Looking at the soaring Tokyo stock market, surging Tokyo office prices and a raft of strong economic statistics, it is easy to think that Japan is back into boom or even bubble economy conditions. The recovery has moved from dependence on exports to what chief economist Richard Jerram at Macquarie Securities in Tokyo calls “self-sustaining domestic demand”. The banking system too has moved out of crisis, and lending is picking up again.
Yet, to hear people like finance minister Sadakazu Tanigaki tell it, Japan is still mired in deflation, and talk by Bank of Japan (BoJ) governor Toshihiko Fukui of raising interest rates is dangerously premature. Tanigaki has reason to downplay the good news: the government is in debt to the tune of 150% of GDP, and any rise in inflation expectations could trigger a crisis in the government bond market, analysts say.
Fukui too has a hidden agenda, some say. He knows Japan’s bubble economy of the late 1980s took off partly because the BoJ was slow in raising interest rates, and he does not want to be caught napping again. Fukui is the man in the middle of the conflict and is under attack not only from Tanigaki but also from prime minister Junichiro Koizumi and other politicians who have challenged the central bank’s independence on monetary policy.
End of DEflation?
Despite this, on March 9 the BoJ declared an end to the policy of “quantitative easing”, under which it has kept Japan awash in a sea of financial liquidity for five years. This sent a signal to financial markets that the deflation which had plagued Japan for nearly a decade had ended, and that the time had come for the BoJ to stop targeting the amount of money in the system, and to revert to a conventional strategy of targeting the price of funds.
Fukui stopped short of raising interest rates at that point and left the overnight call rate at zero. But now that he wants to move it up by 25 basis points to 0.25%, the political hue and cry has started again. “We see improvement in the Japanese economy, led by domestic demand, and it is likely to continue. But we haven’t fully overcome deflation,” Tanigaki insisted during a meeting of Asian and European finance ministers in Vienna in early April.
The BoJ points to several months of positive movement in Japan’s consumer price index as ammunition for its decision to start tightening (even if the broader price measure known as the GDP deflator is still in negative territory). Fukui wants to move faster than most economists realize, and to begin raising rates this summer before any move gets politically entangled with the Liberal Democratic Party (LDP) election of Koizumi’s successor in September.
Other factors appear to justify monetary tightening. Signs of economic recovery are strong – including the fact that Japan’s real GDP grew at an annual rate of 5.6% in the final quarter of 2005. Industrial output has been growing strongly, unemployment (at 4.1%) is at its lowest level in five years, consumer spending and private capital investment are buoyant, and corporate sentiment is improving. The Nikkei 225 stock average has surged from a low of near 7,000 two years ago to over 17,000, while rents in certain Tokyo office blocks are back to bubble economy levels.
Ulterior motives
Some analysts suspect Fukui’s motives are more than purely economic. The BoJ “wants to give the impression they are on the ball”, says research partner Mark Brown at Japaninvest, Tokyo. Meanwhile, Alexander Kinmont, managing director of Prospect Asset Management in Tokyo says the BoJ’s aim is to “create an environment in which the true state of the market is concealed, and in which the fear of a further bubble provides cover for raising interest rates”.The BoJ denies that its anxiety to raise rates stems from fears of another asset bubble of the kind that sent stock, land and real estate values soaring to astronomic heights during the late 1980s – making the grounds of the Imperial Palace in Tokyo worth more on paper than the entire state of California, and putting the Tokyo Stock Exchange on a par with the New York exchange in terms of total capitalization.
Nevertheless, Jesper Koll at Merrill Lynch in Tokyo notes that the BoJ “recently established a new policy framework that explicitly takes risk of future asset price inflation and bubbles into account for current policy decisions, even if the probability of such asset price bubbles may be seen as low at present”. But some analysts speculate that the BoJ might end up averting a bubble at the cost of bond market crisis.
Bond yield concerns
With some ¥700 trillion of debt outstanding, which eats up 20% of the national budget in service costs, the Japanese government is desperate to prevent a rise in bond yields that could result from an increase in inflation expectations. Until last year, the yield on the benchmark 10-year government bond had languished for a long time at around 0.5% in Japan’s deflationary environment. Now it has moved above 1.5% and is set to go higher.
Yields could jump once the BoJ raises short-term policy rates and once the rise begins to spread out along the maturity curve, dealers say. That would raise the government’s funding costs significantly, and would set back efforts to restore the budget to primary balance (where expenditures roughly match revenues excluding the impact of borrowing on both sides). This could trigger a bond market crisis, they add.
In theory, the government has little cause to fear a major bond market sell-off because the vast majority of its bonds are held by Japanese banks and other financial institutions and by the vast, state-owned postal savings bank. They are unlikely to dump Japanese Government Bonds (JGBs), some argue. Moreover, as only around 4% of JGBs are held by foreign investors, Japan has no reason to fear an overseas sell-off either.
But corporate treasurers and banks in Japan are beginning to move back into the short-term money market as a result of the BoJ’s moves, and their appetite for risk is growing, sources close to the central bank say. If these players decide that yields on JGBs are no longer attractive in the new environment of economic recovery in Japan, the Bank of Japan itself may be forced to absorb even larger volumes of government debt than it holds already. Recovery is thus a two-edged sword for the government.