by Ron Rimkus, CFA
According to legend, Russian minister Grigory Potemkin erected fake settlements along the banks of the Dnieper River in order to fool Empress Catherine II during her visit to Crimea in 1787. According to Kyle Bass, managing director of Hayman Capital, central banks around the world today have erected their own Potemkin villages to deceive the public into thinking that the world's economic problems are solved. They aren't.
In a recent conversation with Bass, a prominent central banker noted that a central bank pursuing aggressive monetary policy can have some positive effect on economic growth. However, the simultaneous engagement in expansionary monetary policy by many central banks yields almost no benefit to economic growth. To illustrate this point, Bass showed a chart of the balance sheet growth of the four major central banks (U.S. Federal Reserve, Bank of Japan (BOJ), European Centrak Bank (ECB) and People's Bank of China). In aggregate, the balance sheets from the big four central banks grew from $3 trillion in 2008 to over $13 trillion today. Moreover, many central banks are printing new money on an unlimited basis, maintaining zero interest rates, and simply shifting the day of reckoning out into the future. Nowhere is this more true than in Japan.
Of course, Bass has been publicly discussing his bearish thesis on Japan for some time, but he updated his work in several important areas at the 66th CFA Institute Annual Conference this week. Until recently, the BOJ had maintained a slightly more moderate monetary policy relative to the Fed and the ECB. However, on 4 April 2013, the BOJ changed the game when it announced a massive ¥7 trillion per month monetary stimulus program (which corresponds to approximately 16% of GDP).
Several months ago, Bass noted that the current account surplus in Japan is critical to Japan's ability to keep interest rates low. This week he clarified that position further, cautioning that when the current account surplus falls below the fiscal deficit, the economics of Japan's low interest rate regime changes. In his words, the numbers are a given at this point, and it is only a matter of timing now. Consequently, he is now focused on qualitative analysis of the public's perception of the problems in Japan.
Citing behavioral and cultural issues, Bass says awareness is abundant as many Japanese understand these problems. In fact, he suggests that many have a collective sense of fatalism about Japan's future, but they hope that the day of reckoning is far enough into the future that they personally don't ever have to deal with it. Still, he believes that those who recognize that the day of reckoning may be within sight choose to ignore the problems because the reality is too stark and perhaps too difficult to bear. Likewise, Bass believes dissonance is also created by the availability heuristic where many Japanese look to their recent experience (without crisis) in their narrow walk of life to guide their judgment.
Nevertheless, despite such dissonance, Bass sees fissures in the status quo, suggesting early signs of validation of his bear thesis. In particular, he noted that the BOJ's massive escalation of bond buying should have stabilized and flattened the Japanese government bond (JGB) yield curve. Instead, the JGB bond market has locked limit down every day (except for two) since that announcement with a large spike in volatility.
In conversations with institutional owners of JGBs, Bass discovered that many Japanese banks have used the announcement as an opportunity to liquidate JGB holdings and purchase Japanese equities. When he asked if these were long-term, strategic bets, these players scoffed. They told Bass that they were just playing the game, "renting" stocks so long as the markets were going up. Already, the BOJ is purchasing about 70% of new bond issuance by the government of Japan. At this rate, there may soon no longer be any real holders of JGBs. Only then will the BOJ come to understand the difference between money and capital.
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