Tanweer Akram (Voya Investment Management)Anupam Das (Mount Royal University)

12th International Post Keynesian Conference (Sep 25-Sep 27, 2014)University of Missouri Kansas City (UMKC)Kansas City, Missouri, USA

The Determinants of Long-Term Japanese Government Bonds’ (JGBs) Low Nominal Yields

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Japan’s Government Indebtedness Has Risen Sharply, But ...

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… Long-term JGBs’ Nominal Yields Declined in the Mid 1990s and Since Then Have Stayed Remarkably Low

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Motivation and the Main Research Question

The Japanese economy has been mired in slow growth that has resulted in large and chronic fiscal deficits (net borrowing) leading to elevated and rising government debt (financial liabilities) ratios. But long-term JGBs’ nominal yields have stayed remarkably low and declined over time.

The conventional wisdom holds that higher government deficits and indebtedness will exert upward pressure on nominal yields (Baldacci and Kumar 2010, Lam and Tokuoka 2011, Tokuoka 2012, Gruber and Kamin 2012, and Poghosyan 2012).

Why have long term JGBs’ nominal yields stayed ultra low?

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The Determinants of Long-term JGBs’ Low Nominal Yields

Monetary sovereignty

Low short-term interest rates

Low inflation and indeed persistent deflationary pressures

Tepid economic activity

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What is Monetary Sovereignty?

A government with monetary sovereignty has the following characteristics (Wray 2012, p. 30):

Sets its own unit of account

Issues liability denominated in that unit of account

A monopoly issuer of unconvertible financial means of payment denominated in that unit of account

The authority to tax and to determine what is accepted in payment of taxes that it imposes

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The Government of Japan Retains Monetary Sovereignty

The Government of Japan clearly: sets yen as the country’s unit of account issues liabilities only in yens is the monopoly issuer of unconvertible

final means of payment denominated solely in yens

has the authority to tax and accepts only yens in payment of the taxes that it imposes.

Hence, it has monetary sovereignty.

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JGBs Are Merely Promises to Deliver More of Its Own Liabilities!

Following Woodford (2001, p. 31), as cited in Tcherneva (2010, p.15), it can be paraphrased that for any sovereign government that issues debts in its own currency, such as Japan, its debt is merely a promise to deliver more of its own liabilities in the future.

There are, hence, no operational barriers for the government of Japan to service its debt. As such, Japanese authorities are theoretically free from obsessing about fiscal consolidation. (In contrast the euro zone countries and the state governments of the U.S. have no monetary sovereignty.)

The liabilities of governments that retain monetary sovereignty and are currency issuers are fundamentally different from that of households, businesses, and governments that do not possess sovereignty and hence are currency users.

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Christopher Sims and “Paper Money”

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Nominal Debt Merely Promises Costless “Paper”

Christopher Sims (2013) has argued that the following:

“since nominal debt promises to pay only costless paper, it is never necessary for it to default”

“a central bank with the fiscal backing from a Treasury that can issue nominal debt is the most powerful form of a lender of last resort”

“The effects of monetary policy actions depend on … fiscal policy actions they stimulate …”

“Nominal and real government debt are quite different, as are inflation and outright default.”

“Central bank ‘independence’ should not mean that all connections between monetary and fiscal policy authorities are severed.”

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Hypothesis: Low Short-term Interest Rates Have Kept Long-term JBGs’ Nominal Yields Low

Low short-term interest rates, induced by the monetary authorities, have been a key driver of JGBs’ low nominal yields, while monetary sovereignty implies that the Government of Japan has the ability to always service its debt issued in its own currency.

Japan’s experience of JGBs’ low nominal yields under extremely accommodative monetary policy and ultra low policy rates vindicates Keynes’s (1930) view that long-term interest rates primarily respond to monetary policy which exerts its direct influence on short-term interest rates.

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Keynes’s Insights on LT Government Bonds’ Nominal Yields

The central bank usually sets the overnight rates and various other short-term policy rates. This was well understood by John Maynard Keynes (1930), as cited in Kregel (2011).

Fundamental uncertainty about the future and the effect of short-term realization on long-term expectations can keep long-term interest rates largely in harmony with short-term interest rates.

Keynes’s (1930) conjectures, as cited in Kregel (2011), on long-term interest rates were based on his interpretation of the empirical research of Reifler (1930).

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Short-term Interest Rates Follow the Bank of Japan’s Policy Rates

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Persistent Deflationary Trend Since Early 1990s

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Economic Activity Has Been Stagnant Since mid 1990s

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Notations

The long-term government bond yield, rLT

The short-term interest rate, rST

The forward rate, fST,LT-ST

The future short-term interest rate, rF

The term premium, z The expected rate of inflation, E, and the current rate of inflation, The expected rate of economic activity, 𝒚𝑬, and the current rate of

economic activity, 𝒚

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The Yield of a LT Government Bond Depends on the ST Interest Rate and the Appropriate Forward Rate

1 + 𝑟𝐿𝑇𝐿𝑇 = (1 + 𝑟𝑆𝑇 )

𝑆𝑇(1 + 𝑓𝑆𝑇,𝐿𝑇−𝑆𝑇 )𝐿𝑇−𝑆𝑇

𝑟𝐿𝑇 = ɸ 𝑟𝑆𝑇 , 𝑓𝑆𝑇,𝐿𝑇−𝑆𝑇

𝑓𝑆𝑇,𝐿𝑇−𝑆𝑇 = 𝜏 𝑟𝐹 , 𝑧 = 𝛾 𝜋𝐸 , 𝑦𝐸 = 𝛾 𝜆 𝜋 , 𝜅 𝑦

𝑟𝐿𝑇 = ɸ 𝑟𝑆𝑇 , 𝛾 𝜆 𝜋 , 𝜅 𝑦 = 𝜗 𝑟𝑆𝑇 , 𝜋, 𝑦

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ST Interest Rates and Current Conditions Affect LT Government Bonds’ Nominal Yields

The short-term interest rate directly affects the long-term government bonds’ nominal yield.

The forward rate depends on the future short-term interest rate and the term premium, which depend on inflation expectations and growth expectations.

However, investors’ expectations of the rates of inflation and economic activity are respectively influenced by the current of rate inflation and the current rate of economic activity. The near term views almost always affect investors’ long-term economic and investment outlook.

The short-term interest rate decisively determines the long-term government bonds’ nominal yields.

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Monthly and Quarterly Data

Short-term interest rates, %: Treasury Bills 3 month (TB3M), and Treasury Bills 12 month (TB12M)

Inflation year over year, %: Inflation ex food & ex energy (CINF), Inflation ex fresh food (CFINF), and General inflation (INF)

Industrial production, year over year, %: IP

Japanese Government Bonds’ (JGBs) nominal yields, %: JGB2YR, JGB3YR, JGB5YR, JGB7YR, JGB10YR, and JGB20YR

Public finance variables as a share of nominal GDP, % (quarterly): Gross financial liabilities (GROSSDEBT), Net financial liabilities (NETDEBT), and Net borrowing/lending (BALANCE)

Data sources: Bank of Japan, Statistics Bureau of the Ministry of Internal Affairs & Communication, Ministry of Economy, Trade, and Industry, OECD, Reuters; Thomas Reuters EcoWin

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Unit Root Tests: Stationary Variables

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However Debt Ratios & Deficit Ratios Are Not Stationary

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Main Empirical Findings

The coefficients of short‐term interest rates, whether using T‐bills of 3 months or 12 months, are positive and always statistically significant. It implies that JGBs’ nominal yields are extremely sensitive to short-term interest rates.

The coefficients of the rates of core inflation are positive and statistically significant but moderate in magnitude. It implies that as core inflation picks up (decline) JGBs’ nominal yields rise (fall).

The coefficients of the growth of industrial production are positive but low and statistically insignificant. This implies that JGBs’ nominal yields are fairly insensitive to the pace of economic activity.

The Hansen (1982) J test for over identifying restrictions is used to check for the validity and relevance of instruments. The Hansen’s J statistic is insignificant in most cases, which means that the test does not reject the null hypothesis that the instruments are uncorrelated with the error term.

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Results Using GMM, With 3 Month T-Bills

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Results Using GMM, With 12 Month T-Bills

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Results Using 2SLS, With 3 Month T-Bills

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Results Using 2SLS, With 12 Month T-Bills

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Conclusions

Long-term JGBs’ nominal yields have stayed low because of low overnight and shot-term interest rates, low observed inflation and persistent deflationary pressures, muted inflationary expectations, and tepid growth and Japan’s monetary sovereignty.

Low short-term interest rates, which are really the outcomes of monetary policy, are the primary drivers of long-term government bonds’ low nominal yields.

Monetary sovereignty entails that the government of Japan can always service its yen denominated government bonds.

Highly accommodative monetary policy and ultra-low policy rates have kept JGBs’ nominal yields low in spite of elevated government debt ratios and chronically high fiscal deficit ratios.

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This Presentation is Based on Recent Papers

Akram, Tanweer, and Das, Anupam (2014a). “Understanding the Low Yields of the Long-Term Japanese Sovereign Debt,” Journal of Economic Issues 48(2): 331-340.

Akram, Tanweer , and Das, Anupam (2014b). “The Determinants of Long‐Term Japanese Government Bonds’ Low Nominal Yields,” unpublished working paper.

Akram, Tanweer (2014). “The Economics of Japan’s Stagnation,” Business Economics 49(3): 156–175.

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