May 18, 2017 10:00 am JST

Gordon French: As domestic returns wane, Japanese investors should go south

Asia's emerging bond markets can offer a wealth of opportunity

A sign shows the yield on the 10-year Japanese government bond on April 19.

If finance was science fiction, Japanese pension funds and insurance companies would be the inhabitants of a planet where the most precious commodity -- return on investment -- has all but disappeared. Now they must leave behind their familiar planet and search outer space for these elusive returns.

Japan's investors are driven by the inexorable force of demographics, with the country's population expected to shrink from 127 million to about 83 million by 2100, according to official figures. A declining population, deflation and low growth suppress returns from the domestic economy, while the rising average age of Japan's citizens creates an ever-greater need for investment returns to fund retirement plans.

The good news is Japan has plenty of financial resources. The total assets of its pension funds and insurers, combined with the securities investments of its banks, amount to a colossal 1,123 trillion yen ($9.91 trillion), by some estimates.

For decades, much of this was invested in Japanese government bonds. Generating returns by doing that is much more challenging today: Yields are close to or below zero out to 10 years. As a result, these investors turned first to government and investment grade bonds in mature markets such as the U.S. and Europe, which, compared to Japan, offered some incremental yield -- for a while.

But there was a snag. With most of the capital rushing out of Japan, the so-called dollar-yen basis (the cost of using yen to borrow dollars for investment) grew wider and wider, making it more expensive for Japanese investors to fund their portfolios. Then the yen started to strengthen, putting more pressure on returns from foreign investments.

Assailed on all sides by forces beyond their control, are Japanese investors doomed to failure in their mission to find returns overseas? Not necessarily. Let us consider the choices.

CORPORATE COUSINS Many observers expect two more rate hikes from the U.S. Federal Reserve this year, but that still only takes the target range for the Federal Funds rate to 1.25-1.50%. There is little prospect of European rates rising either. The answer for Japanese investors may be to strike out into emerging markets bonds. We are already seeing greater Japanese participation in U.S. dollar bond issuance from emerging markets in Asia, as well as in the international market for privately placed bonds, both in U.S. dollars and Japanese yen.

There are also attractive returns to be found in local currency bonds from China, India and members of the Association of Southeast Asian Nations. The dollar-yen basis is not a problem in these markets. In fact, Japanese investors can turn currency swaps to their advantage with bonds from places such as South Korea, Thailand and -- further afield -- South Africa and Mexico.

So Japanese investors need the returns that emerging bond markets can provide. And emerging markets in Asia need deeper, more efficient bond markets to reduce reliance on bank lending, strengthening capital markets to fund much-needed infrastructure investment. There is a clear convergence of needs here, but the unfinished work of liberalizing and opening up the region's bond markets is preventing more of Japan's capital from being deployed where it is needed around Asia.

Much progress has been made but the development, depth and liquidity of Asian local currency bond markets is restricted by structural issues. With domestic asset management in its infancy in many Asian markets, one issue is limited retail investment.

Savers often prefer to keep their money on deposit at banks, which means that local banks tend to be extremely liquid and happy to do the kind of large-scale, long-term lending that would be funded by the bond markets in many developed economies. There is also a wide variation between markets in terms of taxation of fixed income investments, foreign exchange regulations, settlement cycles, documentation standards and approaches to credit ratings.

All of these factors make entering these markets a challenge for conservative Japanese institutions. But I believe that these investors will continue their exploration of Asian emerging markets bonds in a disciplined and incremental way. Policymakers around Asia should facilitate this by continuing reforms that make their bond markets more investable. For markets across the region seeking long-term funding for growth projects, this is a golden opportunity.

Gordon French is Asia-Pacific head of global banking and markets for HSBC.

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