What’s next for the Bank of Japan?
The Bank of Japan has used every implement in the monetary policy toolbox to try to kick-start the economy. Does it have any tricks left to fight the impact of the coronavirus? Matthew Thomas reports.
In January 2013, just a month after Shinzo Abe was elected as Japan’s prime minister, he announced an ambitious plan to kick-start an economy that had suffered two ‘lost decades’ of tepid economic growth and deflation. Abe said the government would fire ‘three arrows’, referencing a Japanese folk tale. The three arrows were fiscal spending, monetary easing and structural reform.
Each was intended to address an evident problem in Japan’s economy. Fiscal spending would give a jolt to demand. Monetary easing would break the despair of those who had no confidence inflation would ever return. Haruhiko Kuroda, appointed as governor of the Bank of Japan (BoJ), announced a 2% inflation target, a crucial move to anchor expectations. Structural reform, the thorniest but arguably most important change, would shift a labour environment which left employers unable to fire their employees – and those employees unwilling to look for better opportunities elsewhere.
In September 2020, Abe announced he was retiring, citing ill health. His premiership can already be considered a success in one sense, by offering political stability to a country that had previously endured five prime ministers in five years — including Abe himself, who ruled the country between 2006 and 2007. But the verdict is still out on the success of the three arrows.
Most economists agree that structural reform did not go far enough, despite some attempts to promote flexible working hours and bring in more foreign labour.
Fiscal stimulus has also been a mixed bag, undermined by the government’s decision to raise consumption taxes twice, in 2014 and 2019. Monetary policy, however, seems to have be1en much closer to the mark.
“If we use the arrow analogy then we can talk about the forcefulness and steadiness of the arrow shot,” says Stephen Schwartz, head of Asia Pacific sovereign ratings at Fitch Ratings, in Hong Kong. “Monetary policy has been the most forceful and steady. The shooter gets high marks for form.
“In terms of hitting the target — which was 2% inflation — the arrow was wide. But it succeeded in some important ways. One was turning inflation positive after years of deflation, resetting wage and inflation expectations in the process. That was a fundamental success.”
That is something economists widely agree on. The BoJ may not have achieved all the success hoped for when Abe announced the three arrows, but ending years of deflation was no small feat.
Between 1999 and Abe’s election in 2012, annual consumer price inflation in Japan had been positive only twice, according to data from the World Bank. Since 2013, it has been positive every year apart from 2016, although interim numbers have shown signs of deflation this year, amid the coronavirus.
This success has not been without its cost. The BoJ has helped redefine the role of a large central bank, using a range of tools from negative interest rates to widespread asset purchases in an unflagging attempt to spur lending.
The numbers are huge. The central bank now owns almost 50% of outstanding Japanese government bonds (JGBs), compared to around 12% at the start of 2013, according to data from Japan Macro Advisors. Perhaps more shockingly, economists estimate it is an effective hoarder in the ETF market, owning around 85% of available funds.
In the weeks and months that follow the exit of Abe, economists will ask plenty of questions about the success of BoJ’s aggressive monetary easing campaign. But there is a more urgent question: what other tools do they have left?
Japan has managed to keep coronavirus cases much lower than other developed economies. The country’s 73,581 cases by September 10, representing just 0.05% of the population, make it the envy of other developed nations. But the economic impact of the coronavirus has been severe — and there is a risk the central bank has little firepower left if things get worse.
The old new normal
The Bank of Japan is a good example of a 20th-century central bank. Before the global financial crisis of 2007-8, central banks did simple, predictable things: meeting regularly to decide the direction of interest rates, buying and selling government bonds through open market operations and carefully managing messaging to anchor inflation expectations.
The basic tools of central banking have not changed in the wake of the crisis but central banks have found new, surprising uses for those tools. Negative interest rates were almost unthinkable before the financial crisis; they are now an obvious option for central bankers. Asset purchases are now much more than a part of old-fashioned open market operations, instead becoming a powerful tool to influence the direction of asset prices and rates, as well as to influence sentiment. Central banks are now much more comfortable directing banks’ lending, particularly by giving them incentives to lend to small-and-medium enterprises.
The BoJ has led much of these changes. Although it was not the first central bank to adopt negative interest rates — that dubious distinction goes to Sweden’s Riksbank, which made the move in 2009 — Japan’s was the first of the world’s major central banks to do so, when it announced in 2016 that it would charge 0.1% on excess reserves from banks.
It is easy to forget quite how bold the BoJ’s monetary assault has appeared at times. When it adopted its programme of determined easing after the 2012 election, it was moving in the opposite direction of other major central banks.
In 2013, the year that Abe announced the three arrows programme, the US Federal Reserve’s decision to start unwinding its own quantitative easing led to the ‘taper tantrum’, a sell-off in Treasury bonds that caused panic in emerging markets.
The BoJ’s plan was simple: it would do anything possible to steer inflation expectations upwards. Kuroda unleashed a programme of huge JGB buying in early 2013, before taking in corporate bonds, commercial paper and ETFs.
The net result was an end to decades of deflation, a sharp rally in the equity markets between 2013 and 2015 and a new faith among foreign investors that Japan was turning a corner.
The central bank did not do everything right. Its all-guns-blazing approach to easing financing conditions made little distinction between ageing corporations and promising start-ups, a problem in Japan’s sometimes creaky economy.
“The BoJ could have taken a stronger role in guiding the banks to ease up lending to zombie firms that were not turning a profit, reallocating capital to industries that would be more productive,” says Steve Cochrane, chief Asia Pacific economist at Moody’s Analytics, in Singapore. “That’s a difficult thing to do, but it might have been a sensible direction.”
On most counts, however, the central bank deserves an ‘A’ for effort. Kuroda’s total war against deflation was such that it has become common over the years to hear bankers wonder whether he had run out of firepower. Always, he has found one more bullet — usually at the expense of the BoJ’s balance sheet. But much of those early successes have now been lost.
The coronavirus has brought Japan back into deflation, although most economists think this will be a temporary blip. The Nikkei 225 index is essentially flat on the year, after slowly coming back from a 30% sell-off earlier in the year. Analysts reckon foreign investors have pulled out of the country en masse.
The conventional explanation is that Kuroda’s aggressive action at the central bank needed to be followed by moves from other arms of government, particularly the ministry of finance. “Monetary easing is nothing but a way of biding time for other reforms,” says Tetsufumi Yamakawa, chief economist at Barclays Securities Japan, in Tokyo.
Although there was an increase in spending, it was offset by rises in consumption taxes. Attempts at structural reform, although not entirely without merit, have also largely failed.
“We certainly expect the BoJ’s policies would have made a good contribution to the economy if they came alongside the right structural reforms,” says Yamakawa. “But I’m not sure structural reforms were ever really a political priority and, in any case, they have not worked. The ultimate goal of structural reforms is increasing labour productivity growth; that is now negative.”
It comes as little surprise to many in Tokyo that structural reforms have not ended up being a success. Many local bankers have been sceptical about the possibility of significant labour market reforms since the three arrows policy was first unveiled. Part of the problem is that changing the labour market is not simply a question of rewriting the rules; it also requires a cultural shift.
“Wage growth is one of the key ingredients to boosting the economy but it is tough to generate,” says Fitch’s Schwartz. “It probably comes down to lingering rigidity in the labour market. Could they have been more forceful about labour market reforms? Yes. But that really means changing a culture. There was stigma for workers to take more time off and overtime has always been much more normalized in Japan than elsewhere.”
The net result is that, despite little evidence of economic revival, the BoJ is now the biggest holder of government bonds in the country, a virtual monopolist in the ETF market and an increasingly important source of demand for corporate bonds and commercial paper.
The BoJ’s role in the economy dwarfs other major central banks. Its balance sheet was worth 103.5% of gross domestic product in November 2019, even before the latest splurge. The ECB’s balance sheet was 39.5% of the eurozone economy at the time, while the Fed held a balance sheet worth 19.3% of US output, according to data compiled by the Wall Street Journal.
The fact that the BoJ has grown so large appears to leave it with few options to address unforeseen crises, including the coronavirus. The likelihood is not that the BoJ can find entirely new tools but will simply upgrade old ones.
The BoJ’s immediate response to the coronavirus was to announce a $700bn package that included some old tricks, including an increase in purchases of government bonds, corporate bonds and exchange traded funds, alongside a few new ones: its Special Funds-Supplying Operations, to help keep banks liquid, and a separate scheme to encourage lending to small-and-medium enterprises. What’s left?
The obvious option is that the central bank moves further into negative interest rate territory. Central bank officials have made clear in private meetings with analysts and economists that this is a possibility, but most observers think this is unlikely.
One reason is simply weariness with the negative interest rate policy, a move which initially seemed like a quick bit of shock therapy but which has now lasted four years. The move has put serious strain on the balance sheets of Japan’s mega-banks, as well leading to dislocations in the corporate bond market.
Another reason to think the central bank will not go further into negative territory is that part of its attempt to counter the pandemic so far has involved a reversal of the policy. A facet of its coronavirus response was to offer a 0.10% interest payment on bank deposits held with the BoJ, as long as those deposits are matched by loans the banks have made to SMEs.
“There is an increasing awareness in the market and in academia that deepening the negative interest rate policy doesn’t make a lot of sense,” says Yamakawa at Barclays. “It has not been a success in Japan and the central bank is already taking some steps which undermine the negative interest rate policy.”
Another option is that the BoJ increased the size of its already-bloated balance sheet, most likely from upping its purchases of government and corporate bonds. There are some downsides to this, too.
The BoJ’s greater commitment to propping up the corporate bond market through secondary market purchases is already having unintended consequences in the primary market (see separate story). The hoovering up of JGBs also poses risks, by sucking significant liquidity out of a crucial reference point for the risk-free rate.
Most economists think that the emphasis will instead be on putting the other two arrows back in the bow. Yoshihide Suga, chosen by the ruling Liberal Democrat Party to succeed Abe, is widely expected to continue the key policies of Abenomics. As the Bank of Japan runs out of options, he will be under increasing pressure to unleash the forces of fiscal spending.
“It’s hard to imagine that the BoJ can do much more than it already has, given the size of the balance sheet and given that interest rates are already negative,” says Cochrane. “There’s not much manoeuvrability. The only thing left is fiscal policy, although if the government is going to spend more there’s going to have to be more bond issuance – and that will mean more JGB buying from the BoJ.”
There is another concern for bankers and economists watching the BoJ’s expanding remit over the last eight years. How exactly can the central bank unwind its enormous holdings of the country’s government bonds, corporate bonds and equities?
Even a small reduction in its $6.4tr balance sheet will take serious work. But it does not have to look far for inspiration. Japan already boasts the world’s largest pension fund in the Government Pension and Investment Fund (GPIF). That hints to a potential solution to the central bank’s difficult-to-unravel ownership of Japan’s asset markets.
“They really need a long-term plan to unwind these assets,” says Yamakawa. “Without a plan, it will become very difficult to restore the confidence and credibility of the market. I suspect the solution will end up being the creation of a second GPIF to finance these assets but there doesn’t seem to be any discussion on that at this point.”