Rush to dollar assets costing Japanese investors dear

Cash-rich Japanese banks are paying almost as much extra to borrow dollars on the currency swaps market as they did when they were fighting for survival two decades ago, due to their insatiable appetite for higher-yielding dollar assets.

Instead of buying dollars in the currency markets, Japanese banks and investors can get dollars by swapping yen loans into dollars using these over-the-counter derivatives instruments, thus avoiding currency risks.

But pricing of the swaps, which in the 1990s was inflated by the mountain of non-performing assets on Japanese banks' books, is now being driven mostly by demand for dollars to fund an overseas investment binge.

The cost of swapping yen to dollars for five years has risen to a two-year high of 73.5 basis points, a level historically recorded only at times of strong financial stress.

The swap spread had been shrinking since late 2011 when six major central banks halved interest rates on their dollar swap agreements in late 2011 to 50 basis points to deal with market stress during the euro zone crisis.

But the spread started rising in the middle of last year even as spreads for other currency pairs such as euro/dollar remained largely stable.

The steady rise in the cost of swapping yen to dollars reflected Japanese investors' stampede into foreign assets, especially high-yielding dollar assets.

"Because returns on domestic products are so low, foreign-currency-denominated stocks and bonds are popular among Japanese investors. Their need for dollar funding is pushing up the cost," said Makoto Noji, senior fixed-income strategist at SMBC Nikko Securities.

Despite an aggressive money-printing programme by the Bank of Japan since late 2012, domestic economic activity remains subdued, and local investments deliver poor returns, which has pushed Japanese investors to look overseas.

In 2014, they bought 12.1 trillion yen ($98 billion) of foreign securities after net sales of 6 trillion yen in 2013.

In the first three months of this year, they bought another 12.1 trillion yen, with heavy buying in stocks, based on balance-of-payments data from the Ministry of Finance.

Japanese were also active in foreign direct investment, spending about 12 trillion yen in each of 2013 and 2014, up about 35% from the preceding two years.

The BOJ stimulus policy was aimed at prodding banks to move away from the safety of government bonds and to take more risks in lending to the private sector, or buy riskier assets such as stocks.

But while bank lending has been growing for the last 3-1/2 years, the growth has been narrowly focused on lending to real estate firms and homebuyers.

The overall economic performance was patchy, with the economy shrinking 1% in the year to March, the first annual contraction since 2009/10. ($1 = 123.0500 yen)