View from City Road: Hedge funds small fry next to Japanese

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The blame for turning the bond market fall this year into a rout should be put at the door of Japanese investors. Those notorious hedge funds were just a sideshow.

As the costs of the February market crisis emerge day by day in the mid- year results of Swiss Bank Corporation, HSBC and the like, the quarterly review of the Basle-based Bank for International Settlements confirms that the Japanese were the international investors who really panicked.

Of course, the root cause of the crash was a tightening of American monetary policy. But the BIS report casts new light on what happened next, by analysing the enormous flows in international banking and securities markets during the first quarter, when most of the dealing losses were racked up.

It finds a prime cause of this turmoil was heavy sales of securities by investors worldwide, but in particular there was a 'major reduction' in holdings of foreign securities by investors in Japan.

An idea of the scale of the Japanese sales in February and March can be had from the banking repercussions. As Japanese investors sold bonds and fled into cash, which they put on deposit, their domestic bankers were able to reduce borrowings from Europe by dollars 34bn.

Some of the sales proceeds were also recycled from Japan to the US. And as investors everywhere plumped for the safety of cash, banks in the US, Germany, Switzerland and France experienced net inflows of funds of more than dollars 90bn at the expense of Japanese and to a certain extent British banks. The total outflow through the Japanese banking system in the first quarter was put at dollars 77bn.

Meanwhile, derivatives were beating all records as dealers fought to unwind loss-making bets on interest rates or to hedge against renewed turmoil in the markets. Interest rate contracts traded on futures exchanges rose 73 per cent in the six months to June, against a year earlier.

The BIS reports that in April, Japanese investors started buying again. But by then the damage was done, and banking markets were bracing for the next crisis - the surge in the yen that emerged in June. With financial flows on these scales, governments become helpless spectators.