All eyes are on the BOJ

Richard JerramThe Bank of Singapore’s Chief Economist Richard Jerram doesn’t fault the Bank of Japan for the jam it is in. That, he says, is the result of 20 year’s policy mismanagement. The BOJ is ‘doing whatever it takes’ to end deflation and to produce economic recovery. Pursuing loose monetary policy, it has massively expanded its balance sheet with bond purchases that eventually must be unwound. Global investors now wait in heightened anticipation for the BOJ to announce its ‘exit strategy’.

Jerram is a top-ranked economist with an intimate understanding of Japan. Before joining the Bank of Singapore, he lived in Tokyo for 15 years where until 2009 he was Chief Economist at Macquarie Capital Securities (Japan). He held a like position at ING Securities (Japan) before its acquisition by Macquarie in 2004. Earlier in his career he was Senior Economist at the Economist Intelligence Unit where he covered the Asia Pacific region.

Solomon: You are well positioned to comment on Japan’s economy having lived there many years. What’s your view from Singapore?

Jerram: The state of Japan’s economic cycle has improved in the past couple of years. Over this period monetary policy has gone from being deeply conservative to being aggressively supportive of the economy. That has had a dramatic positive impact on growth, corporate profits and the labor market. The output gap is close to nil and the country is nearly back to full employment. Thanks to this Japan’s economy has recovered about as much as one can expect.

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While the state of the economic cycle is positive, Japan’s underlying growth rate is at best 1% without there being any real signs of inflation. This shows how deeply entrenched deflationary expectations have become. Some factors influencing the underlying growth potential can’t be easily changed, like Japan’s aging demographics. Others, such as structural reforms, theoretically can be altered. Unfortunately the Abe administration has not made much progress with ‘third arrow’ reforms.

To help stabilize public finances, taxes need to go up. This should be possible given Japan has too little tax compared with most other developed economies. The consumption tax probably needs to go to 20%. Small businesses need to be more efficiently taxed – which is to say to be taxed at all. The Administration could also cut government expenses, such as welfare commitments that should be capped through means testing.

The greater issue is Japan’s skewed intergenerational income distribution which conceals policy mismanagement over the past 20 years. Over that period the government has borrowed from future generations. That has caused the nation’s net debt to GDP ratio to reach 150%. I am worried that the economy is near full employment, yet the budget deficit remains 5 to 6% of GDP. In addition the nominal growth rate is at best 2%. This suggests the debt to GDP ratio is heading towards infinity.

Since that’s impossible, there will likely be a breaking point when wealth gets redistributed to the government through the tried and trusted mechanism of inflation. Alternatively, the government could confiscate half of people’s wealth through a one-off transparent wealth tax to write off the nation’s debt. It amounts to the same.

Either way I think it leads to an equitable outcome because those contributing the most to a resolution would be the elderly who benefited from the policies of the 1990s and 2000s. You could argue that they already realize a redistribution of wealth is going to happen, which is why people are saving.

Solomon: When might this event take place?

Jerram: It’s a mugs game to predict exactly when a break might occur. Government finances are on an unsustainable path without a realistic stabilizing mechanism. But that was also true 10 years ago. For decades people have been predicting a meltdown. Those who have been short Japanese government bonds (JGBs) for the past two decades have lost all but their shirts. The endgame will likely be ugly, but I have no idea when that will be. It is one of the most predictable disasters in the global economy, second only to the Chinese credit bubble.

Solomon: Japanese households own about $10 trillion of net financial assets, about the same size as the national debt. Would not a crisis arise when there are insufficient underlying household assets to support the government debt? Economists say household savings will decline as the growing numbers of elderly spend their pensions.

Jerram: While the household savings rate is near zero, there is surprisingly little evidence to support the commonly held notion that the savings rate declines as a population ages. Johns Hopkins University Professor of Economics Christopher Carroll found almost no correlation between a nation’s demography and its savings rate. Also, when household savings surplus declines – is that because demand is strong or because corporate savings surplus expands? Or is it because taxes have gone up so government deficits have decreased? If you squeeze one part of the equation, another part moves automatically, but you never know which one it is. It doesn’t lead you to any understanding behind what’s happening.

Solomon: The BOJ currently owns 23% of all outstanding JGBs. Through monetary easing, they’re buying up new and old issuances to pay for budget deficits and keeping interest rates near zero or subzero. Could not the BOJ prevent a bond crisis by continuing to increase their share of the JGB market?

Jerram: The idea the BOJ can prevent a crisis is an interesting one. If they are overwhelming the market with bond purchases, they may well be able to control marginal pricing. What they can’t control is the exchange rate. It’s possible that an exit-strategy related panic results in depreciation of the yen and not a collapse of the bond market because the BOJ can control the later.

When people realize the BOJ has no means of exiting from their extraordinarily large balance sheet, then investors could pull their money out of yen to invest in governments with more solid finances and better managed currencies. So the yen exchange rate could be the barometer of the crisis rather than the government bond market.

Solomon: Is there a limit to the number of JGBs the BOJ can buy? What would stop them from owning 100% market share?

Jerram: This is the most uncomfortable part of the story.

Zimbabwe experienced hyperinflation when people realized that tax revenues would not guarantee the value of their currency because the central bank owned all of their own debt. Surprisingly, Americans also fear that their government can never repay the national debt through taxation, yet this has not led to hyperinflation. The difference is the Fed maintains its credibility because there is no clear sign the US debt is being monetized.

The Fed has a semi-credible exit strategy which it outlined early on. Also the numbers in the US are half believable and investors expect the US economy will continue to grow. People think that when the economy recovers the Fed will raise interest rates, stop buying new debt and let existing ones roll off their balance sheet.

In Japan’s case, the BOJ will own debt amounting to almost 100% of GDP by the end of next year. Eventually it must unwind those buys. It has a fine line to walk between having no exit strategy at all and worrying markets about a premature exit. If they say they will to try to normalize their balance sheet within the next 40 years for instance, investors may sense the permanent monetization of debt and shift their inflation expectations. The lack of a credible exit strategy would suggest a Zimbabwe-style outcome at some point.

At present the BOJ’s policy board is quietly discussing an exit strategy. They’re keeping a low profile to be certain their arguments are well-rounded for when they release their plan to the public, perhaps later this year. However, I’m doubtful they will present a credible exit strategy given the scale of what they own and what they need to sell.

Solomon: Should Japan’s economy meltdown, could there be contagion to the rest of the developed world?

Jerram: I don’t think so. Japan is not that big a country anymore. Also, an outflow of yen to other currencies should be supportive of other markets.

Solomon: Many thanks for giving us your opinions from Singapore.

Richard Jerram

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