Ironically, Japan’s massive debt pile means that the secondary market for its bonds is larger than most other countries, simply by virtue of the vast amounts of bonds that it has to keep issuing in order to roll over its debt.

This provides the repo market with an alternative to US Treasuries; and more importantly, German and Swiss debt. Both of which are issued by governments with strong reputations for fiscal probity, and thus in much smaller amounts.

This perspective also provides another way of understanding why German and Swiss debt have such low (i.e. negative) yields.

Their governments’ aversion towards borrowing naturally means that they issue less debt, while their perceived sense of fiscal responsibility lowers the probability of default in investor’s minds.

The consequence of this is low supply and high demand, especially for use in repo transactions, where the bonds’ negative yields are of less importance than their utility as collateral.

All of which only serves to further highlight the importance of having JGBs as another source of collateral in the global repo market.

Which brings us to an ironic, and quite surprising potential twist in Japan’s saga of over-indebtedness – the country’s own central bank, the Bank of Japan (BoJ), might play a crucial role in accelerating default.

How is this possible?

Simply because of QE.

As with European and American sovereign debt, the supply of JGBs has been reduced (severely, in some cases) by central bank bond buying. The Bank of Japan (BoJ) has been implementing QE for the last 20 years, reducing liquidity in its own domestic bond markets in the process. (The BoJ owned about 48% of all government debt at the end of 2020)

Reduced liquidity in turn reduces the utility of JGBs as collateral in two ways.

Firstly, the people who need or want to purchase JGBs for use as collateral in repo cannot easily do so.

Secondly, repo market participants who accepted JGBs as collateral and want to sell them cannot do so without moving prices sharply in a manner unfavorable to themselves. 

Both these consequences make JGBs less attractive to use as repo collateral, which could in turn lead to severe second order effects such as JGBs losing their collateral premium.

Which is just a fancy way of saying that traders and investors could stop buying JGBs for use in repo transactions, resulting in higher JGB yields, especially at the short end of the JGB curve.

While this is an extreme scenario, considering that JGBs remain the best “safe” asset for Japanese banks and insurers to own (owning other sovereign bonds comes with FX risk, regardless of how highly rated they are), it is not an entirely remote possibility.

The BoJ themselves tacitly admitted as much by recently announcing that they would reduce the amounts they would purchase in order to make trading in the secondary market more active.

Ultimately, the Japanese government’s dependency on being able to roll over its debt puts it at the mercy of market demand.

Moreover, the enormous amount of debt that they have to continuously refinance leaves little margin for an increase in interest rates. If liquidity issues turn out to be the spark that finally blows it all up, the BoJ might end up having to finance an even larger portion of the government’s borrowing.

How would markets react then?