers:
  - A one-percentage rise in the composite CDS spreads in advanced countries could raise Japan’s CDS spreads by 30 basis points.
  - Sample period May 2009 - June 2011 regressions (dependent variable: 5-year Sovereign CDS for Japan) show:
    - Coefficient on 5-year sovereign CDS spreads (advanced countries): 0.49 (0.07) to 0.30 (0.09) across specifications.
    - Coefficients indicate global equity returns and implied volatility also correlate with Japan’s CDS spreads.

### Banking system exposure and interest rate risk
- Banks hold a large amount of JGBs (more than 15 percent of total assets, excluding Japan Post Bank).
- BOJ estimates for FY2010:
  - A 100 basis point increase in interest rates across all maturities increased the value of interest rate risk (including from loans) by around ¥500 billion at major banks and about ¥400 billion at regional banks.
  - The total value of interest rate risk corresponds to 10 percent of major banks’ tier-1 capital and more than 30 percent of regional banks’ tier-1 capital.
- Probability-based distress model results:
  - Potential impact from a hypothetical sovereign distress event on Japanese financial institutions has significantly risen compared to pre-global financial crisis periods.
  - Drivers include higher JGB holdings in the financial system and higher sensitivity of market investors to linkages between sovereign risk and financial institution distress.

### Fiscal vulnerability and scenario implications
- Fiscal sustainability under yield shock:
  - If sovereign yields rise by 100 basis points over the next 5 years, the net debt-to-GDP ratio would remain at high levels over the long term, even after a 10 percentage points of GDP adjustment in the structural fiscal balance between 2010-20.
  - Scenario assumptions referenced:
    - Yields hike by 100 basis points gradually over 5 years between 2011-16.
    - Nominal interest rate growth differential assumed to converge to 225 basis points over the long term (125 basis points pre-global financial crisis average since 2000 + 100 basis points).
    - 10 percentage points of GDP improvement of the structural primary balance assumed between 2010-20 in the adjustment scenario.

### Policy recommendations and conclusions
- Stabilizing and reducing public debt is critical to maintaining confidence in the JGB market because factors holding down JGB yields could diminish over time.
- To limit risks from declining fund supply, higher market volatility, and global spillovers:
  - Fiscal policy should aim to reduce public debt quickly.
  - Given limited scope for expenditure cuts, fiscal adjustment should take a balanced approach that involves both raising revenue and curbing expenditure growth.
  - Lengthening maturities of JGBs would lock in low interest rates and reduce rollover risks.

*Source: _wp11292 - 0.5 percent to 1.6 percent (Figure 4).*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11292.pdf_