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The Bank of Japan’s High-Wire Act

September 18, 2018

Central bankers across the developed world are either on the road to tightening monetary policies or speaking about how they plan to do so. Not in Japan, where the economy still depends on monetary stimulus and central bank Governor Haruhiko Kuroda fears talk of removing it would rattle markets and undermine his quest to kill deflation once and for all. And who can blame him? Massive market imbalances fueled by years of asset purchases mean his exit path will be fraught with danger. A misstep could send the economy sliding.

Sources: Bank of Japan, Japan's Economic and Social Research Institute, U.S. Federal Reserve, U.S. Bureau of Economic Analysis, data compiled by Bloomberg

With Kuroda staying quiet on his longer-term plans, Bloomberg surveyed economists and market strategists for an exclusive analysis of what the end game could look like for the world’s most aggressive monetary stimulus of the modern era. There were some surprising results. For example, nearly half of analysts said there’s a moderate or high chance that a spike in interest rates during the BOJ’s exit makes it impossible for the government to manage its debt, threatening it with bankruptcy.

And if Kuroda is successful in reviving inflation to his desired 2 percent, the BOJ could lose tens or even hundreds of billions of dollars as interest rates rise and the value of its nearly $5 trillion in assets falls.

Source: Thirty-two economists and market strategists who responded to a Bloomberg survey from Aug. 27—Sept. 3, 2018

Analysts cited the impact on commercial banks’ profitability as the biggest obstacle to the BOJ keeping its stimulus in place indefinitely. Years of rock-bottom interest rates have cut lending margins and deprived banks of low-risk gains from investing in Japanese government bonds (JGB), forcing them to take on more risk as they looked for other sources of profit.

While a little more risk was initially seen as a good thing, the BOJ never planned to keep its stimulus in place for so long. Its own gauge of lending attitudes among banks points to the highest tolerance of risk since the 1980s bubble era—and is at the edge of overheating.

Sources: Bank of Japan, Economic and Social Research Institute

No. 2 on the list of reasons the BOJ can’t go on forever is the havoc it has caused in the market for government bonds. Its buying has dried up the supply of bonds, undermining the market’s critical function of pricing risk. And the more bonds the central bank buys, the bigger its potential losses when it exits. The BOJ is already tiptoeing away from asset purchases. Its annual bond-buying has slowed to nearly half its 80 trillion yen official guideline, even as that target remains unchanged in its policy statements.

The BOJ has also been snapping up equities—supporting bullish sentiment for now but creating a whole new set of long-term problems. The buying has been so extensive that it’s now among the biggest shareholders in a host of large companies—from Fast Retailing Co. to semiconductor firm Advantest Corp.—and owns three quarters of all shares in Japan’s exchange-traded funds.

Sources: Banks of Japan, The Investment Trusts Association

While the BOJ has indicated a willingness to slow its ETF purchases, selling its stock is another matter. Some 25 percent of analysts surveyed said there’s a high risk that selling would trigger a large decline in the market, and more than 40 percent said the BOJ would still be holding at least 25 percent of the nation’s ETF shares 20 years from now.

Faced with near-zero interest rates at home and soft demand for corporate loans, Japanese commercial banks have also continued to look abroad for profits. With overseas lending now accounting for about 30 percent of total loans at major banks, foreign currency-denominated assets have become a concern for regulators. They cite potential threats such as volatility in foreign-exchange markets, spikes in dollar-funding and hedging costs, and possible liquidity problems in times of market turmoil.

Japan’s institutional investors have been looking overseas as well. Holdings of foreign securities are up 28 percent over five years, to a record high of about $3 trillion. If the BOJ pushes interest rates higher, a lot of that money will start flowing back, adding unwelcome strength to the yen. That would undermine the BOJ’s efforts to stoke inflation and make Japanese exports more expensive on global markets. About three quarters of analysts said long-term Japanese rates of 1.5 percent or even 1 percent would trigger a significant reversal of those investments.

Source: Bank for International Settlements

Lending for real estate has exceeded that to any other sector. It’s risen to record levels in absolute terms and as a share of the overall economy. The financial regulator is keeping a wary eye on property lending by regional banks, as well as the sustainability of some of their business models. Nobody is warning of a market collapse or crisis, and the BOJ even thinks some lenders have become more cautious lately. But real estate lending as a share of the economy is also approaching overheated territory, according to another central bank gauge.

When the time comes, it could be costly for the BOJ to remove its stimulus. Some say it wouldn’t really matter if the BOJ suffered big losses because it can basically print money. But others say doing so would threaten the central bank’s credibility, invite political interference in its affairs and risk a collapse of the nation’s currency.

Sources: Japan Center for Economic Research, National Graduate Institute for Policy Studies, Bloomberg reporting

As if all of that weren’t enough, the 73-year-old BOJ governor must pull off the high-wire act of normalizing policy in an aging economy that’s as exposed as any to the ravages of a global trade war. It’s little wonder he’s loathe to even discuss how the greatest monetary experiment of them all will end.

Assists: Cynthia Li, Connor Cislo, Toru Fujioka, Yuko Takeo, Yuji Nakamura, Gareth Allan, Russell Ward, Takashi Amano and Jeremy Scott Diamond

Editors: Brett Miller and Malcolm Scott

Notes on loss estimates: Fujiki’s loss estimate assumes the BOJ hits its 2 percent inflation target in March 2020; Feuda-Samikawa and Takano’s estimate assumes core inflation hits 2 percent in fiscal 2022 and short-term rates rise to 2 percent around 2027; Ito’s estimate assumes the BOJ keeps interest rates low for a long time and raises long-term rates first to minimize losses.

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