The human, physical and financial toll from Japan’s recent disasters is being assessed by various experts. Fixed income and credit analysts too are trying to calculate the likely costs – and in their case, its effect on Japanese bond markets.
“It’s not obvious that the costs of reconstruction will affect the country’s credit rating. The impact of the earthquake and tsunami on industrial production should be much less than after the Kobe [Great Hanshin] earthquake in 1995,” said Bunt Ghosh, vice-chairman fixed income Asia-Pacific at Credit Suisse.
Early estimates by most analysts suggest that the cost should be less than the ¥10 trillion ($124 billion at today’s exchange rate) bill for post-Kobe rebuilding.
Despite a public debt ratio already of 200% of GDP, “Japan is very well protected by its vast net external savings (around 59% of GDP). It has the cash necessary for re-building, and industrial production should rise rapidly fuelling investment-led growth”, Ghosh added.
Credit Suisse estimates the initial downward effect on Japan’s industrial production to be around 25%, taking into account the impact of power shortages and damage to factories. In its base-case scenario, in which both power supply and manufacturer’s production capacity return to normal by early June, the bank forecasts industrial production to increase by 1.6% for the calendar year. On the other hand, its pessimistic scenario, where neither are normalised until September, would cause an estimated 10% decline in industrial production in 2011.
“Japan’s credit rating was on a negative trend before the crisis, but that trend has not been accelerated – with one serious caveat. The strength of recovery and maintenance of industrial production throughout the country depends very much on the continuity of the power system. The power situation is crucial,” explained Ghosh.
Credit rating agencies say that Japan’s deep and liquid government bond market should be able to absorb the fiscal costs of reconstruction during the next few years without any significant increase in risk premiums.
This is despite warnings by the IMF last month that Japan’s outstanding debt and fiscal deficit was “unsustainable”, and the concerns that the agencies themselves had about the lack of political commitment to solve the problem.
Japan’s sovereign five–year credit default swaps (CDS) traded to 130bp on March 17, before falling to 105bp in Tokyo late the following afternoon, as some confidence grew that the damage to the nuclear power plant in Fukushima could be contained. But, the cost of insurance is still much higher than the 78bp that Japan’s CDS spread was quoted at before the earthquake and tsunami on March 11.
A rise in a CDS index represents worsening perceptions of creditworthiness; if a borrower defaults on its bond payments, a CDS contract will pay the buyer the face value of the underlying securities.
But, yields on short- and medium-dated Japanese government bonds fell last week as the Bank of Japan pumped ¥38 trillion of liquidity into the market. The yield of the five-year benchmark slid to 0.48%, and 10-year yield fell to 1.145%, the lowest since the start of the year, and its premium over five-year yields fell to 70bp. Speculative yen purchases by foreign investors also channelled cash into the bond market, and as domestic investors switched out of domestic equities, according to a Hong Kong-based trader.
Bond price gains were pared back on Friday after the G-7 group of countries said they would jointly intervene to curb the yen’s rise.
Monetary policy easing and a strong central bank bid for short tenor debt are likely to lead to a steepening of the yield curve. The difference between five- and 30-year yields rose to 173bp, the highest since December 7, and could move wider as investors expect the government to issue more than ¥10 trillion of earthquake restoration bonds.
Market disruption might be alleviated by central bank purchases – if the law restricting central bank underwriting proves flexible – which would reduce pressure on long-dated bond yields.
“After the Kobe earthquake, 10-year JGB yields dropped 150bp, yet the yield curve steepened as the Bank of Japan slashed short-term interest rates and injected liquidity into the system. This time as 10-year yields have fallen, the curve has flattened because the short end is anchored [to already very low rates],” said Ghosh.
Meanwhile, the Markit iTraxx Japan index of 50 investment grade companies jumped to 147bp on March 16, compared with 98bp six days earlier. In volatile trading, the contract closed the week at 129bp.
Corporate bond spreads had been narrowing as Japan’s economy showed signs of recovery in recent months and, in particular, since late last year when the Bank of Japan decided to buy investment-grade corporate bonds as part of its monetary easing measures.
Japanese bank capital bonds were especially volatile last week due to the gyrations in the Nikkei index, as investors worried about banks’ equity exposure in general and to Tepco in particular, and feared a deterioration in asset quality. At one point on March 15, some bank capital bonds dived five to seven cash points.
But William Mak, an analyst on Nomura’s credit sales and trading desk, pointed out that “the impact of the earthquake on banks’ asset quality or credit cost should be manageable, given their well-diversified loan book”.
He warned, however, that it is too early to quantify the effect on employment conditions and the property market, which in turn will affect non-performing loans and credit costs.
