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The Bank of Japan – Coming to the end of its rope

KEY POINTS

  • The purpose of the negative interest rate policy (NIRP) is to flatten the yield curve. However, in contrast to the BoJ’s expectations, investors are hesitating to rebalance portfolios, particularly towards foreign assets. Moreover, few see the NIRP as a powerful tool for increasing inflation.
  • NIRP could be an impediment to economic growth rather than a facilitator, unless the policy leads to a sizable depreciation of the yen. A fall in interest income simply discourages households and corporations, which are carrying excess savings.
  • However, the BoJ has no choice but to increase the penalty on excess reserves. Without the resurgence of market turmoil, imminent action (in March) would probably not take place, Lingering confusion over the NI RP in terms of implementation, system adjustment, fair market pricing and understanding the concept of the policy in general, should mean that the central bank will stick to the current policy for a while longer.
  • The BoJ is expected to move again in April or July, when the CPI trend is deviating from its 2% target and council members voting against the NIRP are gradually replaced. 

Introduction

It seems the Bank of Japan (BoJ) has exhausted all the options to appease investors if the financial markets fall into difficulty up again. Scepticism is mounting that the BoJ’s negative interest rate policy (NIRP) would not drastically change for the landscape capital flows and the economy. The NIRP appears contradictory to the existing QQE and the market foresees that they will somehow cancel each other out. Distortions in the policy could be wider if the monetary authority adopts additional QQE or a reinforced NIRP. In short, the Bank of Japan has little capability to initiate a turnaround of the dollar/yen and equity prices.

1. What is the BoJ misinterpreting? 

The BoJ believed that market interest rates would fall and the reality has matched its expectation. What differentiates the BoJ’s NIRP from the policies conducted by the Danish, Swedish and Swiss central banks is the shape of the yield curve. In the experience of Europe, the yield curve tends to steepen (bull-steepening) as rates on the short-end fall substantially. Asset managers are forced to venture towards the longer end of the yield curve to grasp positive yields.
In contrast, the Japanese yield curve experienced a downward parallel shift. This is because the Bank of Japan still maintains quantitative directives, under which the Bank purchases net JPY 80 trillion in JGBs every year. The combination of the NIRP and the quantitative commitment has markedly reduced risk the premium in the longer end of the yield curve. However, the sharp decline in yields on longerdated maturity bonds have led investors to other options. Many asset management companies suspended subscriptions of large-denominated time deposits, MMF and fixed-income investment trusts. Investors are simply withdrawing money from these instruments and keeping it in safes in their homes and offices, contrasting with the BoJ’s anticipation that commercial banks would lend more money and investors would shift to riskier assets in and outside Japan.

2. Why is the BoJ bound for the NIRP

On the surface, global financial woes and the subsequent surge in the yen since the beginning of the year have nudged the Bank of Japan to cross the Rubicon River. The central bank considered an extended QQE, buying a further JPY 10 trillion in JGBs and few more ETFs, as the market increasingly expected some remedies from the central bank. However, assuming the manner he has followed since he was appointed, Governor Kuroda is not likely to believe that a simple expansion of existing QQE could “surprise” the market. Moreover, there are few assets available in the market now that the BoJ has bought up more than 30% of total national debt and almost 60% of existing ETFs. 
The QQE has significantly flattened the yield curve. In the three years years to April 2013, when the BoJ introduced QQE, 2/5 year, 5/10 year and 10/20 year spreads were 20 bp, 67 bp and 80 bp on average, respectively. Since Mr. Kuroda has been in office, the average spreads have changed to 10 bp, 10 bp and 82 bp each. This shows that QQE was able to flatten the yield curve on maturities up to 10 years, whereas the longer end of the curve is virtually unchanged.
In short, the Japanese central bank introduced the NIRP to break the stalemate as a last-ditch measure. As a consequence the 10/20 yr. spread edged down to 68 bp The unsolved question is whether the NIRP will cause fluctuations in consumer inflation, which QQE has failed to stimulate over the last three years. Market players are unenthusiastic in this aspect as, in a survey conducted by Bloomberg, only 27% of large institutional investors responded that the NIRP would effectively boost inflation.

3. What is left for the BoJ?

Given the contradictory nature of the current QQE with NIRP, the Bank has two options. First, the Bank will keep the rate of -0.1% on excess reserves but apply it to broader current account deposits. At the moment, 85% of total current reserves at the BoJ are earning 0.1% and only 4% will be charged 0.1%1. This means that the Bank is no longer sticking to its annual quantitative target of 80 trillion, as commercial banks are becoming hesitant to park their money at the BoJ in light of its rates on current account deposits. Private financial institutions are likely to become reluctant to sell their JGB holdings to the BoJ, as a larger proportion of the income is subject to “taxation”. The BoJ will have to forfeit the domain of quantitative easing. Secondly, the central bank will widen the scope of the negative interest rate with the portion to be penalised unchanged. This is plausible from a technical point of view, but will accentuate the bull-flattening of the yield curve. It will also end up overshadowing the earnings outlooks of financial institutions and hampering asset management by pension funds, corporations and individuals.
Japanese investors look unlikely to promptly switch to overseas assets if damage from stricter NIRP is extremely severe. Domestic fixed-income assets are regarded as a buffer for risk-taking. Households with JPY 1,650 trillion (USD 15 trillion) in financial assets will instantly lose JPY 36 billion in interest income from ordinary deposits. They will additionally lose as much as JPY 50 billion in income from time deposits if the NIRP lingers. As for pension funds and insurance companies, income from 400 trillion in bonds and deposits will shrink by JPY 250 billion if the short end of the yield curve sinks further and the longer-end flattens. In this regard, the assets’ shaky situation may squeeze investors’ risk tolerance and hamper foreign investment.

2016-03-07-Initial-framework
2016-03-07-Plan A
2016-03-07-Plan B

 

4. When will the BoJ move? 

Despite the controversial NIRP, the BoJ has no choice but to reinforce the policy in order to halt the equity market free-fall. As Mario Draghi says, doing something is better than nothing. The BoJ is expected to show its strong commitment to counter the financial market rout as early as in the next monetary policy meeting on March 14 and 15.
Nevertheless additional easing in April or July sounds fair. There are a number of obstacles against the imminent credit easing. The trading and settlement system is not able to completely cope with the negative interest rates. More importantly, rapid declines in market interest rates and credit spreads will jeopardise financial institutions. The NIRP will seriously hit profits at Japan Post Bank since the half state-owned bank will continuously accept a significant amount of deposits from households at 0.001% and place the statutory proportion of the deposits at the BoJ, some of which are subject to the negative interest rate. The postal bank has to invest in money-market instruments and domestic bonds despite their negative yields, since the bank is prohibited from lending to the private sector. Its extremely cautious stance on investment limits its exposure to relatively high-yielding foreign assets.
The Bank of Japan will feel that spring wage negotiation is ephemeral while consumer prices are staying far below the 2%. Good news for Gov. Kuroda is that the terms of two council members – Shirai and Ishida – who voted against the NIRP in January, will expire in March and June, respectively.
Some expect yen-selling interventions. However the idea is counterproductive and may fuel competitive currency devaluation by countries. The U.S. Treasury Department accepts the BoJ’s NIRP because it believes the NIRP is conducted solely for the purpose of sweeping off deflation and stimulating domestic demand. In contrast, the United States is very uncomfortable with intervention into the foreign currency market, particularly prior to the US presidential elections and the enactment of the TPP agreement.

5. Is any limit on the NIRP?

Theoretically speaking, the unprecedented policy would work as long as commercial banks sell JGBs in the market at a deeper negative yield than the penalty rate on excess current balance. Yet the strategy would kill financial institutions in the end now that lending based on adding spread to JGBs and/or LIBOR / TIBOR is becoming unprofitable. Financial institutions will not be able to dodge the adverse impact of the NIRP unless they impose a negative interest rate on retail deposits or add to their range of fee-paying businesses. 
At the moment, the BoJ is imposing the -0.1% rate on a limited portion of total current-account deposits outstanding (in consideration of the financial situation of heavily-dependent regional banks, Japan Post Bank and life insurers). 
Indeed, the BoJ explicitly says that it does not want a situation where interest income from total current-account balance completely disappears in order to secure profits of financial institutions and thus financial stability. Therefore the BoJ feel payments on the Policy-Rate Balance should not exceed income from the Basic Balance. As stated, the central bank will control the former between 10 to 30 trillion. In the current framework, that means that the implicit floor for the negative interest rate is around -1%2. Maybe this will be a limitation.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The QQE has significantly
flattened the yield curve

 

 

The BoJ will widen the scope of
the negative interest rate with
the portion to be penalised
unchanged

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

A number of obstacles will delay
additional easing

 

 

Publication finalised on 03 March 2016

Akio YOSHINO, Equity Research and Strategy at Amundi Japan

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The Bank of Japan – Coming to the end of its rope
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