JPRI Working Paper No. 109   (April 2006)
The BOJ Talks The Talk (But Will It Walk The Walk?)
By Marshall Auerback

Henry Kaufman, a leading American Wall Street economist, once argued that the only thing the U.S. had more to fear than a perpetually sluggish Japan was a Japanese economic juggernaut. In making this point, Kaufman was implicitly drawing attention to Tokyo's key role of helping to perpetuate the global liquidity glut, which continues to this day despite repeated interest rises by the Federal Reserve over the past 18 months.

In the aftermath of Japan's post-bubble economy, its traditional borrowers were relegated to the sidelines as they busily pared down debt, leaving a huge pool of BOJ-created liquidity free to be deployed in a massive yen "carry trade."   Seeking to rid the economy of debt deflation dynamics, Japan's monetary authorities have for several years allowed today's leveraged speculative community to borrow virtually free in yen, and then recycle that money back into US-dollar denominated instruments, thereby mitigating the impact of rising US short term interest rates.

A major by-product of this carry trade, therefore, has, until recently, been a decline in U.S. long term rates (in spite of the Fed's tightening), resulting in the so-called "conundrum" of falling long term rates (alluded to by former Chairman Greenspan in Congressional testimony last year) in spite of rising short term rate increases by the Fed. Typically, long-term rates tend to rise as monetary policymakers raise short-term rates. But not in the current episode. Despite steady monetary tightening beginning in the middle of 2004, the yields on long-term U.S. Treasury securities have until recently actually declined; as a consequence, the current level of long-term interest rates seems to be well below what one would expect on the basis of economic fundamentals. I would argue that the actions of the Bank of Japan have played a key role in perpetuating this state of affairs.

To be sure Japan's role has not been unique in this regard. Other central banks - from China to the Gulf States - have recycled vast surplus export dollars back into the U.S., all of which has contributed to ongoing downward pressure on U.S. interest rates and upward pressure on asset prices.

But it is Japan, not China, which now appears ready to change the status quo, if one is to judge by the recent statements of the Bank of Japan. The BOJ is suggesting that its own period of extraordinary monetary munificence is coming to an end. We may therefore be on the verge of testing the validity of Kaufman's assertion.

The Bank of Japan has long mooted the notion of ending its exceptionally accommodative monetary policy, but this time there appears to be more substance behind the threat: Between the fourth quarter of 2001 (the last deep trough in gross domestic product) and the fourth quarter of last year, the Japanese economy expanded by 9.9 per cent, in real terms. In the fourth quarter alone last year, the economy grew at a 5.4 percent annualized pace.

In many respects, this has been a typical externally led Japanese recovery, given that exports have generated an astonishing 30 per cent of the increase in demand, investment is responsible for 18 per cent, and government consumption a further 14 per cent. In comparison, private consumption has generated a mere 39 per cent of the increase in demand.

But in contrast to previous false starts, which long characterized the Japanese economy during the post-bubble era, this recovery does appear finally to be extending beyond the export sector: Unemployment rates are falling, thereby buttressing consumption, and Tokyo's residential and commercial land prices are finally rising for the first time in over a decade. Construction cranes once again grace the central Tokyo skyline after years in enforced hibernation. The upshot: Japan's gross domestic product growth was roughly double that of the European Union last year. And last month, system-wide bank lending was in positive territory for the first time in more than five years. The major banks have restructured, and drastically reduced their non-performing loans by two-thirds. This in turn has freed them up to lend again to domestic corporations, whose debt is finally below pre-bubble levels.

Responding to the accumulating evidence of a self-sustaining recovery, Toshihiko Fukui, governor of the Bank of Japan, has begun to signal to the markets that the country's era of ultra-loose monetary policy is drawing to a close. The BOJ' s nine-member policy board decided by a 7-1 vote in early March (one member was absent because of illness) to switch to the unsecured overnight call rate as a monetary adjustment target, rather than using the outstanding balance of current-account deposits held by private financial institutions at the central bank. Two government representatives - one from the Finance Ministry and another from the Cabinet Office - attended the policy board meeting as observers. But they did not invoke their rights to request the postponement of the vote on a policy change until another meeting, which implies that some sort of national consensus has been reached on the change in policy (until recently, the mooted change in BOJ policy had been vigorously contested by the Ministry of Finance and various leading LDP politicians).

The March 11 decision marked the first time in about 15 years, except a brief period in which the BOJ hastily lifted the zero-interest rate policy from the summer of 2000 to early 2001, that the central bank had reversed its policy to one of tightening.   Fukui told a news conference the central bank made the policy change as an uptrend in consumer prices has taken root amid the steady economic recovery, which fulfilled the central bank's self-imposed conditions for lifting the ultra-loose policy. The BOJ Governor had said earlier that the end to "quantitative easing" would not mean an immediate tightening in policy but would be a stepping stone toward a more "normal" monetary policy and "a return to more neutral interest rates."

Obviously, this has significant implications for the Japanese themselves. Domestically, in spite of significant debt reduction, absolute debt levels still remain exceptionally high, particularly in the public sector. For all of the discussions of the disastrous state of America's fiscal imbalances, they have been historically dwarfed by Japan's. With a ¥40 trillion budget deficit in Japan, about 8 percent of GDP must be borrowed. Last summer, Japan's Ministry of Finance estimated that a one percentage point rise in interest rates would increase Japan's debt servicing cost by ¥3.3 trillion, about $30 billion over three years and by a larger amount in future years as new borrowing at higher interest rates occurs. As Japan's economy grows and inflation atrophies, its long-run fiscal goal needs to be to stabilize and then reduce its high (140 percent) ratio of government debt to GDP.

What about outside Japan?
Foreigners, including the Asian central banks who finance the trade deficit (by endlessly recycling their surpluses into dollars) and the leveraged speculative community (which has made use of cheap Japanese short term financing through the carry trade), together have long constituted the marginal bid in the U.S. bond market. Consequently, their actions have served to boost U.S. asset prices and lower risk spreads, a fact recently acknowledged by New York Federal Reserve chief, Timothy Geithner. To date, investors and consumers have enjoyed the benefits of cheap foreign credit, even as the Federal Reserve has sought to counteract this by raising U.S. rates over the past year. But as Fukui has recently indicated, all this might begin to change if the Bank of Japan is truly serious about "normalizing" their monetary policy.

One consequence of today's world of derivatives-laden, globalized portfolio flows, is that liquidity has flowed from wherever it is available at the lowest expected cost (i.e., today Japan) to where it is most needed. Liquidity, in other words, abhors a vacuum. The global securities financial apparatus now operates across national borders and outside the purview of individual central banks. As the U.S. Federal Reserve has bumped up rates, enterprising speculators and their brokers and/or derivative salespersons have simply looked overseas for cheap funding sources. The BOJ has become an indirect accomplice because Japan has become the primary source of low cost financing. This has largely neutralized the tighter monetary stance of the Fed, and contributed to the so-called "conundrum" of lower than expected long term interest rates.

For all of the talk about America's flattening yield curve (which might normally signal that the end of tightening is close upon us), a more applicable model (which reflects the globalization of capital) is one which incorporates the nominal expected cost of borrowing short-term in yen, which in turn implies a still positively sloping "global yield curve." That would suggest that more tightening lies ahead, although the ball might pass from the Fed to the BOJ.   Confronting the source of this speculative capital is a monumental challenge for Governor Fukui, which explains his ongoing reticence to break definitively with the BOJ's practices of the past decade.

Thus far, all we have really had from Japan's monetary authorities is talk. In announcing the decision to end its ultra-easy policy, the BOJ sent a clear message that the transition toward what Fukui calls "more neutral interest rates" will be gradual, indicating that benchmark interest rates will remain near zero for some time and that it will only gradually reduce the amount of liquidity in the banking system. The BOJ is widely expected to keep interest rates around zero, where they have been for most of the past seven years, at least until the second half of this year.

The central bank said it will gradually lower the current account deposit balance toward the legally required level of around 6 trillion yen from the current range of 30 trillion to 35 trillion yen over a period of a few months to ensure stability in the financial markets. And Fukui also indicated that the BOJ will maintain roughly the current level until the end of March, taking into account expected strong demand for funds toward the March 31 end of fiscal 2005. Further seeking to allay frayed bond market nerves, the BOJ Governor also said he wasn't seeking to imply that once the account balance is lowered to the legally required level, short-term rates would soon start to rise above 0%.

In fact, to prevent a sharp rise in long-term interest rates, the central bank also said it will continue to buy 1.2 trillion yen worth of government bonds a month outright "for some time" to help prevent volatility in the bond market. Fukui said, however, that the BOJ must "eventually" reduce its outright buying of Japanese government bonds at some point from the present 1.2 trillion yen per month.

Perhaps the ominous action in global bond markets in early March 2006, along with the precipitous decline in the dollar, to some extent curbed Fukui's range of action and given the bank some taste of the difficulties lying ahead. In response to rapidly RISING Japanese government bond yields, the BOJ governor made a very Greenspan-like comment to the effect that the central bank would "take appropriate steps so as not to shock financial markets." In defense of the Bank of Japan, it is worth noting that it faces a very delicate balancing act: on the one hand, the central bank clearly wishes to normalize Japan's monetary policy as the country emerges from more than a decade of sub-par economic growth. Yet to do so too abruptly risks creating havoc, both inside and outside of Japan.

How did we get to this stage? Under quantitative easing, adopted in 2001, the bank flooded the financial system with excess liquidity. This, against a backdrop of exceptionally high prevailing debt levels. In the past many analysts, notably Paul Krugman, had proposed this as a course of action for the BOJ, arguing that one possible solution toward solving Japan's debt deflation dynamics would be to boost inflation above expected levels, effectively establishing a debt confiscating policy to establish self-sustaining growth, as opposed to the stop-starts which have characterized the Japanese economy over the past several years.

To some extent, this is now occurring, but such monetary largesse has not been without unhealthy by-products. Consider the following: In a February 2005 piece for FinanceAsia , economist Richard Duncan made the startling observation that in 2003 and the first quarter of 2004, monetary authorities in Japan created 35 trillion yen:

"To put that in perspective, ¥35 trillion is approximately 1% of the world's annual economic output. It is roughly the size of Japan's annual tax revenue base or nearly as large as the loan of $2500 for every person in Japan and, in fact, would amount to $50 per person if distributed equally among the entire population of the planet. In short, it was money creation on a scale never before attempted during peacetime."

I have long held the view that debt deflation dynamics were a major contributing cause of Japan's long time economic malaise. With excess private debt and incipient price deflation, I argued that prevailing extremely low nominal interest rates were ineffective in stimulating demand in the Japanese economy. Wherever debt deflation dynamics prevailed in the past, such as in the 1930's in the U.S., it was a monetary policy that succeeded in increasing the monetary aggregates rapidly enough to raise the general price level. Historically, when this occurred, the subsequent rise in nominal income greatly alleviated debt deflation dynamics and an economic recovery ensued. I argued that given the state of Japan's economic plight, this stimulus had to be pursued with exceptional vigour.

Unfortunately, in light of Duncan's analysis, it is very hard to make the case any longer that the Bank of Japan has never pursued this policy with anything like the degree of vigour required. Of course, one problem was the unwillingness of either the Japanese government - or the American government for that matter - to allow the foreign exchange markets to work unfettered in spite of this massive monetary creation. During the 15 month timeframe analysed by Duncan, the MOF bought more dollars through currency intervention then during the previous 10 years combined. Japan's monetary and financial authorities embraced "inflationism" with a vengeance.   It is very important to understand that the dollar yen rate is not where it is thanks to the market, but because central banks, notably the Bank of Japan, have put it there. In the process, the Bank of Japan has accumulated more than $1 trillion in foreign exchange assets. This, at a time when the country's net foreign asset position continues to produce billions of dollars of income per month.

Not all of that surplus liquidity has found its way back into the Japanese economy.   Rather, it has simply flowed into the U.S., helping to sustain the latter's ongoing credit bubble. If "liquidity does indeed abhor a vacuum," then the actions of Japan's monetary and financial authorities demonstrate conclusively that its first port of call is invariably the place where it is needed the most, which today remains the USA.

Which brings us to the other risk inherent in a big shift in Japanese monetary policy: The Bank of Japan's largesse has indirectly contributed to reducing the cost of American capital in spite of the fact that last year's U.S. current account ended some $805bn in the red (around 6 per cent of GDP). To finance this deficit, "foreigners" (including the leveraged speculative community largely domiciled in non-U.S. jurisdictions) acquired more than $1 trillion worth of US securities. To be sure, foreign central banks, such as the BOJ, have also played a large role in this financing almost a quarter of America's financing needs in the 4 th quarter of 2005.

But it is an analytical oversimplification to suggest that foreign central banks recycling their surpluses back into dollars in and of itself continues to put downward pressure on US rates and upward pressure on asset prices. By reflexively recycling their large accumulated surpluses back into dollars, it is clear that the central bankers have provided a lead for the global leveraged speculative community (hedge funds, the proprietary desks of investment banks and the like), acting as "sub-underwriter of last resort," thereby encouraging the perpetuation of practices such as the global "carry trade."

It is true that many Americans have hitherto benefited from cheap foreign credit. But what about the long term effects? Such abnormally low long-term interest rates have already contributed to several bubbles, from the residential housing market to private equity. If the Bank of Japan follows the Fed's footsteps and long term rates begin to rise globally, the fallout from these bubbles will be severe, particularly in the U.S.  

Will the Bank of Japan have the stomach to follow through on its threat? Last week's rapid back-peddling by Governor Fukui suggests that the BOJ will not move dramatically to change the prevailing status quo.   The sad irony of this period is that in spite of the searing experience of its own bubble, the BOJ's long-time monetary largesse has inadvertently help to repeat the experience globally. It is compounding the mistake by following in the footsteps of the Fed, seeking to confront the resultant excesses through gradual baby steps, presumably helping the latter in its mopping up exercises when the inevitable bubble burst occurs.   But such gradualism has not worked in the US and it is unclear whether it will work with the BOJ either, if recent U.S. experience is anything to go by. Ongoing telegraphed baby-steps by the Greenspan Fed has provided no impediment whatsoever to an overheated financial sector. To the contrary, the evidence of the past 2 years suggests blow-off excesses were further accommodated in spite of the much vaunted move to a "neutral interest rate."

Of course, the global liquidity boom created by Japan's monetary munificence cannot last indefinitely. First of all, it is inherently inflationary - that is why the CRB index has soared, and gold and silver are at multi-decade highs. In addition, the relationship between foreign providers of credit and American debtors is dysfunctional. In order to act as consumer of last resort for the whole world, the U.S. economy has been pushed into a debt bubble that thrives on conspicuous consumption and fraudulent accounting. At the same time, global economic growth has been sustained through a perverse dynamic in which the people producing the goods cannot afford to buy them and the people receiving the profit from goods production cannot consume more of these goods. The size of the U.S. market, large as it is, is insufficient to absorb the continuous growth of the world's new productive power and now foreign central bankers, such as the Bank of Japan, are seeking to withdraw the liquidity that helped fuel this imbalance. There is no countervailing support to offset the actions of the Bank of Japan, in spite of the alleged "global savings glut," all of which implies a huge toll is about to be inflicted on the global economy as a consequence of years of mispriced risk and misallocated capital. It is going to take a lot of nerve for Fukui to hold his course, particularly as the BOJ emerges as the new global scapegoat from any potential fall-out from his bank's actions.   My guess that if he blinks first, but Pandora's Box has been opened, the leveraged speculative community might well decide it doesn't want to keep its place at the card table for long. Then we'll have a real problem on our hands.

MARSHALL AUERBACK is a Denver-based international financial analyst who writes regularly for JPRI on economic and political developments in East Asia. His most recent article was "China's Revaluation Reflects a Myriad of Competing Interests," JPRI Critique Vol. XII, No. 4 (August 2005).

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