Japan’s brave new world of unconventional easing

Japanese equity markets have been swooning in the hope of a brighter future. Following the re-election of Prime Minister Shinzo Abe and the appointment of Bank of Japan Governor Kuroda, the NIKKEI 225 soared 45 per cent to 13,568; the highest levels in more than four and a half years.  

Surprisingly, fixed income markets participated in the rally. Japanese government bond prices witnessed such aggressive moves it forced the Tokyo exchange to temporarily suspend trading in the government sector twice in the overnight session of 4 April. The current 10 year Japanese government bond swung more than 62 bps, after hitting a session low yield of 0.315 per cent. The yen suffered its own fate. The currency traded at its lowest levels in more than four years hitting 99.78 JPY/USD on 10 April. What is causing this steep depreciation in the yen? Why are investors so optimistic on the prospects of a country struggling with two decades of deflation? 

Shinzo Abe, Japan’s fifth prime minister in three and a half years, is creating quite the buzz. With his re-election comes the unveiling of Abenomics; three ‘arrows’ of aggressive monetary easing, fiscal stimulus and supply side reforms, expected to lift an economy mired in three recessions in five years.  

Similar to policymakers in the world’s largest developed economies, the new governor began his reign by unleashing his first ‘arrow’; unprecedented monetary easing unlike any the developed world has seen. Eliminating the existing asset purchase programme, the main easing tool of former Governor Shirakawa, Governor Kuroda embarked on the largest purchase of bonds since QE began in 2001. In a valiant attempt to double the monetary base in two years and increase the attractiveness of risk assets, the Bank of Japan is targeting purchases of JPY7.5 trillion per month in long term bonds versus the JPY3.4 trillion of short term bonds in the first quarter of the year. The governor is also changing the target for money market operations from the overnight call rate to the monetary base. The change in rates is expected to attract more than JPY 270 trillion by the end of 2014.  

Other unprecedented easing measures include expanding the range on new purchases to include maturities up to 40 years, increasing holdings of ETF’s and REIT’s by JPY1 trillion and JPY30 billion respectively and increasing the inflation target to 2 per cent from 0 per cent currently. The suspension of the banknote rule which limits the value of bonds purchased below the cash in circulation has given the governor even more room to run. Admittedly, the scale and breath of Kuroda’s programme is quite ambitious. The Bank of Japan targeted increase in balance sheet is 30 per cent of GDP in 20 months. By comparison, the QE measures of the Federal Reserve expanded their balance sheet by less than 15 per cent of GDP and lasted five years.  

The second ‘arrow’ of the newly minted prime minister, fiscal stimulus, has some deep rooted challenges. Following a painful deleveraging process and balance sheet repair from a debt financed bubble in the 1990s, the private sector is less apt to invest in an economy suffering from 15 years of deflation. Consequently, Prime Minister Abe is expected to propose an investment tax credit and other incentives to spur borrowing and investment from the only viable source of sustainable growth. The prolonged debt overhang from the crisis created an aversion to debt resulting in Japan boasting one of the highest savings rate in the developed world at 9 per cent of GDP. Prime Minister Abe now needs to balance prudent fiscal contraction of the public sector with the private sector as the main driver of final demand. 

The final ‘arrow’ in the prime minister’s arsenal, supply side reform, poses quite the challenge for his new cabinet. With an ageing population and a mature economy, no clearer is the need for deregulation of the Japanese markets to spur private investment and growth. The minister has promised further details on his plans but has begun negotiations on trans-Pacific trading deals and has further surrounded himself with senior officials from the economy, trade and industry cabinets unlike his predecessors.  

Given the failure of the Fed, European Central Bank and Bank of England to stimulate their economies back to sustainable growth, there is a mountain of doubt Prime Minister Abe will deliver on his plans in the next twenty months. With public debt at more than 200 per cent of GDP, failure to meet the two per cent inflation target or an unexpected increase in long-term yields may pose the greatest challenge yet for the world’s third largest economy.  

 

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information. Statistics and Data Source: Bloomberg LP. 

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