The Bank of Japan's rare dollar funding operations may have the key side effect of underpinning Japanese banks' overseas lending by relieving some of the distortions stemming from strained money markets. Japanese lenders have stepped into the breach as US and European banks shrank from lending, hobbled by bad debt linked to the collapse of the US mortgage market.
When the crisis took a turn for the worse last month after Lehman Brothers collapsed, the cost of dollar funding shot up even for Japanese banks, which have escaped the worst of the mortgage meltdown, raising the risk that they too could cut lending.
Thus the BoJ's operations to supply dollars are helping keep open a pipeline of credit to the global financial system as it struggles through the worst crisis since the Great Depression of the 1930s. And Japanese lending abroad is at a decade high. "As foreign financial institutions, particularly US, shrank their balance sheets, relatively sound Japanese banks stepped in and filled in for them," said Kiyoshi Iida, senior market economist at Totan Research.
"If the dollar pipeline for Japan is shut, Japanese banks could shrink their overseas lending, further hitting the US economy," he said. The BoJ, which did not join other major central banks in supplying banks with dollars in the first round of co-ordinated operations before last December, joined this time and held its first dollar tenders on September 24.
While the first operation did not draw bids for the total amount on offer, the second dollar injection of $20 billion for three months on Tuesday was expected to find strong demand because it covers the period when banks close their books for the end of the year. The move may partly reflect the BoJ's intention to mend the distortion in Japan's currency swap market, where a lot of market players seek the funding they need in different currencies.
Some market sources said the central bank had asked Japanese banks in Tokyo about dollar demand ahead of its inaugural dollar funding, while several money market traders said mostly Japanese financials participated in the debut dollar tender. "A key reason for conducting dollar funding operations in Japan is to supply dollars for Japanese banks," said a head of the treasury department at a big Japanese bank.
"This is an extraordinary time when markets are disfunctional and even healthy institutions get the brunt of credit jitters. The root cause of the premium we have to pay for dollar funds now is fundamentally different from the 'Japan premium'," he said.
Heightened fears about bank counterparties defaulting after the demise of Lehman Brothers virtually froze the currency swap market as players simply refuse to lend, with the global dollar shortage distorting dollar funding costs even more.
Currency forwards jumped, reflecting an increased forward premium on the dollar as more players used swaps to meet their dollar needs. At the worst point, when the quarter ended on September 30, Japanese banks were willing to pay a record 77 basis point premium to hold three-month dollar LIBOR.
Before the credit crisis broke, that amount was typically near zero because there is typically not much cost involved in swapping yen LIBOR for dollar LIBOR. Scarce liquidity forced Japanese banks to pay extremely high premiums for the dollars they needed to keep and expand overseas lending businesses even when their credit quality was sound.
As of end-July, outstanding loans at overseas branches of Japanese banks stood at 35.7 trillion yen ($343 billion), the highest since August 1999, BoJ data showed. Overseas lending by Japanese banks had steadily risen over the past several years as they wrote off mountains of bad debt from their own banking crisis and bolstered their capital bases.
The BoJ said in a recent report that Japanese banks had increasingly extended loans and credits overseas, while US and European lenders had become more hesitant. "Japanese banks, with abundant yen, have played some role in easing the global credit crunch, lending to overseas firms as foreign banks shrank their exposures," said Tsutomu Hattori, chief manager at Bank of Tokyo-Mitsubishi UFJ's treasury department.
While overseas lending isn't a main business for Japanese banks, it's a promising area that they won't give up easily. "It'll deal a blow to global liquidity circulations and economic activities if the fragile pipeline that has allowed outflows of Japanese money is clogged," Hattori said.
The increased lending also comes as Japanese financial institutions have taken advantage of opportunities created by the crisis, with Mitsubishi UFJ Financial Group taking a 20 percent stake in Morgan Stanley and Nomura Financial Group buying the Asian assets of Lehman Brothers. The BoJ's dollar operations have helped revive the currency forward market by giving incentives for some lenders to lend out dollars to Japanese banks, traders say.
The flip side of a recovering dollar supply is, however, a narrowing gap in dollar and yen forward rates, hitting foreign banks in Japan in need of yen as collateral for cash. "The dollar funding may be helping to revive the forward market, but it doesn't resolve the root cause of counterparty risks," said Masayuki Ebira, director of money markets at Barclays Capital in Tokyo.
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