The BOJ's Qualitative Exit Problem

by: Adam Whitehead

The BOJ’s response to the global central bank imperative to address risk asset bubbles is framed by its balance sheet holdings of risk assets.

The BOJ is out of ideas and policies to deal with the changing economic environment.

The size of the BOJ’s balance sheet is about to overtake that of the Fed.

The Japanese banking sector and economy have geared up to a weakening of the yen against the US Dollar.

A change of leadership of the BOJ may be required to enable the new collaboration between monetary and fiscal policy.

(Source: Bloomberg)

At the request of the Bank for International Settlements (BIS), developed global central banks have recently been forced to address the macro-stability risks that their QE has created in asset price valuations. Their response has been to opine on the QE exit and higher interest rates, in order to prevent the bubble from inflating further. The BOJ is the odd one out, in that its risk asset bubble is to be found on its own balance sheet as a consequence of Qualitative Easing in the form of ETFs. The BOJ’s exit strategy will therefore require a Qualitative component. Some observers feel that BOJ Governor Kuroda may be lacking in the qualities required for this next phase in Japanese monetary policy history.

The debate over when and how the BOJ will scale back its QE programme continues to roll on from the last report, with no indication that BOJ Governor Kuroda has any interest in ending it at this point in time. The next speaker on the matter was Board member Yutaka Harada who opined that the scaling back of the BOJ’s balance was not something that should be feared by markets when it comes, despite the fact that the BOJ will take some capital losses on some of its holdings as yields rise. Further controversy was created when it was rumoured that the BOJ is currently re-calibrating its communication strategy to include the probability of the reduction of its balance sheet.

BOJ Deputy Governor Kikuo Iwata clarified the situation somewhat by admitting it will be difficult for the BOJ to give specific scenarios and appropriate guidance on how this will occur. Taking him at face value, this looks like an admission that the BOJ has no strategy in place to execute that it can begin to give guidance upon. The BOJ therefore seems to be out of policy ideas, apart from yield curve targeting and warehousing ETFs. This lack of ideas will be picked up on later in this report.

(Source: Business Insider)

The latest data shows that the BOJ’s balance sheet at $4.48 Trillion is just about to overtake that of the Fed in size. The BOJ already holds proportionately more of total Japanese government debt outstanding, than the Fed holds as a proportion of Federal government debt. The BOJ is just about to outdo the Fed in absolute terms also. Should the Fed begin scaling back its balance sheet later this year, this overtaking will become a permanent feature in the absence of any moves by the BOJ to follow the Fed. This crossover point should be a natural catalyst for the yen to weaken against the US Dollar. If the yen cannot weaken based on this fundamental, then this will be a serious headwind for Japanese economic growth and the rise of inflation.

The question over the real intention and capability of the BOJ to exit QE was then raised by the revision to Q1/GDP and signals from the government over the upcoming BOJ Governor vacancy. Q1/GDP was revised lower to 1% from the previous estimate of 2.2%. This weak backdrop then framed the communications over the BOJ Governor position that swiftly ensued.

The government signaled that the filling of the upcoming vacancy of BOJ Governor is now a priority. Chief Cabinet Secretary Yoshihide Suga also made it clear that the final decision will be made by Prime Minister Abe. According to Suga the most suitable candidate appears to be one that shares the sincere intentions and capabilities of the Prime Minister to rid the economy of deflation. Whilst remaining equivocal about the prospects for Governor Kuroda being retained, Suga made it clear that the governor has adhered to the Prime Minister’s directive thus far. What happens in the future is however more important, as we shall see later in this report.

For his part Governor Kuroda’s verbal cover letter, for the application to have his tenure renewed, showed his interest to finish the job that he has started. Kuroda opined: “While the policy approach has steered Japan’s economy in the right direction, our intellectual journey has not yet been completed,” and that “the rate of change in the consumer price index recently has been around 0 percent and there is still a long way to go until the price stability target of 2 percent is achieved.” Talking specifically about the yen, he indirectly hinted that it may need to be weakened as a consequence of a strategy to reverse declining inflation expectations. He noted that: “I continue to monitor exchange rate development and certainly could be concerned about, if the exchange rate deviated from what economists call the equilibrium range of exchange rate, substantially -- upward or downward …. But we do not manage our monetary policy in order to stabilize the exchange rate.”

From his speech it is evident that Governor Kuroda was sketching out how he would act if he were to be re-elected. From his discourse it is clear that he sees his task as a long-term one that will not be swiftly achieved. Neither does he see scope for the previous unilateral devaluation of the yen, that took markets by surprise and was widely tolerated by the developed nations. This time around, with President Trump and the threat of being labelled as a currency manipulator squarely in view, the opportunity to seize such a unilateral initiative is not on the table. Kuroda is thus willing to be patient out of practical necessity. It remains to be seen if Prime Minister Abe is as patient. One suspects not, but even Abe cannot move the obstacle of President Trump. Kuroda’s patience may be the practical way to operate, but it implies a lack of new ideas to address the Trump global environment. Prime Minister Abe does not seem to the patient type, so something has to give - either the BOJ’s policy or its Governor.

(Source: Nikkei Asian Review)

There are tangible signs, as noted in the previous report, that both the Ministry of Finance and the BOJ are trying to accommodate if not even appease President Trump. Recently, both Finance Minister Taro Aso and Governor Kuroda have downplayed the impact of the J-curve, by which the weak yen has boosted Japanese exports. There has also been a notable waning in the impact of the weaker yen on export volumes. This waning currency export stimulus could in fact be evidence of global deflationary forces nullifying the stimulus of a weak yen. Ceteris paribus no longer applies therefore when a unilateral currency weakening is applied. Policy makers’ moves to appease President Trump may therefore be a tacit acceptance that weakening the yen does not work out in the medium to long term, once trade partners catch up and respond with reflationary actions of their own. The combination of reflationary actions by all involved cancel each other out and lead to further disinflationary conditions.

Taking into account, the diminishing efficacy and opportunity for deliberate currency manipulation by Japanese policy makers, has caused the yen to strengthen. This has then coincided with a prolonged period of disinflation. This prolonged disinflation now requires a policy response. Since both the BOJ and MOF have agreed in principle that the J-curve is dead, it may be concluded with some certainty that they are on the same page. Cabinet member Mr Suga’s previously published job description for the next BOJ Governor, requiring fortitude in the quest for inflation, also implies a combined fiscal and monetary response to the rising deflationary headwind is being envisioned by Japanese policy makers.

The previous report also noted policy adviser for hire Ben Bernanke calling on a combined Japanese fiscal and monetary response to the deflationary threat. His call was also supported by the IMF. The IMF recently followed up on this initial support with further informed opinion, which states that: "We're (NYSE:IMF) comfortable with the stance of (BOJ) monetary policy. Recent changes to the monetary policy ... (ARE) the right, useful approach." One can therefore conclude that said combining monetary response is currently in the making, to be triggered by the next BOJ Governor.

The latest BOJ decision to leave policy unchanged came as no real surprise. Attention was focused on any communications about balance sheet reduction. The only hint of a change in rhetoric was the BOJ’s characterization of the economy as "turning toward a moderate expansion." This is hardly the stuff that inspires serious notions about balance sheet shrinkage, however this is evidence of forced compliance with the global central bank imperative to exit QE.

The recent slipping of Prime Minister Abe’s halo, through allegations of corruption, has come as a setback to the momentum that he has created for further monetary and fiscal stimulus. The poor showing of Abe’s LDP in Tokyo local elections, where there was a record turnout, are a sign of things to come across the nation. This stalling out in popularity, which may even turn into a political reversal of fortune, will thus put even further pressure on the BOJ to do the economic heavy lifting until either the Prime Minister has reset his halo or he has been replaced. BOJ Deputy Governor Kikuo Iwata recently began this lifting process, even before the Tokyo election debacle for the LDP, with the comment that the economy still needs the “powerful” monetary policy stimulus because inflation is undershooting the target.

A further catalyst to stimulate future attempts to weaken the yen was also identified by the BIS. In its latest report, the BIS noted that the leveraged accumulation of US Dollar assets by Japanese banks has mushroomed. This can be put down to the hunt for yield in a negative yen interest rate environment. US Dollar denominated assets on the balance sheets of Japanese banks surged to about $3.5 trillion by the end of 2016, with assets exceeding liabilities by $1 trillion. A rise in US interest rates puts this leveraged asset base at risk for capital losses, which will impair the banks’ abilities to support the Japanese economy. Since the US Dollar denominated assets dwarf the liabilities, a fall in the value of the yen versus the US Dollar will boost the P&L of this position. Japanese banks have been betting on a weaker yen. The gradual rise in US interest rates may not be enough to move the P&L significantly, so the BOJ may have to oblige by taking concerted action with the MOF to weaken the yen. Failure to do so could put the Japanese banking system, already under margin pressure from ZIRP/NIRP, into a position in which it cannot support the economy. The Japanese banking system and its economy in general have therefore been geared up to a fall in the yen. Failure of the yen to weaken would be disastrous for both.

The BIS analysis is however a mixed blessing for Japan. Much as the analysis of Japan’s gearing towards a weaker yen was highlighted, there was a more important global context to be taken into account. The BIS also warned all developed market central banks that debt levels are now significantly higher than their peak in the credit cycle that ended with the Credit Crunch. The unanimous response has been that all said central banks have made significant noises about scaling back the size of their balance sheets and normalizing interest rates, even though inflation and economic growth remain sub-optimal. The BOJ reluctantly joined the chorus of voices opining the potential for scaling back QE, although this Japanese commentary sounded more forced and lacking in real sincerity. BOJ Board member Yutaka Harada thus opined that ETF purchases could be scaled back if inflation data comes near to target. His specific reference to ETF’s rather than JGB’s signals that the BOJ’s intention is to deflate an asset bubble rather than to strengthen the yen by pushing up JGB yields. The problem for the BOJ however, is that it owns the ETF asset bubble that it allegedly intends to deflate.

The call by the BIS for global central banks to deflate asset bubbles, by scaling back QE despite the lack of economic fundamentals to justify this, has produced an interesting response from Japan. Broadly speaking, the main transgressors - namely the Fed, ECB and Bank of England - have all made noises about scaling back QE in response to the BIS call. The BOJ has not overtly responded in the same magnitude. The response by Japan has come indirectly by way of the ETF market. One of the chief architects of Abenomics, dating back to 2001, had more to say on this indirect response. His apocryphal response has also been framed by his comments about the BOJ and its coming leadership vacancy. It would seem that the two events of normalization and next BOJ Governor have been deliberately linked.

According to Nobuyuki Nakahara, a former BOJ board member, a QE exit “will surely come up within the next five years and we need someone who can prepare for it." He does not see inflation hitting the 2% BOJ target until 2023. He also does not believe that current Governor Kuroda is the man capable of taking the BOJ through this transition phase to 2023, because the Governor is apparently lacking in ideas which make him lacking in credibility. Nakahara’s comments are important because he is viewed as the Godfather of QE, dating back to 2001. He is also a mentor of Abe senior as well as Abe junior the current Prime Minister. It would seem that the Godfather wishes to see new blood at the BOJ and a new social contract between it and the MOF to enable the financial gymnastics required to monetise fiscal deficits and prevent the yen from strengthening.

In reference to the risk asset bubble, Nakahara clearly has worries about the BOJ’s dominant position in the ETF market and the systemic risk that this represents. In the case of other global central banks’ exit strategies, they are lucky in that a sell-off in risk assets which they are opining will create the bid for the sovereign bonds that they hold. They will thus be able to exit QE into a flight to quality bid from private investors. The BOJ however may get stuck with its ETFs, since they are the very risk bubble that is being deflated.

In the case of this risk facing the BOJ, Nakahara has devised a unique ETF exit strategy. Japanese companies will be enabled and incentivised to buy back the shares underlying the ETFs that the BOJ holds. Whilst his strategy may save the BOJ, it will simply allow Japanese companies to avoid having to try and create economic value through growth strategies, by enabling them to deliver shareholder value through buybacks. Presumably he has not thought this one through very well; and is therefore looking for a new BOJ Governor who has some new ideas to address the perennial problem of Japan Inc’s failure to embrace economic growth strategies.

(Source: Bloomberg)

The recent release of flow of funds data from the BOJ, shows that since the adoption of the yield curve targeting strategy the central bank’s holding of longer dated bonds has continued to rise. Balance sheet growth since the yield curve targeting began has also slowed. Yield curve targeting thus to some extent has inhibited monetary policy expansion. Perhaps the most alarming statistic form the flow of funds data is the picture of corporate cash holdings continuing to rise. Capex and hence economic growth driven by the corporate sector remains an alarming absence from the Japanese economy. Corporates aren’t raising wages either, so their contribution to the Abe’s plans for growth and inflation is totally lacking. Their contribution to shareholders through buybacks or dividends is rational and supportive of equity valuations despite the lack of economic growth however. If Mr Nakahara is correct, this rational behaviour is about to be stimulated further by the BOJ over the next five years. A new deal between the BOJ and the MOF is therefore imperative. A new BOJ Governor to go with this new deal is also an elevated probability.

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.