The Bank of Japan has by now bought up more than 44% of all outstanding Japanese government bonds (JGBs), a quantum leap from 5% in 2011, and more than twice the ratios held by the Federal Reserve or the ECB. An IMF paper provides evidence that rising bond purchases undermine market liquidity, particularly when central bank holdings exceed critical thresholds. The consequences of declining liquidity could be systemic. JGBs are essential for local funding transactions and lower liquidity means higher price volatility. The potential scarcity of JGBs has also raised concerns as to the sustainability of Japan’s ultra-easy monetary policy.

Han , Fei and Dulani Seneviratne (2018), “Scarcity Effects of Quantitative Easing on Market Liquidity: Evidence from the Japanese Government Bond Market”, IMF Working Paper, WP/18/96.

Kobayashi Shun and Toshiyuki Sakiyama (2018), “Liquidity in the JGB Cash Market: An Evaluation from Detailed Transaction Data”, Financial Markets Department, Bank of Japan, Financial Markets Department, Bank of Japan.

The post ties in with SRSV’s summary lecture on the Bank of Japan’s non-conventional monetary policy, particularly the section of “Risks for the financial system”.

The below are mostly quotes from the IMF paper. When they come from the Bank of Japan paper it has been noted. Emphasis and cursive text have been added. Also some key statistics have been updated, based on recent Bank of Japan data.

The importance of the Japanese government bond market

“Deep and liquid Japanese government bond (JGB) markets have contributed to a stable and low yield curve, providing stable and cheap funding for the Japanese government. This is important…given that Japan has the highest public debt in the world relative to the size of economy. [General government debt reached 236% of GDP at the end of 2017, according to the IMF fiscal monitor] of which over 90% are JGBs or short-term Treasury Discount Bills…Nearly 90% of such debt is held by residents.”

JGBs also play a vital role in facilitating funding markets for financial institutions in Japan…The efficiency of funding markets depends heavily on the easy availability of JGBs to facilitate transactions…They are a…used as the collateral in almost all repurchase agreements and in the secured call money market, and are the main instrument used by broker-dealers and other market participants to hedge positions.…[Also, they] are still a vital component of the balance sheets of all financial institutions in Japan, much more so than in international peers [see figure below]. In particular, they account for more than 10% of total bank assets and nearly 40% of the assets of insurance companies and pension funds.

Monetary policy and scarcity concerns

“Central banks in major advanced economies have embarked on quantitative easing programs to provide…monetary easing beyond the zero lower bound and reduce long-term interest rates. As a result, their balance sheets, particularly holdings of domestic government bonds, have expanded rapidly to unprecedented levels.”

The holdings of government bonds by the Bank of Japan (as a share of total amount outstanding) have exceeded the other major central banks. To stimulate economic growth and end deflation, the Bank of Japan (BOJ) launched in April 2013 the quantitative and qualitative monetary easing (QQE) program with unprecedented large-scale asset purchases, most of which were concentrated in JGBs, to expand monetary base and lower long-term interest rates. Until September 2016, purchases were targeted at ¥80 trillion of JGBs per year, equivalent to almost one-sixth of domestic GDP. The large magnitude and protracted duration of QQE have resulted in a dramatic increase in the JGBs held by the BOJ. Although the BOJ reduced the amount of JGB purchases to about ¥40-50 trillion (annualized) as a result of the introduction of yield curve control (YCC) in September 2016, its JGB holdings continued to rise to over [44% of total amount outstanding by June 2018], far exceeding the shares of domestic government debt securities held by other major central banks that have also implemented quantitative easing measures such as the Bank of England (25%), European Central bank (22%), and Federal Reserve (17%).”

“Quantitative easing can…reduce market liquidity when the increase in the central bank’s holdings of certain securities leads to a scarcity of those securities and hence higher search costs in the market…Scarcity effects could dominate other [monetary policy] effects when the share of the BOJ’s holdings exceeds certain thresholds.”

“Interest in liquidity and functioning of the JGB cash market by market participants is rising. For example, results from Bond Market Survey on the JGB cash market reveal a considerably large portion of responses claiming that market function is ‘low’…In Bond Market Group meetings, opinions on difficulty of transactions were expressed, especially concerning the difference in liquidity by issue.” [Bank of Japan]

Evidence of scarcity effects

“The rapid expansion of the BOJ’s balance sheet appears to be associated with signs of potential scarcity in the JGB markets. JGB trading in most maturities seems to have been negatively impacted by BOJ purchases, as investors have become increasingly reluctant to sell bonds out of their remaining portfolios…Both the number and amount of fails in JGB transactions have trended upward and become more volatile since 2013…The BOJ has been conducting the Securities Lending Facility (SLF) through repos since 2004 to provide the markets with a temporary and secondary source of Japanese government securities.”

“This paper uses the estimated bid-ask spreads developed by Corwin and Schultz (2012)…[These are] based on the observation that daily high (low) prices are almost always buyer-initiated (seller-initiated) trades. Hence, the ratio of high price over low price (the high–low ratio) reflects both the variance of the security and its bid-ask spread. Although the former component increases proportionately with the length of the trading interval, the latter does not—allowing us to derive a spread estimator as a function of high–low ratios over one-day and two-day intervals. Specifically, the sum of the price ranges over two consecutive single days reflect two days’ volatility and twice the spread, while the price range over a two-day period reflects two days’ volatility and one single spread. Therefore, the difference between the sum of the high-low ratios from two consecutive single days and the high-low ratio from the respective two-day period reflects a single bid-ask spread.”

“The Corwin-Schultz bid-ask spreads are estimated for each JGB issue at the bond level as well as at the maturity level for ‘on-the-run’ JGBs….There appears to be a gradual increase in the measure after the implementation of QQE in April 2013… Many market participants attributed the decline in JGB market liquidity, at least partly, to the scarcity of JGBs in the market.“

The consequences of bond scarcity

Deterioration in…JGB market liquidity tends to be associated with a higher volatility in the JGB markets. There is a positive correlation between the S&P/JPX JGB VIX index—a measure of the implied volatility of JGBs—and the Corwin-Schultz measure of JGB market liquidity since the GFC …The average correlation between the two is about 0.5 during 2008–17.”

“There appears to be a positive or U-shaped relationship between the Corwin-Schultz measure of JGB market liquidity and the share of the BOJ’s holdings for some maturities….In fact, a U-shaped relationship also appears to exist in a cross-country context between the market liquidity of domestic government debt securities and the share of these securities held by domestic central bank…implying that market liquidity tends to decline when the share of domestic sovereign bonds held by the central bank increases once it exceeds a certain threshold…This mechanism is also consistent with the empirical finding from the mortgage-backed securities market in the United States that the effects of quantitative easing on market liquidity was first positive but turned negative later after QE3 as the scarcity associated with the large-scale purchases by the Fed increased.”

“[The] key variable in the empirical analysis is a measure of the scarcity of JGBs in the market at the bond level…We use the share of each JGB issue held by the BOJ to approximate the degree of scarcity… Results from the maturity-level regressions tend to suggest a negative impact of the BOJ’s outright purchases on the market liquidity of 2-10 year JGBs… Moreover, the maturity-level results for 2-10 year JGBs seem to be consistent with the theoretical prediction of a U-shaped relationship between JGB market liquidity and the share of the BOJ’s holdings.”

“Results from the bond-level fixed-effects panel regressions lend support to [two hypotheses]…

  • Hypothesis 1: The BOJ’s outright purchases have significantly negative (flow) effects on JGB market liquidity.
  • Hypothesis 2: The flow effects of the BOJ’s outright purchases on JGB market liquidity become negative when the share of the BOJ’s holdings exceeds a certain threshold.”
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Ralph Sueppel is founder and director of SRSV Ltd, a research company dedicated to socially responsible macro trading strategies. He has worked in economics and finance for almost 25 years for investment banks, the European Central Bank and leading hedge funds. At present he is head of research and quantitative strategies at Macrosynergy Partners.