Central Banking & Governance: A Japan’s Perspective

Now, more than ever, we live uncertain times. One could expect the next crisis to be over some economical reason, however, this is not the case. It is true that debt levels are high in some countries and that there may be a general bubble, but, due to the COVID-19, the main economy was forced to stop. When companies are forced to stop working, families will be affected because unemployment will increase, and some others will see their buying power severely decreased. It also has a high impact on governments because they will not only have lower revenues but also have to increase spending, worsening public debt.

It is also relevant to see how bubbles and a crisis may not be that related. A bubble does not necessarily lead to a crisis. Take the dotcom bubble as an example. During and after the dotcom bubble, the USA GDP did not decrease. I believe that this happened because it wasn’t a bubble feed with debt but with equity. In an equity bubble, when it bursts, what happens is that the investors lose their money but there may not be huge defaults on debt because it wasn’t that significant in the beginning. This is one of the reasons that makes Central Banks, Governments and International Organisms intervene, when the risk of defaulting and to make the creditors lose all their money is clear. When a wave of defaults starts, it can easily spread through companies and governments which can trigger a crisis.

On the other hand, when Central Banks intervene there’s also the moral hazard problem to save and protect bad investors from a crisis that they helped to intensify. They are, as Ted Truman said, collateral beneficiaries. As Timothy Geithner says in Stress Test, “it is impossible to design aneffective rescue for the intended beneficiaries – the people who lived and worked in those countries – without some collateral beneficiaries”.

These and other factors make Central Banks, Governments and International Organisms actions complex and complicated. There is no perfect formula for how to act and what to do or on how to intervene, but throughout history, these organisms have been participating in the global economy and have been trying to intervene in a better way. One tool Central Banks have is the called Quantitative Easing (QE), which is a form of monetary policy that increases the domestic money supply, increase economic activity and avoid the decrease of assets that are used as a collateral for debt. It consists of a Central Bank purchasing longer term government bonds, as well as other types of assets. Buying these securities adds new money to the economy and is also used to lower interest rates by bidding up fixed-income securities.

Following the Asian Financial Crisis of 1997, Japan fell into an economic recession. Beginning in 2000, the Bank of Japan (BoJ) – Japan’s central bank – began a QE program to curb deflation and to stimulate the economy. However, the QE campaign failed to meet its goals. Between 1995 and 2007, the Japanese GDP fell from $5.45 trillion to $4.52 trillion despite the BoJ’s efforts. When this QE program began, the interest rates were already low. Indeed, loans decreased over the period of the program. Since 1997 the GDP stagnated, debt levels have been rising and the 10Y Bond Yield has been having negative returns (it’s necessary to point that, unlike Greece, e.g., it’s main debt is internal, i.e., their creditors are not foreign). Nowadays Japan’s public debt to GDP is roughly 240% (Greece’s is 180%) which may be a problem for their government and central bank.

BoJ has an unusual and unconventional way to intervene. Their QE programs began to focus also on equity, especially ETFs. This has been having 2 big effects: injection of liquidity; giving legitimacy to products that didn’t have them. BoJcontrols about 75% of ETF markets and, throughthese products, it owns about 8% of the Japanese equity market, being a top-10 shareholder in about 90% of Nikkei 225. I believe that this makes them even more interested in having liquidity on markets and to stop them from crashing in order to protect their assets and intervention instruments.

Because Japan is very dependent on exports, the BoJ has an even more active interest than the ECB does in preventing an excessively strong currency. The central bank is known for going into the open market to artificially weaken its currency by selling it against U.S. dollars and euros. Therefore, its main responsibility is to maintain price stability and ensure the stability of the financial system, which makes inflation the central bank’s top focus.

BoJ started another QE program in 2014 and has recently removed the limit for buying government bonds, preparing for an unlimited QE. It would be expected to get governments deficits to face this pandemic, but this means that the government of Japan can issue “as many bonds as wanted”, deteriorating its public accounts. Japan already has a huge debt and the bigger it gets the higher the interest rate will be because of the risk of default. A study made by One Road Research based on the actual trends puts the interest paid on its debt higher than the tax revenue by 2040.

Investors don’t seem as worried with Japan as with other countries. In fact, due to Japan’s debt nature, the autonomy to apply monetary policy and to have a larger margin of fiscal policy, the risks on this economy can be lower. However, not only Japan has an old population but also there’s still a huge debt. I believe that even if this problem does not affect foreign investors that much, it is still a problem, and looking “the other way” is halfway to worsening it.

Japan’s government and central bank are in complicated terms. Deflation, debt, aging population and some more problems are serious, and will be aggravated by today’s crisis and potential recession. BoJ and the government have a complicated future. BoJ already went public saying that the 2% inflation target will be missed and is prepared another QE program. The problem seems to be getting bigger and based on the current trends if nothing drastic is done we may see Japan’s economy aggravating or even default.

Article published in our May Newsletter

Diogo Marques, BSc in Economics

Published by lisboninvestmentsociety


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