March 3 2017, 22:15 JST

On Borrowed Time

For a printable version of the report please click here.

On the surface, Japan seems to be having the best of its times. Its corporate profits renewed historical high in the last quarter of 2016. Despite the turbulence in the exchange rate in 2016, both manufacturers and non-manufacturers were able to consistently expand their profit throughout the year. 

Japanese companies enjoying record profits

The prosperity was shared to the general public in Japan, not through raises in their wages, but through a reduction in the unemployment. The unemployment rate in Japan is hovering around 3% in the last few months, the lowest rate in 22 years. The Japanese economy is likely to be in a state known to economists as “full-employment”, where only “frictional”, or “transitional” unemployment remains in the labor market. The Japanese newspaper in recent months are full of stories of industries suffering from labor shortages. The new job offers to applicant ratio show that there are more than 2 job offers available for each applicant looking for work. 

Two job openings for each job seeker

Unfortunately, the current prosperity is unlikely to last for long. In our view, the monetary stimulus that has been sustaining the prosperity has to be removed soon, mostly likely within the next 12 months. Since Abenomics started 4 years ago, the monetary expansion provided by the Bank of Japan (BoJ) played an essential role in stimulating the economy. Owing to the aggressive bond purchase program by the Bank of Japan, yield curve flattened significantly between 2012 to 2017. In the mean time in the US market, the market gradually priced in rate hikes by the Fed and steepened at the shorter end.  

BoJ completely flattened out the yield curve in 4 years

While US curve steepened in the same period

As the interest rate differential between US and Japan widened, the value of yen tumbled. Since 2015, the Japanese yen has weakened to a level not seen since 1970s. 

As a result of the BoJ’s aggressive JGB purchase, the BoJ now owns more than 42% of the whole JGB market. In certain segments of the JGB market, the BoJ’s ownership has reached over 60%. 

The limit to QE in bonds

A number of economists have argued that there is a limit to how much JGBs the BoJ can buy. A group of economists led by Kazumasa Iwata, a former Vice Governor at the BoJ, argued that the limit will be reached in the summer of 2017. Economists at IMF argued that the limit will be reached either in 2017 or 2018. They both argue that there is a “minimum” JGBs that must be left in the hands of private sector so that they can meet regulatory requirement. For example, life insurance companies are required to hold long term assets to match their long term liabilities by regulations. Since there are scarce alternative to long term JGBs, life insurance companies will be unwilling to sell their JGB holdings no matter what.

While we cannot pin down exactly when the “limit” will be reached, we will probably be seeing the sign of the strain in the next 12 months. At that point, the BoJ is likely to judge that the benefit of continuing on its JGB purchase program will not exceed the cost of completely losing the functioning interest rate markets in Japan.   
The limit to QE in equity ETFs
The quantitative easing policy by the BoJ involved more than bond purchases. The BoJ is also purchasing equity ETFs, initially at the pace of 3 trillion yen per year, and then at the pace of 6 trillion yen per year since July 2016. At the current pace, the BoJ will own more than 20 trillion yen of equity by early 2018, more than twice the size of the capital of the BoJ. In case of equity ETFs, the limit we see to the purchase program by the BoJ is of a political nature. Once the BoJ owns more than 20 trillion yen of equity ETF, any major downswing to the stock market will severely impair the capital of the BoJ. In an extreme case, the BoJ could face a technical insolvency if the unrealized loss on its equity ETF holdings exceed its capital. Political backlash against the technically insolvent BoJ could paralyze its monetary policy. 
In our view, while Japan may appear to be enjoying the best of its times, the worst of its times may be just around the corner. Japan is on borrowed time and the time is running out.