Unrealized JGB Losses Growing Due to Higher Interest Rates, and Mounting Financial Risks in the Course of Policy Revisions

On November 28, the Bank of Japan released its financial statement for the first half of FY2023. Its total operating profit for the first half of the year came out to 3.44 trillion yen, an increase of 89.3 billion yen from the second half of FY2022. While the depreciation of the yen led foreign exchange-related profits to show a deficit of 268.9 billion yen, the interest on JGBs showed a gain of 206.8 billion yen, while ETF dividends and other profits were up by 121.9 billion yen, and thus the Bank’s operating profit increased in that period.

However, given that the Bank of Japan’s semi-annual financial statements and fiscal year results reveal the market value of the securities in the Bank’s possession, they frequently attract public attention. In July the Bank made an operational tweak to its Yield Curve Control (YCC), leading long-term interest rates to rise, and in turn this led unrealized losses on JGBs held by the Bank of Japan to grow massively from 157.1 billion yen as of March 31, 2023 to 10.5 trillion yen as of September 30. This works out to around 83% of the Bank’s capital base of 12.7 trillion yen, and for an ordinary private bank it would spell a severe situation in terms of financial risks.

The JGBs held by the Bank of Japan are subject to accounting using the amortized cost method on the assumption that they will be held to maturity, and are not subject to fair market valuation. Now, it’s a fact that if the Bank of Japan does hold onto JGBs that have suffered a valuation loss until they mature, no actual loss will be suffered.

However, one must see that the occurrence of a massive unrealized loss carries the risk of damaging the credibility of the Bank of Japan’s monetary policy and financial affairs, as well as the credibility of the country’s currency.

BOJ could be forced to sell its JGBs before maturity

Going forward, if inflation risks were to become more severe, making it necessary for the Bank of Japan not only to raise interest rates but also to shrink its balance sheet (i.e., quantitative tightening), the Bank might have no choice but to sell off its impaired JGBs before maturity. On such occasion, long-term interest rates would also rise further, which means that the Bank’s realized losses would also grow in scale, and its capital base would be significantly damaged.

In addition, depending on the extent of the damage incurred to its capital base, the Bank of Japan may well be forced to receive an infusion of public capital from the government. In that event, given that this could become a public burden, the Bank of Japan’s missteps would face criticism from the Diet and from the general public, and that might conceivably even lead to a debate over revising the Bank of Japan Act in a way that would curtail its independence.

In light of those potential future risks, the unrealized losses on JGBs at the present time can’t really be considered to pose no problem for the public or the financial market. Consequently, the risk of the declining confidence of currency leading to inflation, severe depreciation, and destabilization of the financial market cannot be ignored.

What should be questioned is not future policy revisions but rather past policies

Moreover, one reason that the Bank has incurred these tremendous unrealized losses is that it has inflated its JGB purchases. On the Bank of Japan’s balance sheet, the growth of its outstanding JGB holdings on the asset side corresponds to the growth of the outstanding balance of current accounts held on the liabilities side. As the Bank of Japan proceeds to eliminate its negative interest rate policy and raise policy interest rates, interest payments on current account deposits at the Bank will balloon, surpassing the interest income earned from the Bank’s JGB holdings and consequently putting pressure on its earnings.

In other words, the Bank of Japan’s massive JGB purchases—by way of the growth of its unrealized losses and its deteriorating profit margin—will suddenly bring to the fore all of the financial risks that had thus far been hidden as the Bank moves to revise and normalize its policies.

Given the current state of high prices and the like, policy revisions such as YCC tweaks and the elimination of negative interest rates may appear to be sensible, but the Bank of Japan won’t be able to avoid the potential deterioration of its financial strength in the course of these policy revisions and normalization. The sensibility of the extraordinary financial easing policies it has pursued up to now will likely be called into serious question in the times ahead.

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  Takahide Kiuchi

  Executive Economist