Capitalizing on his sweeping electoral victory over the weekend, Japan’s next prime minister, Shinzo Abe, stepped up pressure Monday on the Bank of Japan to ease monetary policy dramatically in an effort to end deflation and jump-start the country’s economy.
Abe’s center-right Liberal Democratic Party scored an overwhelming victory in Sunday’s parliamentary election after a highly unusual campaign in which he focused his attacks more on the central bank than on the outgoing government of Prime Minister Yoshihiko Noda. NHK public TV said Monday the LDP had won 294 seats in the 480-member lower house of parliament while its ally, the New Komeito party, won 31 seats, giving them the two-thirds majority needed to overrule most matters in the upper house, where Noda’s Democratic Party of Japan holds the largest number of seats.
During the campaign, Abe had declared that the top priority of an LDP government would be to bring an end to the deflation that has plagued Japan’s economy for 15 years. To that end, he called on the Bank of Japan to double its inflation target, to 2 percent, and to ease aggressively along the lines of the U.S. Federal Reserve Board to reach that goal. He also identified the strong yen as an archenemy of business and vowed to press for measures, including purchases of foreign bonds by the BoJ, to weaken it. Abe even threatened to override the central bank’s independence if it didn’t bow to the will of the government.
Abe kept up the pressure at a post-election news conference on Monday. “It was very rare for monetary policy to be the focus of attention in an election, but there was strong public support to our view,” he said. “I hope the Bank of Japan takes this into account” when its policymaking body meets this Wednesday, he added.
Financial markets reacted to the LDP victory by pushing the yen lower, to 83.78 to the dollar from 83.45 on Friday, and driving up Japanese stock prices. The Tokyo Stock Exchange’s Nikkei 225 index rose 91.32 points, or just under 1 percent, to 9,828.88.
Japan’s central bank has long drawn criticism from outside economists for its seeming passivity. The bank’s determined effort to rein in asset prices in the late 1980s effectively burst the country’s property bubble and set in train a lengthy period of stagnation — the so-called lost decades — that have produced a stubborn deflation. The BoJ was slow to adjust to the changed circumstances. It didn’t adopt an inflation target until February 2012 and then set it at a mere 1 percent, the lowest of any major central bank. Although the BoJ has bought bonds over the past decade, it has resisted the bold intervention style and explicit economic targets adopted by the Fed.
What’s new today is the extent to which the BoJ is under attack at home. Abe, who served a previous stint as prime minister in 2006 and 2007, has been notably strident in his criticism, but he is hardly alone in his attacks. Lawmakers summoned central bank governor Masaaki Shirakawa to the Diet, Japan’s parliament, several times in February 2012 to criticize his cautious policy approach and urge stronger action on deflation. The pressure appeared to work, as the BoJ that month unveiled its inflation target and announced an increase of ¥10 trillion ($122 billion) in its asset purchasing program.
But with deflation persisting and Japan’s economy sputtering — output contracted at a 3.5 percent annual rate in the third quarter — calls for bolder measures have intensified. Indeed, a new consensus seems to have taken hold. After two decades of failed stimulus efforts that have left Japan with the highest debt levels of any major country, while China’s economy has overtaken it in size and South Korea has raced ahead in competitiveness, much of the political class believes that aggressive monetary easing by the BoJ offers the last, best hope of ending the country’s long slump.
Politicians of all stripes are “very serious now about the need to end deflation,” says one senior bank official, who spoke on condition of anonymity.
Markets have clearly sensed a shift in policy in the making. The prospect of easier monetary policy prompted the yen to slide by more than 5 percent between late September and early December, while the Nikkei 225 has risen more than 13 percent since mid-November.
Jim O’Neill, chairman of Goldman Sachs Asset Management, says Japan’s economy, especially its large export sector, has been hurt by a “very overvalued exchange rate,” but he adds that the prospect of a shift in central bank policy could turn that around. “I have been getting more and more negative about the yen for the past couple of years, and I have so far been wrong,” O’Neill says. “But it seems more and more obvious to me that the moment is here.”
It’s not hard to see why Abe and others are focusing their attention on the central bank. The economy has grown at an average annual rate of barely 1 percent over the past two decades. Consumer prices have been falling gently for much of the past 15 years; the annual rate stood at –0.4 percent in October. Politicians are eager to try anything that might give the economy a jolt.
A weaker yen could also relieve some of the pressure on corporate Japan. The currency has eased somewhat since hitting a record high of 75.31 to the dollar in 2011, but many analysts believe it is overvalued by anywhere from 10 to 25 percent.
“The opportunity in Japan will probably be a currency opportunity, being short the yen,” says Mark Dowding, head of investment-grade fixed income at BlueBay Asset Management, a London-based specialist bond manager. “I do believe you’re going to see more balance-sheet expansion next year.”
Abe’s gambit is not without risk. A higher inflation rate and a weaker yen could drive up interest rates and destabilize the market for Japanese government bonds. The country’s low rate levels — ten-year JGBs were trading at yields of about 0.70 percent in early December, versus 1.56 percent for comparable U.S. Treasuries — are among the main reasons Japan can sustain debt of some 236 percent of gross domestic product.
In its annual review of the Japanese economy, released in August, the International Monetary Fund warned that a 100-basis-point rise in JGB yields over five years would keep the debt growing simply because of higher debt-servicing costs; this would occur even if the government succeeded in eliminating its big structural budget deficit, which stands just above 9 percent of GDP. With the country’s fiscal policy effectively tapped out, the Fund recommended further monetary easing by the Bank of Japan, including a substantial increase in asset purchases, to combat deflation and stimulate the economy. Even if the BoJ does open the money taps, there is no guarantee that such efforts will produce the desired result. The central bank may well have been too conservative in the past, but years of asset purchases have given it a balance sheet that at roughly 35 percent of GDP is larger than that of the Fed. And quantitative easing hasn’t proved to be a panacea for Fed chairman Ben Bernanke or Bank of England governor Mervyn King.
“I don’t think there will be much impact of monetary policy on Japan’s deflation,” says Tohru Sasaki, chief foreign exchange strategist at JPMorgan Chase Bank in Tokyo. “The nominal yield [on JGBs] is already zero, and what the BoJ is doing is just buying JGBs from the banks. That does nothing to change inflation expectations. Only if money goes out [into the real economy] and inflation expectations go up will the real yield go into negative territory, and that will make the yen depreciate.”
Achieving the center-right LDP’s goals would seem to be a tall order, but Abe nevertheless appears intent on trying to lift Japan’s animal spirits by setting ambitious targets.
The political pressure on the Bank of Japan is not an idle threat. The next prime minister will have the opportunity to nominate a successor to the hawkish Shirakawa when the bank governor’s term expires in April, as well as two deputies. Those appointments could shift the balance of power on the central bank’s nine-member Policy Board to favor the doves. Three recent appointees to the policymaking body are thought to support greater monetary easing. “If the new appointees are in favor of the Abe policy, that will make a majority in favor of further easing,” says Rei Masunaga, former head of the central bank’s foreign department.
Although Abe has spoken of raising the inflation target as high as 3 percent, the LDP platform calls for the government to reach a compact with the central bank to lift the rate to 2 percent. If the central bank doesn’t cooperate, Abe has said the LDP would propose changes to the 1997 Bank of Japan law to reduce the institution’s autonomy in monetary matters.
Shirakawa has been quick to reject the criticism. A few days after Abe unveiled his proposals, the governor dismissed the higher target as unrealistic, noting that Japan’s inflation rate averaged only 1.3 percent during the bubble years of the 1980s.
“Targeting 3 percent inflation would put upward pressure on long-term yields, and that would be a problem for public finances,” said Shirakawa. Similarly, he dismissed a suggestion by Abe that the central bank buy bond offerings directly from the government, saying it would fan fears of debt monetization. “No advanced country has adopted such a policy,” he noted.
For Shirakawa and his allies at the BoJ, Japan’s deflation and economic troubles are too endemic to be solved by monetary policy alone. “It is understandable that many people are frustrated with the current situation and try to pressure the BoJ to do more,” executive director Kazuo Momma tells Institutional Investor. “But the problem is deep-rooted and is associated with Japan’s economic structure, which tends to create a deflationary environment.”
The roots of Japan’s policy dilemma stretch back to the bubble era. The Bank of Japan hiked interest rates sharply at the end of the 1980s, when it became clear that housing prices were soaring beyond the affordability level of many if not most Japanese. The policy worked only too well. Property and stock prices crashed. The Nikkei 225, which rose sixfold during the decade before hitting an all-time high of 38,957 on December 29, 1989, plunged nearly 39 percent over the next year and continued heading south. Today, 23 years later, the index languishes more than 75 percent below its record level.
As traumatized Japanese corporations focused on paying down debt and restructuring their operations, economic activity slumped and would have been negative but for continued heavy fiscal stimulus by successive Japanese governments. The central bank appeared to be stuck in a state of postbubble shock. It reduced interest rates progressively as the economy stagnated, but it never acted forcefully enough to get ahead of the curve and arrest the decline.
“From 1992 to roughly 1999, they didn’t do anything,” says Adam Posen, a Japan specialist and senior fellow at the Peter G. Peterson Institute for International Economics in Washington who served on the Bank of England’s Monetary Policy Committee from 2009 to August 2012. “They were cutting interest rates slowly, but they didn’t really start quantitative easing, and so deflationary trends and expectations tended to become entrenched.” When the BoJ did start buying bonds, it purchased mostly short-duration paper rather than long-term securities, the area on which the Fed and the Bank of England have focused their firepower. The central bank’s communications policy was equally timid, paying lip service to the fight against deflation in a way that failed to convince consumers, businesses and investors. “No one would ever believe that they were really opposed to deflation,” says Posen.
By the end of the ’90s, the BoJ had slashed its policy rate to zero and committed to keeping it there until deflation ended. At the first sign of recovery, however, in 2000, the bank abandoned the so-called zero interest rate policy, or ZIRP, only to have to reinstate it the following year under then-governor Masaru Hayami when the economy fell back into recession. It was one of many stop-go policy moves during the country’s long economic decline. The bank raised rates yet again in 2007 under former governor Toshihiko Fukui, but a subsequent slowdown — aggravated dramatically by the global economic crisis in 2008 — prompted the bank to cut rates once again to zero.
Politicians, frustrated by the weakness of the economy and the persistence of deflation, have ratcheted up the political pressure on the central bank. Seiji Maehara, minister for Economic and Fiscal Policy in the outgoing Noda government, attended the central bank’s monthly Policy Board meetings and repeatedly urged more-aggressive monetary easing. His presence at the meetings was unusual for a government minister, considering that the 1997 Bank of Japan Act had strengthened the institution’s independence.
Faced with growing criticism from Maehara and the Diet, the Policy Board eased no fewer than four times in 2012, raising its asset purchase program from ¥35 trillion to ¥91 trillion. It also expanded an initiative to subsidize bank lending in a bid to stimulate the economy, an effort similar to the Funding for Lending program recently launched by the Bank of England.
The Noda government continued to push for further action, and in November, Maehara and governor Shirakawa signed a joint pledge to tackle deflation. “The government and the Bank of Japan needed to clearly define their roles and put these down on paper,” Maehara tells II. “It was very important for us to confirm these responsibilities and to make sure that we share joint responsibilities, acting as quickly as possible in getting out of the deflationary situation.”
If elected, Abe will most likely press for more-dramatic action. He wants the Bank of Japan to take a leaf from the Fed’s playbook and do everything it can, including cranking up the printing presses, to defeat deflation.
Someone who shares that view, and is considered to be among the leading candidates to replace Shirakawa, is Haruhiko Kuroda, president of the Asian Development Bank and a former Ministry of Finance vice minister for international affairs. The BoJ must continue to ease policy to break a “vicious circle of deflation and yen appreciation,” Kuroda tells II. “Japan has been the only country in the world to have deflation over the past 15 years. The GDP deflator has been declining every year by 1 percent or 0.5 percent, and the CPI declining also most every year. I think this is really unusual, and this situation must be stopped.”
The aim of policy should be not simply to create inflation for its own sake but to stimulate demand, says Jesper Koll, director of research at JPMorgan in Tokyo. “What you really want to focus on is wage inflation. You want to see that the proverbial Watanabes actually end up with more purchasing power. Ironically, we have had 20 years of disinflation in Japan, and purchasing power has actually continued to go up. There is a risk now that wages are stagnating, and if inflation goes from minus 0.5 percent to plus 2 percent, that is not a good thing.”
Until now, however, the BoJ has been too slow and miserly in expanding its balance sheet to make an impact on prices or wages. “If you look at the balance sheets of the BoJ, the Federal Reserve and the ECB after the Lehman [bankruptcy] shock, the Fed balance sheet more than tripled and the ECB’s balance sheet more than doubled,” notes Kuroda. By contrast, he adds, the BoJ has increased its balance sheet by “maybe 30 percent.”
Takatoshi Ito, dean of the Graduate School of Public Policy at the University of Tokyo and another potential candidate for the BoJ governor’s post, offers a similar criticism. “When the ECB, the Federal Reserve and the Bank of England expanded their balance sheets, the BoJ did not do anything,” he says. “I do believe that was one of the major causes of yen appreciation” in recent years, he adds, along with the “safe haven” phenomenon that has attracted investment flows to the yen since the eruption of the euro area’s debt crisis.
Although Abe has focused most of his criticism on deflation and hasn’t specifically set any targets for yen depreciation, it’s clear that many in Japan, including the outgoing Noda administration, believe the currency’s strength is contributing to Japan’s woes. Finance Minister Koriki Jojima went out of his way at the annual meetings of the IMF and World Bank in Tokyo in October to remind his Group of Seven colleagues that the yen exchange rate was “not in line with Japan’s economic fundamentals.” He noted that the IMF had recently labeled the yen as “moderately overvalued.”
Takehiko Nakao, Finance vice minister for international affairs, drives the point home. “My view is that the yen’s recent appreciation does not reflect the real fundamentals of the Japanese economy and that the yen has tended to appreciate too rapidly,” he says. “Japan suffered from a tragedy last year,” he notes, referring to the Tohoku earthquake and tsunami that devastated the Sendai region of northeast Japan. “We are still in a recovery stage, and our government debt is bought mainly by Japanese investors, but our fiscal condition is not better than others’, and it is not rational that the yen is regarded as a safe haven.”
Japanese authorities made heavy foreign exchange market interventions last year to weaken the yen, but they have not stepped into the market this year. It would be futile to do so at a time when the U.S. and European authorities are creating massive liquidity with their quantitative easing exercises, asserts Christopher Wood, chief strategist at brokerage CLSA in Hong Kong.
Not everyone agrees that the yen is overvalued. Eisuke Sakakibara, another former Finance vice minister for international affairs, whose pronouncements on the currency carried so much weight that he was known as “Mr. Yen,” insists Japan’s problems reflect corporate failings rather than foreign exchange valuations. “It is not because of the exchange rate that some Japanese companies are not doing well,” he says. “They are focusing too much on domestic demand rather than international competitiveness. They need to change their business model. Their prices are too high, and their designs are not suited to the international market. The yen rate is an excuse. Compared with 1995, the yen rate is no higher in real effective exchange rate terms. Inflation in Japan has been zero while in other countries it is higher, so you would expect the yen to appreciate.” Rather than intervening in the currency market, the Bank of Japan should embrace quantitative easing and force-feed the economy with liquidity to stimulate bank lending, Sakakibara says.
The central bank has been reluctant to loosen the monetary strings, however. “The BoJ has been making some effort, but with the message that they do not really want to ease,” says the University of Tokyo’s Ito. He blames a faulty communications strategy as well as timid monetary policy. “After the Lehman shock the BoJ missed an opportunity,” Ito says. “The second missed opportunity was in February this year, when they announced the 1 percent inflation goal. The market responded strongly, believing that the BoJ would take a radically different tack from the past. The yen depreciated, and stock prices surged, and the market waited to hear concrete goals, but the BoJ failed to follow up.”
The central bank’s reticence reflects a deep-rooted tendency to focus on the mistakes of the past. Ever since the property and stock market bubble of the late 1980s, the bank has had a strong bias toward fighting inflation, even during the past 15 years, when consumer prices have generally declined.
For a long time the tight-money stance did not seem to matter too much. Successive governments for years maintained modest economic growth and reasonably full employment with heavy fiscal stimulus. The government budget deficit averaged 6.4 percent of GDP between 1996 and 2005. As the public debt climbed above 100 percent and later 200 percent of GDP, markets remained calm and the political class was largely unconcerned. Unlike the U.S., which relies on foreign borrowing to cover a good part of its deficit, Japan finances roughly 95 percent of its deficit thanks to the massive savings held by its citizens and institutions.
The recent stall in the economy as demand from Europe and China waned has shaken the complacency of political leaders. Almost everyone agrees that Japan’s current trajectory — the IMF projects that the deficit will hit 10 percent of GDP this year and the debt will surpass 235 percent — is unsustainable. Abe decided that dramatic remedies were needed. In September he formed a study group that includes economists such as Heizo Takenaka, a former Internal Affairs minister who prepared the privatization of Japan Post in the past decade, to come up with a strategy for preventing the economy from foundering on the shoals of deflation. The group has been largely responsible for the policy reforms proposed by the LDP. Takenaka is close to Abe, and he is mentioned as a possible successor to Shirakawa, although he has been quoted as saying he isn’t seeking the job.
The big hope for reining in Japan’s deficit is a doubling of the national consumption tax. Noda used up a lot of political capital in 2012 in pushing through the Diet a law that will raise the tax from its current level of 5 percent to 10 percent in two stages by 2015. The LDP supported the bill and was happy to see Noda’s reform-oriented DPJ take responsibility for such a politically unpopular move. The tax increase is conditional, however, upon the economy being strong enough to sustain it. That is where the Bank of Japan comes in. Abe and other politicians believe an ultraeasy monetary policy is needed to strengthen the economy enough to implement the tax hike and begin reducing the deficit.
“It is important to have an economic environment conducive to raising the consumption tax,” says Economic minister Maehara. “Without a tax rise, Japan would be unable to solve its fiscal problems and to meet its responsibilities to the international community.” The IMF and the Organization for Economic Cooperation and Development have repeatedly called on Japan to bolster fiscal revenues and reduce its public debt burden. One senior MoF official acknowledges that Japan’s fiscal condition is now “critical.” Bank of Japan officials are skeptical of the idea that monetary policy alone can revive the economic growth rate, and they certainly don’t think BoJ policy can do it in time to help gain popular acceptance of a tax increase. “It is really difficult for people in Japan to imagine that the inflation rate could be steadily 1 percent or 2 percent,” says one BoJ insider. “People just get too accustomed to the situation where prices are not moving so much. What has created the problem is the steady decline in the growth rate — that and the fact that the population is aging and has already started to decline. Also, the productivity growth rate is significantly weaker now than it was in the 1980s or 1970s. People now expect Japan’s economy to continue to experience very slow growth. That creates a lack of spirit in the corporate sector, and households do not spend much on housing or cars and other durables.”
In other words, liquidity does little good if people lack the confidence to borrow. The same dilemma, of course, plagues the Fed, the ECB and the Bank of England.
“What we really need is not liquidity,” says JPMorgan’s Sasaki. “What we need is demand for loans and for risk. The funding costs for low-credit investors may become a little bit lower. The most important point is that banks must be prepared to take credit risk.”
In a bid to do just that, the BoJ has been making funds available to banks at a rate of just 0.1 percent for periods of up to four years.
So far, the central bank has made this cheap funding available only to certain, officially designated growth sectors, including environmental and energy businesses, medical ventures, natural resources and tourism. The bank had only ¥1.3 trillion of such loans outstanding as of June. In November the BoJ decided to extend the program to all sectors of the economy. Under the new arrangement, which is expected to begin in the new year, the central bank will provide low-cost funds to banks in amounts proportional to the quantity of their new net lending. Significantly, banks can use the funds for just about any purpose — business loans, consumer loans, mortgages — and for overseas as well as domestic lending. “We are ready to provide an unlimited amount of money as long as banks increase their lending,” says one official. “This should create an incentive to lend more.” Economic Minister Maehara says he regards the expanded lending scheme as a “breakthrough” in helping to combat deflation.
Although the BoJ appears to be more willing now to pump money into the private sector of Japan’s economy, it remains wary of being seen as willing to finance the government’s deficit. The central bank normally limits its purchases of long-term government bonds to the amount of banknotes in circulation (currently about ¥80 trillion). In recent years it has breached that limit; the excess purchases will reach about ¥34 trillion by next year. Aggressive buying of bonds “may create the impression that we are financing the government debt, and that is something we would like to avoid,” says one central bank official. The BoJ has made it clear that these exceptional asset purchases “are for the purpose of monetary easing, not for making it easier for the government to borrow more.”
By itself, the lending scheme is unlikely to rescue an economy suffering from two decades of very sluggish growth and more than a decade of deflation.
“The problems with the real economy are deeply rooted and cannot be solved by monetary policy alone, meaning that the government also has a task to perform,” says Shigemitsu Sugisaki, vice chairman of Goldman Sachs Japan Co. and a former deputy managing director of the IMF. “I am supportive of more monetary easing as an antideflation policy, but it has to go hand in hand with measures to address the problems in the real economy. The most important measure would be to give the private sector freer market access through deregulation, albeit with some supervision, and structural reform.”
In short, the key to success will be having monetary and fiscal policy working together, says JPMorgan’s Koll. “The Bank of Japan has been printing a lot of money,” he says. “The new thing that Abe brings to the table is a great focus on policy coordination. The BoJ needs to be responsible and needs to be held accountable.”
