As Bank of Japan continues to print money effectively out of thin air to fuel a new round of quantitative easing, has the central bank simply become a bottomless ATM for the Japanese Government?
Japanese investors were given a big treat on Halloween, after a surprise announcement from the Bank of Japan (BOJ) Governor Haruhiko Kuroda which sent the Nikkei index rallying to highs above 17,000 points last week. Kuroda announced that the central bank will boost its annual asset purchase program to a pace of 80 trillion yen (over US$700bn) a year, up from the previous range of 60-70 trillion yen a year. Within this policy change were three key elements: tripling annual purchases of real estate and equity funds, increasing annual purchases of government bonds and extending the average maturity of such bonds. The sudden escalation of Japanese quantitative easing efforts came eerily just after the US Federal Reserve announced the end of their stimulus program.
Why quantitative easing?
Japan has been battling with deflation for the past two decades, ever since the asset burst of the 1990s. The economy stagnated as companies shifted manufacturing to cheaper locations abroad, which caused wages and consumer spending to fall. This was exacerbated by the ageing population and led to a fall in general consumer prices, causing deflation.
Figure 1 % Change in 2010-Base Consumer Price Index, less imputed rent (Source: Japan Ministry of Internal Affairs and Communications)
A plan was devised to salvage the Japanese economy from deflation by allowing the central bank to purchase large amounts of assets from the market, also known as quantitative easing. Typically, a government stimulates the economy indirectly by lowering interest rates to encourage consumer spending and bank lending activity. However, such expansionary monetary policy works no longer when interest rates can be lowered no further, as in the case of Japan. At this point, the government has to employ quantitative easing to directly stimulate the economy, by purchasing assets from financial institutions, typically government bonds. This large injection of liquidity into the markets pushes up the value of the bonds and makes them less attractive to investors, thereby encouraging institutions that sold the bonds to lend the proceeds to individuals or companies and thus lower their interest rates.
Armed with this measure, the BOJ set a two-year 2% inflation target in 2013; the central bank aimed to rapidly expand its balance sheet and devalue the yen, thereby boosting growth in exports and lift inflation. However, new data released last month showed a further drop in crude oil prices, which could trigger a short-term fall in inflation expectations and hinder efforts to reach the 2% target. This could have been one of the main motivations behind the sudden Friday stimulus announcement.
It remains to be seen whether Kuroda can achieve the 2% inflation target in the next fiscal year, but at the same time, Prime Minister Shinzo Abe has promoted other economic reforms such as encouraging a riskier appetite in the country’s pension fund. As the new stimulus lowers yields for government bonds, the Japanese Government Pension Investment Fund (GPIF) has announced a portfolio rebalancing away from bonds and towards equities, in order to boost returns. However, the risk management involved in this decision is seriously questionable; as the world’s largest pension fund with assets under management of over 127 trillion yen (US$1.2 trillion), GPIF is responsible for the future livelihoods of the entire ageing country.
On the other hand, Abe is considering a further increase in the consumption tax to reduce government debt. The BOJ raised the consumption sales tax early this year from 5% to 8%, its first increase since 1997. In a way, the increase in sales tax encouraged spending as consumers hoarded goods in advance of the tax hike, while the increase in tax revenues also helped rein in the largest public debt burden in the world. However, any further increase in sales tax could curb consumer spending, already hurt by the mentality of storing value in money by saving instead of spending, which has been ingrained in Japanese consumers in a deflationary environment over the past two decades.
Structural reform is key
Quantitative easing was by-and-large a Japanese invention, and has been used in the country for over a decade, each time with only short-term results. The new stimulus from Kuroda will certainly help alleviate the issue of deflation, but it is definitely not the panacea for Japan’s troubles. Deflation is simply a symptom and the illness can only be cured by tackling the structural issues in the Japanese economy. Even if the 2% inflation target is reached, it could only be masking true fundamental problems such as massive government debt or stagnating wages. Kuroda and his stimulus cannot save the Japanese economy – alone.