In strong opposition to a proposal by the Japanese Ministry of Finance to tax cross-border repurchase (repo) transactions, John Vogt, executive vice president of The Bond Market Association, says in a letter to Treasury Secretary Paul O’Neill that the proposal, if enacted, could have an adverse short term effect on the availability of U.S. Treasuries and other securities in the U.S. and global repo markets.
If enacted, the Japanese proposal will “reduce the availability of U.S. Treasury securities or federal agency debt and other private label securities such as mortgage-backed securities (MBS) and asset-backed securities (ABS), “the Association’s letter notes. “It will significantly reduce or eliminate one of the few remaining options available to Japanese financial institutions to obtain low-cost financing.”
The Association explains that according to Japan’s Financial Services Agency, no other G-7 nation imposes withholding tax obligations on its financial institutions for cross-border repo transactions. Such tax policy recognizes the fact that cross-border repos are important sources of low-cost funding for financial institutions around the globe.
The limited range of financing options available to Japanese financial institutions have historically been expensive and have not adequately met the financing needs of Japanese banks given their level of creditworthiness, the Association notes. If Japanese banks are unable to adequately finance their operations in general, and their foreign bond investments in particular, Japanese financial institutions may have to severely reduce or shutter such operations. The resulting downgrade in creditworthiness may trigger an even greater Japan premium raising the cost of financing for banks even further, the Association further notes.
The exemption from the withholding tax proposal for cross-border repo transactions utilizing Japanese government bonds (JGB) would not help Japanese financial institutions meet their financing obligations, the Association states. JGBs are not as attractive an investment or source of financing collateral as certain foreign securities such as U.S. Treasuries or agencies. As a result, Japanese financial institutions will be unable tomeet their financing obligations if they are limited to using JGB collateral in cross-border repo transactions. Additionally, JGBs will become a less attractive source of collateral for cross-border repo transactions, creating an additional disincentive for Japanese financial institutions to fund themselves.
Limiting the exemption to foreign government debt will also present numerous problems, the Association points out. Japanese banks will still be limited in the types of securities they are able to utilize in cross-border repos in order to obtain short-term financing. In addition, a withholding tax proposal that only exempts foreign government debt may make it difficult or impossible for Japanese institutions to finance investments in other foreign securities that do not fall within the exemption. As a result, Japanese institutions may be forced to sell off such foreign securities.
Conversely, the proposal could have, at a minimum, an adverse effect in the short term on the availability of U.S. Treasuries, agencies, and other securities such as mortgage-backed securities and asset-backed securities commonly utilized in the U.S. and global repo markets. This, the Association states, will have an adverse effect on the ability of U.S. and global financial institutions to meet their financing and securities delivery obligations.
If the tax proposal discourages Japanese financial institutions from selling U.S. Treasury, agency and corporate debt through cross-border repo transactions to foreign counterparties, these counterparties will have increased difficulty in obtaining adequate supplies of securities, particularly when securities are in high demand, creating a liquiditysqueeze in the financial markets, the Association explains. A liquidity constraint in such securities could have broader economic consequences given the fact that many central banks around the world rely on such securities to conduct their open market operations.
Should the proposal become law, the Association notes that Japanese banks are likely to develop new ways to avoid the tax proposal. For example, a withholding tax on cross-border repos could potentially drive Japanese financial institutions to conduct their repo operations through their foreign branches to avoid the cross-border withholding tax implications.