Japan call market learning to live with kinks

TOKYO (Reuters) - If the past couple of weeks are any indication, Japan's money dealers are learning to live with occasional market glitches that can send overnight call rates shooting well above the Bank of Japan's target.

Money market players wrapped up the fiscal year that ends this month with positive short-term rates for the first time since 1998, as the BOJ scrapped its zero interest rate policy in July and raised rates again to a decade-high 0.5 percent last month.

Overnight call rates surged to around 0.80 percent on Friday, compared with a weighted average of 0.506 percent on Thursday.

But dealers said the rise was not as sharp as previously feared, as players have become more adept at dealings under positive rates after undergoing a few monthly reserve maintenance periods, a fiscal half-year-end and a calendar year-end.

"There has been a shift in market sentiment over the past few weeks, with the impression that offerers have become more eager to lend even in days leading up to the fiscal year-end, when players tend to get cautious," said a manager at a regional bank.

"Fund flows have become more balanced at last and we feel the market mechanism is working in the right direction," he said.

Traders said a wider range of financial institutions were participating in the market, including Japan Post JP.UL, which had rarely been seen offering funds, despite holding huge surplus funds, when call rates were at 0.25 percent.

Insurers and regional banks also began offering in the market more actively last week, dealers said.

Overnight call rates and repo rates began to ease over the past week and a rise in rates on BOJ tenders settling in the new fiscal year was moderate, suggesting that banks were planning cash positions well in advance to avoid last-minute funding.

The lowest accepted rate on the BOJ's funding operation from Friday to Tuesday was a surprisingly low 0.67 percent, traders said.

"There was no sense of panic about funding among borrowers who cannot directly raise cash from the BOJ," said a managing director at a U.S. investment bank. "Dealings were pretty calm, with bid/offer rates sticking around 0.75 percent," he said.

The 0.75 percent level is the rate on the BOJ's Lombard lending facility, which serves as the ceiling for call rates and other interbank lending rates.

FOREIGN FUND DEMAND

Friday's market tightness was due to some foreign banks scrambling for a small amount of funds as Japanese offers thinned, traders said.

"The jump in overnight rates is an appropriate reflection of a market tightness typical of a fiscal year-end and offers a healthy insight into what rates players must anticipate if they don't plan cash positions well in advance," said a senior trader at a big Japanese bank.

Traders said subdued activity by some European banks, which had periodically tapped the market for huge amounts of funds and put sharp upward pressure on call rates, also helped cap rates.

Traders said the banks may have been urged to improve their risk management as they tended to ignore predictions of daily fund flows in Japan's call market or fund volumes they could raise in light of their credit lines and collateral they own.

But dealers said they remained wary of sporadic foreign fund demand persisting in view of discrepancies between overnight rates in Japan and those in the euroyen market, where short-term yen funds trade in London. Those discrepancies will continue to allow some more aggressive foreign banks, mainly European, to make money on the difference, making Japan's call market more volatile in the process, they said.

Traders said rates on yen cash briefly hit 2.25 percent in the euroyen market on Thursday, though the impact on Japan's call market this session was limited, probably due to the small lot.

"They may be boosting direct dealings or asking their foreign peers to raise funds on their behalf, so we aren't relaxed about their behavior," said a senior dealer at a big Japanese bank.

Why these European banks need so much yen has puzzled dealers and experts.

The BOJ said in a recent report that foreign financial institutions were using cash raised in the overnight call market to buy yen assets like short-term government bills.

As foreign institutions seek arbitrage opportunities across yen interest-rate markets, tightness in the overnight call market is also influenced by whether they raised enough funds in the euroyen market, or whether there were favorable currency swap rates, the BOJ said.

Currency moves also affect swings in overnight call rates as movements in foreign exchange rates determine the cost of swapping the dollar into yen, the report said.

Experts have been cautious about directly linking a rise in call rates due to foreign funding demand to the carry trade because the cash is used for various purposes beyond such trade, in which investors fund in low-yielding currencies like the yen to buy higher-yielding currencies and assets.

When global stock market plunges unsettled financial markets in late February, some said rising Japanese call rates prompted the unwinding of carry trades.

But many experts doubted if risk-takers in the foreign exchange market, which is exposed to a much bigger volatility in exchange rates, would be scared by 10- to 20-basis-point swings in call market rates and close their carry trade positions.