JUNE 24,2016, 15:00 JST

Time for Damage Control

Summary

In our view, it is no longer appropriate for the Bank of Japan to pursue the original goal of Kurodanomics, namely 2% inflation in 2 years. In the first policy statement published under Governor Kuroda in April 2013, the BoJ stated

The Bank will achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years.

In pursuing the goal, the BoJ has overextended itself in the last three years and it no longer has tools to credibly achieve the goal in its original terms. In our view, further expansions in its JGB purchases would do more harms than good. Expansions in risky asset purchases do not seem appropriate in the current market environment. Lowering the policy rate is still feasible, but only by a few more notches. There are some silver bullets left such as a coordinated fiscal and monetary expansion, but such measures are politically difficult to pull off. In our view, Kurodanomics has ended as a failure and it is time for adjust its policy framework to damage-control in order to preserve its credibility as a central bank.

 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 will have limited effects

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 extend the duration further, it seems pointless as 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 holdings

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 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.

Having said that, there are some drastic measures the BoJ could implement to reflate Japan. The first is a purchase of foreign currency denominated assets. It is tantamount to an FX intervention. 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.

The other, perhaps far more powerful silver bullets are a coordinated expansion in Japan’s fiscal and monetary policy. So called “Helicopter Money” would be its extreme form. In our view, it is a valid option, but it has to be executed with a strong political commitment and coordination between the BoJ and other economic policy makers. 

Japan's Fx Reserve