By Hideto Yamamoto
The Bank of Japan (BoJ) unexpectedly announced an additional quantitative easing programme on 31 October. On the same day, the Government Pension Investment Fund (GPIF) announced changes to the allocation of its portfolio.
According to the announcement, the GPIF will increase exposure to both domestic and foreign equities at the expense of lower exposure to domestic bonds. The Japanese government bonds (JGB) that are supposed to be acquired by the BoJ will exceed the potential sales from the GPIF. Hence there are a lot of reasons for party celebrations among equity and bond investors alike. So far most of the commentary concerning this policy change has focused on whether this will work in helping Japan to overcome deflation and the economy to resume growth. However, taking into account the fact that four BoJ board members out of nine were against the move, investors also need to consider whether to expect a serious hangover after the party ends, from the view point of the credibility of the central bank.
The size of the BoJ’s assets is 57% of GDP, which is far higher than those of the Federal Reserve (26%), Bank of England (23%), and European Central Bank (ECB) (21%) as of September 2014. The new policy, in addition to the existing policy, will add another 16% of GDP per year. Although it is a large easing programme, the scale of quantitative easing by country could differ depending on, for example, the relative size of capital markets, the openness of the financial markets, and whether foreign reserves on the balance sheet of the central bank are financed by the monetary base.
Some investors are concerned that the BoJ will make huge losses from holding JGBs. I am not worried since firstly in terms of monetary policy, what matters is the credibility of central banks, not profits or losses, and secondly even if investors think losses are a concern, banknotes, which are usually classified as liabilities, could be considered as quasi-capital of the central bank, absorbing potential losses.
In Japan, perhaps the biggest threat for the BoJ will arrive if the quality of JGBs starts to deteriorate. Is this likely to happen? We believe there are many reasons to be optimistic it won’t. Although the government debt level is high, Japan’s tax burden in the economy is still very low. In addition, most of the JGBs are purchased by domestic investors. Furthermore, assuming that i) the Japanese yen depreciates further, ii) oil prices are lower, and iii) nuclear plants will be reactivated next year as expected, we can expect a bigger current account surplus in the future. These elements should support the JGB market for the time being.
Another potential threat could come from the liability side of the BoJ as the monetary base will expand along with the purchase of JGBs. This could lead to higher money supply, hence high inflation. However, this mechanism has not worked well in the past in Japan. There has not been a clear relationship between the monetary base and money supply, or between money supply and inflation. The experiment in Switzerland is also encouraging, where the expansion of foreign reserves is financed by the monetary base, and yet with no sign of inflation (incidentally, the size of the assets of the Swiss National Bank, including foreign reserves, is 85% of GDP). That said, investors should start to worry once loan growth becomes faster than the nominal growth rate.
We don’t believe investors should worry too much about the mass scale of monetary easing in Japan for the time being. The BOJ is right to be bold; this will buy time for structural reforms, weaken the Japanese Yen, bring inflationary expectation higher, and promote equity investment among domestic investors as well as foreign investors.
Hideto Yamamoto is chief executive and chief investment officer at DIAM International
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