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02 12 2016 | by Victor Xing | Central Banks

Why did BOJ introduce negative rates instead of more QE?

Governor Kuroda’s monetary bazooka: plenty of ammo, dwindling targets

Bank of Japan is the dominant participant in the Japanese Government Bonds (JGB) market thanks to its 80 trillion yen ($706 billion with USDJPY at 113.22) annual QE program.  It is true that BOJ’s willingness to conduct further easing is rarely in doubt under Governor Kuroda‘s dovish leadership (supported by allies such as Deputy Governor Iwata and Nakaso on the Monetary Policy Board), as the central bank pledged to do “whatever it can” to achieve Japan’s 2% inflation target.

Mr. Nakamichi of the WSJ provided another perspective on Governor Kuroda’s “positive attitude and conviction” on the institution’s crusade against low inflation:

It is an ominous development for Mr. Kuroda. He sees Japan’s long bout of deflation as a psychological disorder as much as an economic disease. His job as BOJ chief has been part central banker, part national psychologist. It has been all about creating confidence. From the start, many said he was attempting the impossible. Deflation is notoriously difficult to escape, and had taken deep root in Japan after years of policy missteps.

Last summer he invoked a fairy tale to describe his task.

“I trust that many of you are familiar with the story of Peter Pan, in which it says, ‘The moment you doubt whether you can fly, you cease forever to be able to do it,’” Mr. Kuroda said in June last year. “Yes, what we need is a positive attitude and conviction.”

Conviction or not, even ultra-expansionary monetary policy backed “whatever it can” attitude has its own hurdles – bank reserves can be created electronically via QE, but size of bond issuance by Japan’s Ministry of Finance cannot be easily expanded at will.

Indeed, BOJ’s asset purchase has already threatening to outpace bond issuance amid two factors:

BOJ’s effective monthly purchase reached an average of 9.3 trillion yen (or 111.6 trillion yen annually) by 3Q 2015, far larger than the announced 80 trillion yen annual target (6.7 trillion yen per month).  Even though 112 trillion is still below FY2016’s 147 trillion yen debt issuance projection, the JGB market would indeed appear very tight once demand from pension funds, global asset managers, and banks are factored in.  BOJ policy actions have accelerated the displacement of non-official institutions in the sovereign bond market.

BOJ monthly purchase rises to keep up with bond maturity
BOJ monthly purchase rises to keep pace with bond maturity

BOJ dominates the JGB market

Ministry of Finance also highlighted BOJ’s sizable holding (it became the largest JGB holder as of 3Q 2015) in its FY2016 Government Debt Management report:

BOJ has became the biggest holder of JGBs

Therefore, increasing the pace of annual asset purchase would further add fuel to existing trends (which do not appear to be sustainable), and it would also heighten financial stability risk in an already heavily distorted market where 10 year JGB yield seesaws around 0% (source: Bloomberg, data taken as of 2/12/16 market close):

BOJ negative rates and JGB bond yields

Prime Minister Shinzō Abe’s “three arrows”

Abenomics has three main components (Abe’s three arrows):

  • First arrow: fiscal stimulus
    • Infrastructural projects
    • Fiscal spending packages
  • Second arrow: monetary stimulus
    • QE in the form of asset purchase programs
    • Accommodative interest rates policy
  • Third arrow: structural reforms
    • Improve female labor force participation
    • Relax labor policies to be more tolerant to non-Japanese guest workers
    • Reduce the cost of raising children
    • Halt or even reverse the population decline
    • Corporate reform to make Japan’s private sector more competitive

The first arrow currently faces the constrain of Japan’s sizable sovereign debt (246% debt-to-GDP ratio as of 3Q 2015 vs. 234% in 2Q 2015)

  • Narrowing of fiscal deficit requires higher tax, which is negative on growth
  • Further increase in deficit spending will worsen Japan’s fiscal situation and hinder fiscal policy response if economic conditions deteriorate
  • It is preferable to conduct fiscal reform over the short-term to reduce deficit spending, and to pave the way for stronger fiscal stimulus over the medium-term

BOJ faced opposition from fiscal hawks

Prime Minister Abe had pledged to reduce fiscal deficit, but lackluster economic growth had repetitively shifted priority toward stimulus at the cost of fiscal reform. Additionally, factionalism within the Ministry of Finance between fiscal conservatives and proponents of Abe’s pro-growth agenda also serve to complicate the matter. This was the policy backdrop following the resignation of Abe’s controversial political ally at the Ministry of Finance, Akira Amari.

The end result was a constant back-and-forth between fiscal tightening and loosening, and higher tax collection as a result of former had reduced the projected size of JGB issuance in 2016, thus reducing the choice of targets for Governor Kuroda’s monetary bazooka.

 

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