{"id":46754,"date":"2015-11-25T00:20:00","date_gmt":"2015-11-24T23:20:00","guid":{"rendered":"http:\/\/beta.next-finance.net\/strategie\/bank-of-japan-stupor-or-fear\/"},"modified":"2019-12-31T00:19:52","modified_gmt":"2019-12-30T23:19:52","slug":"bank-of-japan-stupor-or-fear","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/strategie\/bank-of-japan-stupor-or-fear\/","title":{"rendered":"Bank of Japan: stupor or fear?"},"content":{"rendered":"

Since the 2008 crisis, central banks have had a major influence on financial market
\ntrends. The Bank of Japan (BoJ) in particular has orchestrated a historic rally among
\nJapanese equity markets since announcing its quantitative and qualitative easing
\nstrategy (QQE) at the end of 2012. The implementation of an asset repurchase program
\nreflected the willingness of the government led by Shinzo Abe to defeat deflation, which had
\nprevailed since 1998. After its initial rapid success, this policy reached its limits however, as
\ninflation forecasts stagnated below the 2% target set by the central bank. The BoJ nevertheless
\nkept its monetary policy unchanged at the meeting held on October 30th, which surprised
\ninvestors. The BoJ\u2019s audacious strategy is now at a technical and political crossroads. The
\nvarious constraints facing the BoJ provide a clear lesson for the future of unconventional
\nmonetary policies in Europe (eurozone, UK, Denmark, Sweden) and the US.<\/p>\n

At its monetary policy meeting at the end of October, the Bank of Japan surprised the markets
\nby opting to maintain the status quo. The Japanese economic climate is highly uncertain,
\nalthough there are clear signs of a slowdown. Household consumer spending is still struggling to
\novercome the hike in TVA implemented during the spring of 2014, while exports have been hit
\nby the crash in Chinese industrial investment. Corporate confidence has also been undermined
\nby the absence of a snapback in consumer demand. Meanwhile, the leading export market,
\nChina, is undergoing an adjustment. Capex is predicted to remain flat this year according to the
\nclosely-watched Tankan survey. So how can the Bank of Japan\u2019s cautious stance be justified?<\/p>\n

The proximity of other dynamic Asian economies tends to eclipse the fact that an ageing Japan
\nharbors potential annual growth of only 0.3%. The economy does not require spectacular
\ngrowth in order to approach full capacity utilization, which has been triggered by a series of
\nbudgetary stimulus packages initiated by Shinzo Abe since returning to power in 2012. The
\nunemployment rate is at an 18-year low of only 3.4% (chart 1). Core inflation, excluding energy
\nand food, rallied from -1% at the end of 2012 to 0.9% in September, on a rolling 12-month
\nbasis (chart 2). In this context, it is understandable that the BoJ considers that the risks
\nincurred by extending its QQE program outweigh the benefits.<\/p>\n

\"japan-_inflation_excluding_food_and_energy.jpg\"<\/a><\/p>\n

Firstly, QQE feeds through to inflation forecasts primarily thanks to weakness in the yen (chart
\n3). However, the government has faced the bitter experience of collateral damage inflicted by a
\nweak yen. Weakening the currency exchange rate, in an economy which is a heavy importer of
\ncommodities (food, energy and industrial input), is equivalent to a hike in consumer VAT and
\nlevying an import duty on SMEs. Furthermore, the depreciation of the yen enrichens households
\nwhich own large equity portfolios, by boosting revenues among major listed exporting
\ncompanies. The devaluation amplifies wealth inequalities, acting like a negative capital tax. In
\norder to preserve his political capital ahead of the forthcoming senatorial elections (summer
\n2016), the Prime Minister probably encouraged the BoJ to hold fire this time. Furthermore, with
\nthe signature of the TPP currently pending approval by the US Congress, it would be
\ninappropriate for Japan to appear to be involved in a currency war.<\/p>\n

\"yen_vs_1_dollar_exchange_rate.jpg\"<\/a><\/p>\n

Secondly, the BoJ is already buying-up considerable quantities of Japanese government bond
\nsecurities (JGB) and absorbing 10% of public debt per year. At this rate, the IMF estimates that
\nwithin one or two years, under certain hypotheses of domestic institutional investors holding
\nJGBs as collateral, or as liquidity or to satisfy regulatory requirements, the BoJ will run out of
\ngovernment bonds to buy. Thus any acceleration in government bond repurchases will
\nexacerbate fears of the program being suddenly halted, once the central bank runs out of
\npurchasable securities. Anticipated fears of this type of withdrawal syndrome could weigh on the
\neconomy.<\/p>\n

Furthermore, stepping-up the QQE program incurs the risk of overheating the Japanese
\neconomy, which is almost at full-employment, if global trade also accelerates. Japan may be at
\nthe inflexion point of the Phillips curve, which gauges unemployment vs wage inflation. At the
\ninflexion point, any further fall in unemployment incurs the risk of triggering a steep rise in
\nwages. Higher short-term inflation forecasts would lead to capital outflow among domestic
\ninvestors seeking shelter against further cuts in real interest rates. This factor would then cause
\na further depreciation of the yen, which would vindicate the higher inflation forecasts and
\nsteepen long-term rates, which could jeopardize the government\u2019s solvency. The BoJ would
\ncertainly attempt to calm any tensions in the bond market by stepping in as buyer of last resort,
\narmed with unlimited liquidity. However, in the event of a massive bond market sell-off by
\ndomestic institutional investors (banks, pension funds and life-insurers looking to benefit from
\nhigher yields in foreign bond markets, while hedging against future yen weakness), the BoJ
\nwould be forced to buy enormous quantities of JGBs in the market in order to cap rising interest
\nrates, given that public debt exceeds 200% of GDP. This would imply the creation of colossal
\nliquidity by the central bank. The injection of fresh money into the system, which is already
\nawash with monetary liquidity, would cause a surge in inflation expectations and therefore
\ntrigger further capital outflow, which would weigh even more heavily on the yen. The national
\ncurrency would be caught up in a vicious negative spiral. <\/p>\n

It is apparent that when devaluation is the only option remaining open to the central bank to
\nstimulate inflation forecasts, target inflation policy becomes highly risky if public debt represents
\na significant multiple of the total monetary mass. This risk is even greater once the economy is
\napproaching full employment, which represents a turning point at which wages can become a
\npowerful driver behind an inflationary shock, triggered by lower exchange rates.
\nThe BoJ is therefore at a crossroads. Its program implemented to combat deflation was
\nsuccessful, as illustrated by the increase in core inflation towards 1%, but at the cost of
\ncurrency depreciation, which weighed chiefly on consumers. The 2% target is still a long way
\noff, whereas pursuing the program incurs increasing risks.<\/p>\n

The government has now also refrained from putting pressure on the central bank to reach
\ntarget inflation as quickly as possible. Shinzo Abe is aware of the political cost of the increase in
\ninflation from -1 to +1% via the depreciation of the yen. With public debt yielding largely
\nnegative real interest rates and a rapid monetization of the BoJ\u2019s debt reserves, pursuing the
\n2% inflation target may seem highly theoretical and would have no real political upside.
\nEssentially, the Japanese government\u2019s willingness to overcome modest domestic deflation,
\nwhich in many ways constitutes a stable economic equilibrium, could be motivated primarily by
\nthe public debt situation, i.e. reversing the surge in public finances through monetary
\nintervention, without engaging a long-winded parliamentary debate on budgetary policy. In this
\nsense, it appears vital for the government to maintain the current pace of its QQE program,
\nwhich ensures rapid monetization of the debt reserves and limited interest payments for the
\nstate, without the risk of a bond market crash, or undermining domestic political capital
\n(Japanese electors) or exterior political capital (the US Congress approval of the TPP) through a
\nhazardous depreciation of the yen. <\/p>\n

We therefore believe, excluding a sudden downturn in the economic climate, that the BoJ is
\nlikely to maintain its current cautious monetary policy, reflecting the high risks incurred by any
\nattempt to overstimulate an economy which is over-indebted, over-monetized and approaching
\nfull unemployment. The issues facing the BoJ could soon be shared by the Fed, the Bank of
\nEngland and the Royal Bank of Sweden, as Japan in many ways represents a test-case for our
\nunconventional monetary policies.