{"id":51431,"date":"2016-04-27T00:23:03","date_gmt":"2016-04-26T22:23:03","guid":{"rendered":"http:\/\/beta.next-finance.net\/opinion\/bank-of-japan-the-impossible-task\/"},"modified":"2019-12-31T00:40:39","modified_gmt":"2019-12-30T23:40:39","slug":"bank-of-japan-the-impossible-task","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/opinion\/bank-of-japan-the-impossible-task\/","title":{"rendered":"Bank of Japan: the impossible task"},"content":{"rendered":"

The governor of the Bank of Japan (BoJ), Haruhiko Kuroda, was given a clear mandate by the Prime Minister in 2013, to end the deflationary pressure which had been weighing on the country since 1998. In order to do so, the governor implemented an ultra-aggressive monetary strategy, based on massively increasing securities purchases by the central bank and by
\nincluding more risky securities in the asset purchase program, particularly listed real-estate
\ninvestment companies and equity ETFs.
\nThree years after the launch of this quantitative and
\nqualitative easing program (QQE), it is clear that the results have fallen short of initial
\nexpectations.<\/quote>
\n Although underlying inflation has managed to move into positive territory, it has
\nstruggled to break through the 0.8% threshold, compared to the official target level of 2% (chart
\n1). Even worse, anticipated inflation reflected in a variety of sources (fixed-income markets,
\ncorporate and household surveys), have fallen back perilously close to zero. This failure has dented
\nthe credibility of the BoJ.<\/p>\n

Chart 1 | Japan: core inflation (excl. food & energy, % yoy)<\/strong>
\n\"graphique_1_-_japon_inflation_sous-jacente.jpg\"<\/a><\/p>\n

The introduction of a negative interest rate policy (NIRP) at the beginning of the year was a kneejerk
\nreaction aiming to counter the post-Fed yen rally and preserve the gains acquired through
\nQQE in terms of rising anticipated inflation. This intervention certainly forced nominal rates lower
\nacross the entire sovereign yield-curve (chart 2).<\/p>\n

Chart 2 | Japan: 10-year interest rates (JGB)<\/strong>
\n\"graphique_2_-_japon_taux_d_interet_a_10_ans_jgb_.jpg\"<\/a><\/p>\n

However, the introduction of a negative interest rate policy had dangerous side-effects. Firstly, the
\nhostile reaction from banks (wishing to streamline their balance sheets) had not been anticipated
\nand furthermore, the measure made it increasingly difficult for the BoJ to find sellers of JGB for her
\nQQE2 program. The Bank of Japan was already facing the risk of a shortage in purchasable JGBs by
\nmid-2017. Meanwhile, as the market anticipated JGB supply drying-up, with a risk of bank deposits
\ntipping into negative territory, non-financial investors refused to sell their sovereign securities,
\nwhatever the price offered by the BoJ. Anxious to match their income flows with their long-term
\nliabilities, while preserving capital and limiting counterparty risks (which are not zero in the case of
\nbanking deposits), institutional investors are now \u201cliquidity adverse\u201d, which causes a type of \u201cbond
\ntrap\u201d making it even more difficult for the BoJ to achieve its QQE targets. Although Haruhiko
\nKuroda introduced negative rates in order to ward off the risk of a liquidity trap, he ultimately
\ndestroyed the bond-market pricing mechanism. The benchmark previously provided by interest
\nrates has disappeared.
\nFurthermore, the cross-currency basis swaps market has become saturated in Japanese
\ncounterparty-risk, which limits the ability of domestic institutional investors to diversify their
\nportfolios into foreign bonds.
\nHeavy portfolio rotation towards foreign assets (initiated by the giant
\npublic pension fund GPIF) has effectively created strong demand for currency-risk hedging among
\nJapanese investors.<\/quote>
\n These hedges, set up through the cross-currency basis swaps market,
\ntriggered a \u201cJapan premium\u201d on the yen leg of swap contracts (chart 3). This premium has wiped
\nout part of the additional anticipated remuneration from foreign bonds. Investing in foreign bonds
\nhas therefore become less attractive for domestic investors, which increases their dependence on
\nthe JGB market.<\/p>\n

Chart 3 | Japan: spread of cross-currency basis swaps<\/strong>
\n\"graphique_3_-_japon_spread_des_cross-currency_basis_swaps.jpg\"<\/a><\/p>\n

The BoJ is therefore facing a new challenge of finding fresh sources of purchasable assets in the
\ncontext of its quantitative easing program. Governor Kuroda will be under heavy pressure to
\nimplement new stimulus measures at the meeting scheduled on 28 April. The BoJ could always
\nbroaden its QQE margins by stepping-up its risky asset purchases (local government bonds, equity
\nETFs, J-REITS), although the amounts involved would remain modest, given the limited size and
\nliquidity of these markets.
\nEven an extension of maturities among purchased JGBs would fail to
\nsustain the QQE program long enough to credibly achieve target inflation of 2%.<\/quote><\/p>\n

An alternative option would be to abandon the quantitative objective of increasing money supply
\nand instead target long-term interest rates directly. The BoJ would undertake to maintain longterm
\nrates below a given ceiling limit as long as anticipated inflation remains low. The most
\ncredible strategy would nonetheless be for the BoJ to acknowledge that QQE implicitly monetizes
\npublic debt (chart 4) and therefore only makes sense if it is coordinated with an ambitious
\nbudgetary stimulus program and structural reforms. This amounts to reminding the government of
\nthe meaning behind the legend of the three samurai arrows: each one breaks easily on its own, but
\nthey are more resilient when held together.<\/p>\n

Chart 4 | Bank of Japan: share of the JGB market<\/strong>
\n\"graphique_4-dette_publique_japonaise_et_detention_par_la_banque_centrale.jpg\"<\/a><\/p>\n

As Japan boasts a position of net creditor compared to the rest of the world, public debt is a
\npolitical matter rather than an economic issue. Japanese democracy has opted for demographic
\ndecline, to the benefit of national socio-cultural unity, which should help find a political solution to
\nthe challenge of an ageing population. The government nonetheless needs to accept that it has to
\nclearly define the terms of the debate, instead of working behind the scenes by assigning quasifiscal
\ntargets to the central bank, which blurs boundaries between fiscal and monetary authority,
\nand weakens Japanese democratic and capitalistic institutions.<\/p>\n

Unfortunately, Prime Minister Abe no longer appears to enjoy the political capital to implement
\nsuch a Big Bang. His reelection hinges on his promise to drastically adjust the budget, by
\nincreasing value added tax (VAT). If the next VAT hike expected in April 2017 is delayed, the
\ngovernment could have to re-establish its legitimacy by dissolving parliament again.<\/p>\n

Japanese equities and long-term rates are likely to remain highly volatile given the imbalance in
\nthe JGB market and fears of QQE ending as early as mid-2017.<\/quote><\/p>\n

We remain underweight on Japanese equities in our global multi-asset portfolio.
\n