The Demise Of The Japanese Financial System

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The BoJ currently conducts a mass nationalization of private companies.

Entire Japanese yield curve is artificially produced.

Moves that the BoJ now conducts will sooner or later lead to devaluation of yen and a sizable fall against other major currencies.

The BoJ's monetary policy will sooner lead to the financial harakiri rather than to the recovery.

In the last few years, it seems as though central banks are competing which one will distort its financial markets the most through increasing monetary supply. But for now, the Bank of Japan (BoJ) is a clear leader. Compared to other central banks, additionally to bond buying program, the BoJ runs a massive equity one as well.

The main purpose of money printing (professionally and politely called quantitative easing) is to lower the market interest rates. According to central banks, low interest rates, or even better, negative rates, will cause a spillover of savings of people and businesses into investments and consumption, which should ultimately lead to GDP growth. However, in their monetary stunts, central banks and especially the BoJ are doing the exact thing which had initially separated them from the executive power.

Throughout history, rulers mostly printed they own money, which often lead to abuses of monetary powers. In order to finance large deficits, incurred for example for leading of a war, people in power would often use money printing instead of unpopular tax-hikes. In this way they would make up for the shortfall in the budget deficit and the public, at first, would not grasp that rulers are taking more of their income.

During history, the strong increase of money in circulation (the forerunner of quantitative easing) mostly lead to hyperinflation, breakdown of the monetary system, and finally to bankruptcy. In order to avoid numerous repetitions of such messy situation, central banks were separated from executive power and had become autonomous in pursue of independent monetary policies.

As part of this separation, in order to prevent financing of budget deficits, central banks were banned from direct investment in government bonds. But for the purpose of conducting monetary policy, they were allowed to buy these same bonds on the open market. However, at the time, this permission is used (or rather abused) as rarely in the history of modern finance, and the best example of such abuse is the BoJ.

Currently, the BoJ's annually purchases $843 billion of financial instruments, of which approximately $786 billion refers to Japanese government bonds and around $57 billion to Japanese equities. For comparison, Japanese annual GDP is around $4.1 trillion, while the total public debt is $10.46 trillion, of which as much as $6.9 trillion trades with a negative interest rates.

The BoJ annually repurchases approximately 7.5 percent of Japan's existing debt, and currently holds around 39.9 percent of all government bonds. At this pace, in 3 years, the BoJ's share in total existing government bonds will rise to a staggering 62 percent. As the BoJ is already the largest holder of Japanese debt, it becomes increasingly difficult to buy sufficient quantities of the new bonds. This best addresses the issue that the BoJ currently massively funds the Japanese budget gap, which is exactly what central banks are not supposed to do.

Since the bond purchases have not lead to GDP growth, unlike other central banks, the BoJ opted for equity purchases through Nikkei and Topix ETFs. Under the current program, the BoJ annually plans to buy ETFs worth as much as $57 billion, but with the possibility of further expansion. According to Bloomberg, at the end of June the BoJ already held 60 percent of all Japanese ETFs, through which they became the top 10 shareholder of 76 percent of Nikkei 225 companies. In almost one quarter of the Nikkei they became the top 5 shareholder, and for the piano manufacturer, Yamaha Corporation, through ETFs they became the largest single owner. At this rate, by the end of 2017, the BoJ will become the largest shareholder for the quarter of 225 Nikkei companies, which practically means that the BoJ currently conducts a mass nationalization of private companies.

Why negative interest rates do not lead to GDP growth can easily be understood by using the example of an individual saver. If individuals are accustomed to positive interest rates and base their spending and investing on the premises of expected profit, then negative interest rates lead to losses which disrupt initial plans and ultimately lead to more savings. In this way negative interest rates do not inhibit GDP growth, quite the contrary, they decrease the economic activity and lead to lower GDP.

During the past twelve months, the BoJ has increased the M1 money supply by 7.6 percent. For now, the excess liquidity remains in the financial markets and has not spilled into real economy. As Japan is the world's most indebted country with debt to GDP ratio at a staggering 247 percent, the ability to borrow for the period of 10 years at the rate of minus 0.06 percent is the best example of the gargantuan bond bubble. Same applies to the 30-year bond that yields an unrealistically low 0.50 percent. All this suggests that the entire Japanese yield curve is artificially produced, in other words, it is not the result of real market trends but a product of a single buyer with practically unlimited buying power.

Source: OECD

Since during the stagnant economy the BoJ continually increases the money supply, sooner or later this will lead to very high inflation. As they can not spur low inflation now, they will be helpless when the it starts to gallop. Judging by the similar historical situations, high inflation will elevate interest rates which will lead to inability to finance humongous budget deficit that will ultimately end with two scenarios.

The first is the classical default, that is, abolition of payments of coupons and principal that will lead to a sale of bonds and other financial instruments, disintegration of Japanese financial system and to currency crash.

In the second scenario, the BoJ will initially continue to print money and finance budget deficit which will enable government to pay coupons and principal. However, this will further fuel the hyperinflation which will lead to decimation of bondholders, fall of yen, inability of Japan to issue now bonds, and finally to bankruptcy.

Closing Thoughts

Either way, it will end in similar fashion, and judged by the history, moves that the BoJ now conducts will sooner lead to the financial harakiri rather than to the recovery.

There are only a few ways to short Japan, and to hedge or profit from Japanese financial turmoil. The first one is through the ProShares UltraShort MSCI Japan ETF (NYSEArca: EWV). This one provides 2x inverse exposure to the MSCI Japan Index, which covers 85% of the float-adjusted market cap of the Japanese equity market.

The second one is through the ProShares Ultra Short Yen (NYSEArca: YCS). This ETF provides a 2x inverse multiple to the daily performance of the yen spot price against the U.S. dollar.

Both options are a good bet against the Japanese financial system, but the bet against yen would probably be a better one because of a larger upside potential. The BoJ creates money out of thin air, and there is practically no limit to this creation, which will sooner or later lead to devaluation of yen and a sizable fall against other major currencies.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.