Bank of Japan Governor Kuroda: “An entirely new dimension…”
The Japanese central bank is embarking on a path that may have been travelled before by others, but never quite like this. Relative to the size of its GDP, the stimulus package announced by the BoJ is on a scale not seen before, and it is viewed by many as the final attempt by the government to rescue the flagging economy. The amount of government bonds held by the BoJ will be doubled, bringing its annual purchases to Y90trn (roughly $900bn, depending on how fast the Yen is dropping as we write this). This equates to 70% of government bond issuance, which in itself is a staggering number. The range of maturities will be extended to 40 years from previously 3, and the average maturity for coming bond purchases will be 7 years. In addition it will be active in the equity market, buying both ETFs and REITs. The total expansion of the monetary base will equate to about 10% of Japan’s GDP. The move will cause a dramatic increase in the BoJ’s balance sheet, far beyond that currently in place in other countries that have also pursued aggressive monetary expansion over the past several years in order to jump-start their economies.
The following clip from Bloomberg TV reflects the thinking behind the move. Unfortunately it also illustrates the simplicity of the thinking and possible naiveté behind it.
The officially stated goal is to create a 2% inflation rate, thus (theoretically) forcing the Japanese consumers to spend the cash hidden under the mattress. Further pressure on interest rates through increased buying of JGBs should also theoretically induce companies to invest more than they have in the past several decades.
However, it is difficult not to assume that a significant part of the plan entails a controlled devaluation of the Yen in order to increase the competitiveness of Japanese exporters. This of course will never be stated explicitly by either the BoJ or the Ministry of Finance (MoF), but given the history of intervention in the currency market by the BoJ, one has to assume that this entered into the overall equation as a very significant factor when the policy was fleshed out. In addition, the very obvious effect of quantitative easing and inflation creation is that it reduces the size of the government debt in real (inflation-adjusted) terms. Effectively, this is just a wealth transfer to the government from the bond holders, i.e. japanese savers, which is not in itself particularly stimulative to say the least.
At any rate, the move comes as the latest in a long line of attempts by Japanese authorities to reinvigorate the moribund Japanese economy, and for those of us who have observed Japanese monetary and fiscal policy for many years, it would be tempting to dismiss it as yet another attempt ultimately doomed to fail. However, this time it really is different. Or at least, the scale is different.
As expressed by the new BoJ Governor, Mr. Kuroda: “This is monetary easing in an entirely new dimension”.
He is certainly right that this is a new dimension, but that is where certainty stops and guesswork begins. Whether it will have a lasting effect is obviously unknown. Whether it will prove to be a costly gamble for the Japanese economy is impossible to say at this point. The risk is that the BoJ will eventually lose control of interest rates, which would result in a collapse of public finances and ultimately force the Japanese government to default on its debt.
But let’s look at the idea behind the stimulus package. Two important questions need to be answered in the affirmative for this plan to be credible, at least as far as it being a long term solution is concerned.
1. Will higher inflation rates necessarily induce consumers to spend their savings? All economic theory tells us that any rational consumer will do so. However, actual consumers (as opposed to theoretical ones) do not behave perfectly rationally all the time. In Japan’s case, it might take more than a 2% inflation rate to do the job. In fact, if the inflation rate is ‘only’ 2%, and if the gamble currently being initiated by the government and the BoJ at any point begins to look like it might not deliver, or if concern arise that it might result in an unsustainable level of government debt (in an environment where interest rates are being pushed higher), then it might even result in consumers holding on to their cash like never before. In short, it is all about credibility in the medium to long term.
2. Will even lower interest rates result in increased corporate spending? Given that rates have been effectively zero for years (at least in real terms, if not nominally), it is difficult to see why a further reduction would cause a significant shift in corporate behaviour. Although theoretically, lower rates mean lower discount rates which in turn mean higher incentives to invest, Japanese companies have in general been cash rich for years but that has not spurred them on to invest substantially. One has to question whether higher inflation and (even) easier money will do it now.
With regards to the effect on consumer spending and inflation, an instructive compilation of charts were presented in the Wall Street Journal:
The most obvious thing to focus on here is the sheer scale of the planned expansion of the monetary base by the BoJ. This alone warrants serious attention. However, looking closer, it is clear that there is virtually no correlation between monetary base and CPI over the past 7 years for these 4 economies. In fact, the striking thing about these charts is that inflation in Japan appears to be almost entirely driven by the global economic cycle, and not the just Japanese cycle or any efforts made by the BoJ (or the MoF for that matter). Inflation is a truly global phenomenon, and it appears to be driven by real demand (for goods and services) rather than by monetary/liquidity supply.
Not even in far more efficient economies like that of the US or the EU where the transmission mechanism from monetary policy to the real economy is more effective, does ‘helicopter money’ appear to have a noticeable impact on inflation. And of course, ‘helicopter money’ only appears when the economy is in dire straits and interest rates are forced down to a very low level. In other words, the transmission mechanism is far less effective in a depressed economy than the new Governor of the BoJ (and the new Prime Minister) would like to think.
The key point here is to realise the important causality at play, namely that consumer demand tends to drive inflation, and not the other way round. Inflation itself does not necessarily drive demand. This point becomes obvious when one considers that the average global consumer is still more or less as cash strapped and burdened by debt at he or she was 5 years ago, and the propensity to spend is governed, not by inflation rates, but by the availability of funds, job security, confidence in the medium term outlook etc. This is especially true when the expected change in inflation is relatively small. In addition, the idea that the average consumer bases his or her consumption decisions today on expectations for inflation or indeed interest rates tomorrow, is probably somewhat naive. Despite the fact that rates a hugely significant in everything from mortgages, savings accounts, consumer credit, all of which are perfectly observable variables, the vast majority of consumers have no concept of how interest rates are set, or indeed how they should expect them to develop in the future. Paradoxically, higher inflation, which will bring with it higher nominal interest rates, may induce consumers to increase their savings, simply because they also have no appreciation of real versus nominal rates. In other words, whilst individual consumers may fundamentally be rational, they may not necessarily behave rationally in aggregate when it comes to financial decisions.
So where does this leave us? Well, being sceptical about real change in Japan has been a prudent approach to investing in Japanese equities for a long time now. The issues facing Japan are very much structural in nature. The broken transmission mechanism from monetary (or indeed fiscal stimulus) to inflation and consumer spending is just a symptom, not the illness itself. The illness is an inefficient domestic economy, an insular and inflexible management style and mentality throughout most of corporate Japan, highly risk averse consumers, and structural barriers to aggressive and much needed M&A (especially by foreign entities) that all help to maintain the inefficient status quo. There are no simple solutions to these illnesses, but what is clear is this: Whilst the efforts and determination to change the economic landscape in Japan is admirable, treating symptoms rather than illnesses have historically proven utterly futile. Add to that the risk of new asset bubbles, the fact that government debt will reach 245% of GDP this year (making it vulnerable to rising interest rates), the problem of adverse changes to Japan’s demographics vis-a-vis the shrinking labour force (and thus lower tax base) and the increasing number elderly people requiring some form of government spending, and the picture becomes somewhat less idyllic than most market commentators would have you believe.
While this may all seem like a rather sceptical view, the possible medium to long term reality of this ending up as a another failed stimulus attempt of course does not mean that equity markets can’t continue to rise. A recent analysis by an investment bank pointed out that if only 5% of retail holders of JGB’s sold their holdings (as a direct consequence of higher inflation and falling real returns on those JGBs), the value of this 5% would equate to 20% of the current market cap of the Nikkei225. The idea being that a shift from JGBs to the equity market could drive equities substantially higher. It is self-evident that the potential here is enormous, but these sort back-of-the-envelope calculations have been made many times in the over the past several decades now, and ultimately we need to see a sea change in the attitudes of Japanese savers/consumers for the recent policy changes to have a lasting impact.
In the short term however, the rally in Japanese equities could well continue although technically it looks slightly stretched at this point, so corrections should be expected. So far it appears that the market has been driven largely by continued rebalancing of global portfolios back to a neutral Japanese equity exposure. Nominally, Japanese exporters have become significantly more competitive since the announcement of the new BoJ policy as the Yen has weakened substantially so this at least is a real change that will help to drive equities higher. Whether this in turn will induce the all important Japanese retail investors to plough more money into equities remains to be seen, but that could be an additional catalyst for further upside over the medium term. In terms of valuations, the market appears to be close to fair value at this point, but with medium term growth estimates being somewhat up in the air at the moment, valuations will probably not be the main driver going forward. Multi-year structural underweighting in global equity funds are probably still in the process of being reversed, and these types of changes to allocations are famously indifferent to valuations.