The European Central Bank has warned that if the Bank of Japan winds down its ultra-loose monetary policy, euro zone bond markets risk a sell-off as Japanese investors suddenly pull back.
“If the Bank of Japan decides to normalize its policy, this could affect the decisions of Japanese investors with a large footprint in global financial markets, including euro zone bond markets,” the ECB said in its twice-yearly financial stability review. Indicates Wednesday.
The ECB said the risk of “a sudden exit by Japanese investors from the euro area bond market” was one of many possible threats to the euro area financial system, while it argued that the euro area is likely to remain vulnerable even after the recent banking turmoil in the United States and Switzerland. Still largely resilient.
The Frankfurt-based institution said the impact of a potential policy shift in Japan on euro zone debt markets would intensify because it coincided with the ECB starting to reduce its bond holdings this year.
The Bank of Japan recently dropped its forward guidance that interest rates would remain at or below current levels after the country’s inflation rose at its fastest pace in four decades, marking the first step toward unwinding its ultra-loose monetary policy.
Japanese investors hold large amounts of euro zone government bonds, especially French bonds, and are heavily invested in U.S. Treasuries and Australian bonds.
The ECB said the normalization of monetary policy in Japan could lead to a “rapid narrowing of interest rate differentials and increased exchange rate volatility”, adding that this could “reduce the attractiveness of carry trades” – investors borrowing money at low rates in Japan to invest in Foreign high-yield bonds.
Rising interest rates in Japan could prompt investors to repatriate funds, while “valuation losses in local bond portfolios and higher risk-free rates could dampen investor risk-taking behaviour, including their willingness to invest overseas,” it said.
ECB Vice President Luis de Guindos said the ECB’s recent policy tightening – including a 3.75 percentage point hike in the deposit rate since last summer – “could reveal the fragility of the financial system. “.
He said it was “critical” to monitor such threats, including falling commercial property prices, rising government and bank borrowing costs, rising bankruptcies and reduced liquidity in financial markets.
These increased risks, combined with heightened economic uncertainty, made it all the more important for political leaders to “fully implement banking union” in the single currency bloc by introducing a common deposit guarantee scheme, he said.
The ECB said banks in the euro area had “proven resilience” to the failure of several U.S. banks and the crisis at Credit Suisse, which forced it into the arms of rival UBS, noting the region’s banks’ “strong capital and liquidity” position.
But it warned that there were signs of deterioration in the credit quality of loans on banks’ balance sheets as rising borrowing costs, weak growth and high inflation sparked a rise in bankruptcies. “As such, banks may need to set aside additional funds to cover losses and manage their credit risk,” it added.
The European Central Bank said the housing market in the euro zone was “undergoing a correction”. The recent fall in house prices was “so far orderly”, but it warned it could become “disorderly” if rising mortgage costs continued to hit demand. It added that a downturn in the commercial property market “could test the resilience of investment funds”.