June 16 2016, 22:30 JST

End of Kurodanomics

In the press conference following the two days' policy meeting, BoJ Governor Kuroda was unusually vocal in expressing his concern on the recent strength of yen. Normally, he would start his answers to yen-related questions by stating that he would refrain from commenting on the exchange rate market. Today, when asked of the question, he went straight into the undesirability of excessive market volatility and of movements not warranted by “fundamentals”. Clearly, Governor Kuroda wanted to be more forceful in warning the FX market against pushing yen higher. 

However, his warning lacks credibility, in our view. Suppose that yen is to keep appreciating, what could the BoJ do to counter the move? The monetary easing tools the BoJ has employed in the last 3 years seems to have been nearly exhausted. Since Governor Kuroda took its helm in early 2013, the monetary easing actions by the BoJ consisted of 1) increasing the quantity of its JGB purchase, 2) extending the duration of its JGBs purchases, 3) purchasing risk assets such as equity ETF and 4) lowering policy rate. As we explain below, negative side-effects from employing these tools further seem to outweigh positive effects by now. Except for an outright intervention in the exchange rate market, the BoJ does not seem to have any effective tools against further yen appreciation.

Another notable point from the press conference was that no journalists asked Governor Kuroda on the achievability of the BoJ’s stated inflation target of 2% by the end of FY2017. As readers would know, it was not because journalists believed it was achievable. On the contrary, it was more likely because there was a consensus among journalists that achieving the target by a set date has become so unlikely that it became pointless to ask the Governor to repeat the line Governor himself probably does not believe in. As we commented in September 2015, the BoJ seemed to have already given up achieving the 2% inflation target by a set date. We sensed another change in Governor Kuroda's attitude toward the inflation target today though. In the press conference today, while it is difficult to pin it down on specific comments, we felt no enthusiasm whenever Governor Kuroda mentioned the 2% inflation target. It almost seems to us that he has given up actively pursuing the 2% inflation target altogether.  

BoJ has nearly exhausted its policy tools

1) Further increase in JGB purchases will likely damage the financial system

As of May 2016, the BoJ already owns 37% of the outstanding Japanese government bonds. Even at the current pace, it will own more than 50% of the market by early 2018. IMF has already warned that the BoJ needs to taper either in 2017 or in 2018 in order to maintain the normal functioning of the JGB market. In our view, further increasing the amount of JGB it purchases could be harmful as it would bring forward the time when its JGB purchase operation causes harms to Japan’s financial system.

2) Extending the duration of JGB purchases has become pointless

The average duration of JGBs the BoJ purchases have been extended from less than 3 years in early 2012 to close to 9 years in the most recent month, May 2016. While the BoJ could theoretically extend the duration further, it seems pointless at the longer interest rates has already fallen dramatically in the last few months.

3) BoJ cannot bear the risk of further increases in its risk asset holding

The BoJ are currently purchasing equity ETFs at the rate of 3.3 trillion-yen per year and it already owns 8.2 trillion-yen worth of equity ETFs. While the expanding the size of the ETF purchase may have short term effects, it will entail substantial increase in the risk to the balance sheet of the BoJ. As of May 2016, the size of its equity ETF holding alone has already exceeded the size of the capital and provision of the BoJ. 

BoJ's Balance Sheet

We also think that the BoJ must be weary of expanding its equity purchase at the current phase of economic cycle. The calculation of whether to expand its equity purchase may change when Nikkei is closer to 10,000, but it seems foolhardly to buy into equity market level when the global equity market is still close to its historical peak.

4) Lowering policy rate is feasible, but only by a few more notches

The negative rate policy (NRP) is the most recent addition to the BoJ’s toolbox. In our view, the BoJ could still lower its policy rate by a few notches, probably down to -0.5%. It will damage the profitability of the financial industry in Japan, but as Governor Kuroda commented in the press conference today, so long as financial industry remains profitable, lowering policy rate should remain a valid policy tool. In our view, it may even be positive in the long term as it could encourage long overdue consolidation in the Japanese banking sector. However, the effectiveness of further cuts in policy rate seems limited. Lending rates in Japan are already close to zero and the yield curve has already flattened out following the introduction of the negative policy rate at the end of January this year. 

Kurodanomics cannot be maintained any more

In our view, the Kurodanomics whereby an aggressive monetary policy easing can achieve its inflation target is no longer sustainable. In theory, the sharp yen depreciation was supposed to boost exports and corporate profits. Companies were in turn expected to expand its production and capital expenditure and all these economic changes were to eventually trickle down to household through a wage inflation supporting robust private consumption. In reality, the yen depreciation did boost corporate profits, but none of other sequences took place. For some time, the BoJ could preach for patience. However, now that the direction of yen has already reversed, time is no longer on their side. Economic indicators have long started to betray the theory, as early as from 2014. Even the indicator the BoJ created to justify its theory, the CPI excluding fresh food and energy, started to turn south. In short, Kurodanomics theory is no longer sustainable.

Is there any plausible silver bullet?

So, Kurodanomics has failed. Is there anything the BoJ could implement to revive it? In our view, further monetary easing is harmful for the economy unless there emerges an explicit threat to the economy. If yen is to rapidly strengthen, say beyond 95 yen per dollar in the next few months, it would probably be advisable to directly intervene in the FX market. When we consider the dire state of the public finance in Japan, expanding Japan’s FX reserve could prove to be useful in later years. If the JGB market is to show sign of instability, the BoJ may need to expand its JGB purchase to stabilize the market. If the Japanese stock market is to start to free fall, it may become advisable for the BoJ to expand its equity ETF purchase at some point. However, Abenomics is already a lost cause in our view and the BoJ should stop spending its resources in a futile effort to support it.

Japan's Fx Reserve