The Japanese central bank must use its unique position within the country's political system to eradicate entrenched thinking and kick-start its stagnant economy. Writer Charles Smith
Japan lost the dubious distinction of being the world's most predictable democracy in late 2009 when the pro-business Liberal Democratic Party (LDP), Jiminto, lost a lower-house election, after an almost uninterrupted 50 years in power, to the mildly left-wing Democratic Party of Japan (Minshuto).
It is no surprise after such an upset that the Minshuto has attempted some housecleaning. Despite already going through a change of prime ministers and suffering a painful defeat in the upper house of parliament in July 2010, the new ruling party has tried to orchestrate a mass transfer of decision-making power from central government bureaucrats, who made most key decisions under the LDP, to its own MPs.
But there is one area the government cannot touch. Unlike fiscal policy, which in the final few months of 2010 became a battleground between politicians and the once all-powerful officials of the Ministry of Finance, monetary policy is the preserve of the seemingly impregnable Bank of Japan (BoJ). In a nation struggling to extricate itself from a decade of deflationary stagnation, this matters more than usual. It could be one of the determining factors in how the world's third largest economy survives in an increasingly uncertain future.
Down by law
The BoJ is 55% owned by the government, with the remaining 45% held by a variety of private and semi-public shareholders. But its status is that of an organisation rather than a government department, and its independence is guaranteed by the existing BoJ Law, which came into force in 1998 after several decades when a law dating from the Second World War had kept the BoJ firmly under the control of the Ministry of Finance.
Under the existing law, the Japanese cabinet nominates the BoJ governor and other senior officials, and parliament approves or (in one recent instance) disapproves them. Once in office, the governor cannot be dismissed during a five-year term and, in the meantime, the BoJ is not technically accountable to parliament for its actions. This privileged area includes accountability for the bank's failure or success in realising an inflation target.
In fact, neither the BoJ nor the government have published such targets, although the BoJ has issued forecasts about when and how Japan may emerge from the deflation that has persisted, on and off (mostly on), for the past nine years. The question of targets has come to the fore because deflation shares the blame for a number of ills currently besetting Japan's economy, including torpid personal spending and the tendency of corporations to hoard cash rather than invest it.
An indicator for excessive corporate risk-aversion is the low debt-to-equity ratios of many big companies listed on the Tokyo Stock Exchange (TSE). This suggests Japan's top management is more interested in fortifying balance sheets than expanding business. In terms of actual cash, figures published by the BoJ itself show Japanese companies are holding more than ¥200,000bn ($2400bn) in bank accounts, mostly in current deposits.
A former president of one of Japan's major league securities firms, who now serves on the boards of three TSE first-section companies, believes the psychological boost from a published inflation target would help to break the debt-equity logjam. That in turn could create employment, boost consumption and generally serve as a first step to getting the Japanese economy moving. But the BoJ is having none of it.
The BoJ's entrenched position does not mean that its status or its refusal to act have gone unchallenged. In a special session at the end of 2010, parliament debated but rejected a bill proposed by Mina no To ('Your Party'), a small but fast-growing party led by the son of a former finance minister, which would have obliged the BoJ to issue an inflation target and allow its senior officials to be dismissed with parliamentary approval.
A more significant threat to the BoJ's independence might seem to be a pressure group within the ruling Minshuto itself, which is calling on government to establish an economic 'control tower' that would dictate policy to the BoJ, including adoption of an inflation target. The Minshuto body is not backed by the cabinet but claims support from 140 members out of 410 MPs in the upper and lower houses of parliament.
Masaaki Shirakawa, governor, Bank of Japan Masaaki Shirakawa, governor, Bank of Japan Divide and rule
Opinions within the group are said to vary widely, with some MPs supporting the idea that Japan should monetise its way out of the deflationary impasse by buying Japanese government bonds (JGBs) directly from the Ministry of Finance rather than the bond market, as the BoJ is allowed to do under the present BoJ Law. Monetisation, as a quick and drastic way of ending a deflationary slump, was used in the early 1930s by Korekiyo Takahashi, a famous minister of finance who is regarded in Japan as practitioner of the reflationary policies advocated by John Maynard Keynes before the economist published his General Theory of Employment, Interest and Money. Mr Takahashi's story ends in tragedy as he was assassinated in 1936 by a military clique after refusing to use monetisation as means to step up Japanese arms purchases.
According to a former BoJ staffer who now heads the economic team at a US securities firm, the Takahashi legend has become "part of the BoJ's DNA", and is one reason why it is rigidly opposed to using monetisation to boost the economy. Yoshiumi Watanabe, founder and president of Mina no To, believes Japan's experience with artificially low interest rates after the Plaza Accord on exchange rates in the mid-1980s has also left its mark on the BoJ's psyche. Its discount rate was kept down after Plaza, ostensibly by the BoJ itself, but actually under pressure from the Ministry of Finance in an attempt to restrain what Japan viewed as excessive appreciation of the yen-dollar rate.
Low interest rates helped fuel a stock market bubble that peaked in 1989 when the Nikkei index, covering 225 stocks listed on the first section of the TSE, hit ¥39,000 - almost four times its current level. The same low rates sparked a real estate bubble that exploded about a year later, causing a 70% fall in land values over five years and fuelling a massive rise in bad debts held by banks that had lent to the real estate sector.
The collapse of land and equity values in 1990-91 was a trauma for Japan but not a global disaster, unlike the 2008 credit crisis, which began with collapsing US house prices but affected financial markets around the world. That said, Japan's so-called 'lost decade' following the bursting of the bubble turned out to be a decade of opportunity for its central bank.
Unconventional policies
Apart from winning its independence in 1998 when the discredited Ministry of Finance was reorganised and partially dismembered as a punishment for its casual regulation of banks, the BoJ spent the decade devising a series of path-breaking measures designed to cushion the economy's fall and help banks survive the crisis. In 1999, the BoJ embarked on a policy of cutting interest rates in the overnight call market, where banks borrow and lend, to almost zero (the zero interest rate strategy or 'Zirp').
When Zirp was abandoned in August 2000 in what is now seen as a major error of judgement by then BoJ governor Masaru Hayami, BoJ turned to quantitative easing (QE) as a novel way to prop up bank balance sheets weighed down by non-performing loans to the real estate sector and to boost economic activity in general. Under QE, banks were required to increase the current balances held with the BoJ, but the central bank created the funds needed for this to happen and used the extra money to buy securities and other assets from the banks themselves.
This was an original strategy and its size was spectacular. Before QE was launched, bank current accounts with the BoJ were held at between ¥4000bn and ¥5000bn. When the strategy peaked in 2004 before being formally dismantled in 2006, bank deposits with the BoJ had reached ¥35,000bn. Besides helping to prevent what could have been a systemic crisis in Japan's financial system, this process increased the BoJ's balance sheet to 20% of gross domestic product (GDP) - more than twice that of the US Federal Reserve. According to a retired BoJ official who maintains close contact with the bank, the current BoJ governor, Masaaki Shirakawa, at that time an executive director, was the senior official in charge of the delicate process of creating and unwinding QE.
It is not surprising that in a number of speeches to international and domestic audiences during the past year, Mr Shirakawa has pointed to both Zirp and QE as innovations that placed the BoJ a jump ahead of some other central banks. In a speech to the International Journal of Central Banking in September 2010, Mr Shirakawa referred to what he called "unprecedented measures [taken] in the uncharted circumstances in the late 1990s and early 2000s [which were] not well recognised at the time". Mr Shirakawa went on to assert that the BoJ's measures "involved most of the elements in the unconventional policies taken [by governments and central banks] in the recent global financial crisis".
What the governor did not add was that while QE and Zirp probably helped save Japan's banking system, it did not do as much as originally hoped to boost the real economy. This became clear in 2008-09 when the global credit crisis left solidly recapitalised Japanese banks largely unscathed, while the collapse in economic activity that followed in early 2009 hit Japan as badly as other major economies.
Pause for thought
After collapsing in early 2009, Japan's economy began a gradual recovery in the autumn, fuelled mainly by exports to emerging markets. But GDP was still stuck at 80% of pre-crisis levels in the summer of 2010, when economic recovery "seemed to be pausing", as described in the restrained wording of the BoJ's monthly reports.
The BoJ dealt with the 'pause' by issuing a ¥5000bn "comprehensive monetary easing" package announced on October 5. Among other measures, the package created a special fund that will temporarily allow the BoJ to buy long-term JGBs over and above the limits the BoJ's normal rule of confining its JGB holdings to the value of currency in circulation. More remarkably, the BoJ undertook to get directly involved in the stock market by promising, over one year, to buy ¥900bn-worth of listed exchange-traded funds (ETFs) and Japanese real estate investment trusts (J-Reits).
This marked the first time the BoJ had intervened directly in equity markets and, more remarkably, the first attempt by any central bank to target a particular industrial sector. The J-Reit and ETF buying operations had to be signed off by the minister of finance since he is outside the scope of the assets the BoJ is allowed to buy as specified in the BoJ Law.
Promises, promises
In an apparent attempt to ward off political abuse on the inflation target, the BoJ offered the rather tautological promises that it would maintain interest rates at zero in the interbank call market until it judges that price stability is in sight "on the basis of medium long-term price stability".
Kazumasa Iwata, a former BoJ deputy governor who is now president of the Japan Economic Research Centre (and who personally favours inflation targeting) interprets this to mean the BoJ has committed itself to achieving a zero price increase target but thinks it would be good to have an upper limit. As it is, no date is attached for even the zero commitment, and the government's consumer price index (CPI) minus fresh food, which the BoJ uses to calculate inflation rates, has at least one problem.
While the CPI is forecast by the BoJ's policy board to fall between -0.2% and -0.5% during the current fiscal year (ending March 2011) and range between -0.2% and 0.4% a year later, the index is almost certain to be revised downwards in 2011. This is because the list of items used to compile the index is due to be revised next year in accordance with a regular five-year schedule.
The October 5 package was greeted with a mixture of praise and derision in roughly equal measures by veteran BoJ watchers. Robert Feldman, managing director and chief economist at Morgan Stanley MUFG Securities Co, a partnership between the US bank and Japan's largest banking and securities group, estimates that the BoJ would have to invest ¥50,000bn (about 10% of GDP and 10 times the size of the October 5 package) to achieve a significant impact on deflation.
He is supported by Tomochika Kitaoka, senior strategist at Mizuho Securities Co, who believes the BoJ's investment in ETFs and J-Reits would have to be eight or nine times bigger to reduce the risk premium on such items to a level where investors might want to buy them.
Crossing swords
At the Tokyo branch of JPMorgan, securities managing director for economics research Masaaki Kanno takes a very different approach. Apart from dismissing conventional inflation targeting as "unworkable and out of date", he says there was never intended to be a direct "linear correlation" between the BoJ investment in ETFs and J-Reits and the economics of markets. The purpose was simply to change the mood of investors, urging them to take more risk. More generally, says Mr Kanno, the BoJ was right in identifying asset purchases as "the way to go" when the bank and most other central banks have little scope left for traditional monetary policy using interest rates.
Mr Kanno's big concern is that a bubble in JGBs has begun to inflate, assuming the current fiscal deficit is unsustainable. If that is correct then Japan could suffer disaster, since JGBs finance its public debt - the biggest in the world in percentage terms - at 180% of GDP.
While analysts cross swords, the TSE has delivered a mildly favourable verdict on at least some of the BoJ's latest efforts. Between late October and early December last year, as this article went to press, the TSE's Topix index had risen from 803 to 891, while the J-Reit index was up from ¥978 to ¥1070.
But the BoJ's actions represent just one of many factors that have kept Japan stable but stagnant for more than a decade while bordering nations, including China and South Korea, have seen their economies forge ahead. What probably matters most is that Japan has the world's oldest population for a large developed county with a median age of 44 that is rising by the year.
The key to waking the Japanese sleeping beauty may lie with demographic measures such as boosting immigration or increasing the employment rate among the female population. The tragedy is that Japanese politicians seem incapable of devising policies to make these things happen. What can be said about the BoJ is that, unlike the factionalised politicians and demoralised bureaucrats who inhabit Tokyo's political district, it knows what it wants and what it does not want, and can act quickly. Unfortunately, some things the BoJ does not want to do could form an important part of what Japan needs to do to restart its economy.
