Eurozone bond markets are at risk of a sell-off caused by a sudden retreat of Japanese investors if the Bank of Japan ends its ultra-loose monetary policy, the European Central Bank has warned.
“If the Bank of Japan decides to normalise its policy, this might influence the decisions of Japanese investors who have a large footprint in global financial markets, including the euro area bond market,” the ECB said in its twice-yearly financial stability review published on Wednesday.
The ECB said the risk of “Japanese investors withdrawing abruptly from the euro area bond market” was among the myriad possible threats to the eurozone financial system, while it judged the bloc to be largely resilient even after the recent banking turmoil in the US and Switzerland.
The fallout from a potential policy shift in Japan would be accentuated for eurozone debt markets because it would coincide with the ECB starting to shrink its own bond holdings this year, the Frankfurt-based institution said.
Japan’s central bank recently signalled the first step in unwinding its ultra-loose monetary policy by ditching its forward guidance that interest rates would remain at or below current levels after inflation in the country rose at the fastest rate in four decades.
Japanese investors have significant holdings in eurozone government bonds, particularly French debt, as well as vast investments in US Treasuries and Australian bonds.
The ECB said normalisation of Japanese monetary policy could lead to “a rapid decline in rate differentials and increased exchange rate volatility”, which it said could “reduce the attractiveness” of carry trades — in which investors borrow at low rates in Japan to invest in higher-yielding bonds abroad.
Higher Japanese rates could prompt investors to repatriate money, it said, while “valuation losses on local bond portfolios and higher risk-free rates could inhibit the investors’ risk-seeking behaviour, including their willingness to invest abroad”.
Luis de Guindos, ECB vice-president, said its own recent policy tightening — including a 3.75 percentage point rise in its deposit rate since last summer — “can reveal vulnerabilities in the financial system”.
He said it was “critical” to monitor such threats, including falling commercial property prices, higher borrowing costs for governments and banks, increasing bankruptcies, and lower liquidity in financial markets.
These increased risks, coupled with mounting uncertainty over the economy, made it even more important for political leaders to “fully implement the banking union” in the single currency bloc by introducing a common deposit guarantee scheme, he said.
Banks in the eurozone had “proved resilient” to the collapse of several US banks and the crisis at Credit Suisse that forced it into the arms of its rival UBS, the ECB said, pointing to “strong capital and liquidity” positions among the region’s lenders.
But it warned that there were signs of a deterioration in the credit quality of loans on banks’ balance sheets as higher borrowing costs, weak growth and high inflation triggered a rise in insolvencies. “Banks may therefore need to set aside more funds to cover losses and manage their credit risks,” it added.
Property markets in the eurozone “are undergoing a correction”, the ECB said. Recent house price falls had been “orderly so far”, but it warned that if demand continued to be hit by rising mortgage costs this could become “disorderly”. The downturn in commercial property markets “could test the resilience of investment funds”, it added.
Source: Economy - ft.com
