BOJ ‘normalization’ rides on fiscal consolidation

Governor Haruhiko Kuroda in 2016

First published by The Japan Times

As central banks start unwinding their balance sheets later this year, there is growing concern about the financial soundness of the Bank of Japan. Tetsuya Inoue, an economist auditing the BOJ for government bureaucrats, says those who worry about BOJ finances miss the main point: Of much greater concern is the need to bring fiscal deficits under control. Monetary policy, he suggests, must support fiscal consolidation.

Inoue is General Manager and Chief Researcher at Nomura Research Institute, an economic think tank. Before joining NRI in 2008, he was an executive staff member of the BOJ’s Policy Board.

The BOJ already owns 41 percent of the Japanese government bond (JGB) market and 56 percent of the Japanese exchange-traded fund (ETF) market, assets worth a combined ¥490 trillion ($4.4 trillion). To buy more assets, it must bid up prices. This exposes the bank to potential losses, especially to capital losses on its JGB holdings. Speaking before the Diet, BOJ Gov. Haruhiko Kuroda explained that a one percentage point rise in long-term yields would cause ¥23 trillion of BOJ losses. Politicians, investors and academics worry monetary policy normalization could bankrupt an undercapitalized BOJ, which holds just ¥8 trillion in capital and reserves.

The BOJ can never go bankrupt. It is an arm of government with the right to print money. “If you add central bank annual profits into the far future, any kind of current losses can be managed in the end,” Inoue notes. In practice, the BOJ would simply stop transferring back to government the bond coupon payments it receives on its huge asset holdings for a few years, compensating the BOJ for any capital losses it incurs. Those losses would easily be absorbed by taxpayers, adding about 2 percent in total to government’s much larger ¥1 quadrillion debt burden. “There is no need for the Finance Ministry to rush to raise the tax rate to compensate,” Inoue says.

He highlights one important caveat. If the public and investors believe the central government lacks commitment to rein in fiscal deficits, people could interpret central bank capital losses as evidence the BOJ will never normalize monetary policy. They could conclude that it and government intend to permanently monetize government debt (helicopter money). “In this instance, people would lose confidence in the liabilities of government itself,” Inoue explains. Capital flight into currencies of other more stable governments might follow. “In this extraordinary situation, the soundness of the BOJ’s balance sheet matters.”

For years the government has run budget deficits. Taxation covers 60 percent of annual expenditures. The government adds 3.5 percent of new debt each year to cover the shortfall. Social entitlements account for one-third of all government expenses. These are projected to rise rapidly around 2025, when all baby boomers will be 75 or older. If not contained, entitlement costs threaten to bust government finances.

People and market participants worry policymakers lack commitment to bring fiscal deficits under control. Pension reform is only a discussion. Tax hikes have stalled. A consumption tax hike from 8 percent to 10 percent was twice postponed until October 2019, after an initial raise from 5 percent to 8 percent in April 2014 caused the economy to tank. “From a long-term perspective, the consolidation efforts are very important, not only for stability of the government and JGB markets, but for the entire financial system,” Inoue says.

One concern is that central banks always assume that economic downturns are cyclical. Most convincingly argue they can unwind asset purchases when growth returns. But Japan’s case might be different. Here, deficits may be more structural than cyclical.

Each round of monetary stimulus has failed to lift growth and inflation to pre-crisis levels. Each new stimulus compounds into the next economic cycle. As a result, BOJ assets have swelled to almost one times the nation’s GDP while growth and inflation remain well below government targets.

Inoue believes that Japan’s low interest rates are close to neutral — which neither expands nor contracts the economy. “It is ironic to say that normalization is not hard for the BOJ to achieve, because the potential growth rate is already close to the policy rate,” he notes. “Even if the government succeeds in pushing through structural reforms, Japan’s economy cannot grow at the rate of 3 percent or 4 percent over the medium term.”

When Japan’s economy picks up, Inoue worries the BOJ may not be able to easily unwind. The U.S. Federal Reserve should start unwinding later this year. The European Central Bank may start doing so next year. The first central bank to unwind during this period of extremely low interest rates holds an advantage. Inoue believes that foreign buyers will probably snap up higher yielding U.S. Treasuries. “That is why I think the Fed is not concerned about stabilizing the U.S. Treasury market,” he says.

The BOJ, however, can’t consider unwinding until the repeatedly postponed 2 percent inflation target has been reached, perhaps by 2020. Then, global interest rates may or may not be favorable for unwinding. More importantly, “If meaningful steps towards fiscal consolidation are not achieved, overseas investors will not show interest in the JGB market,” Inoue says.

So long as Japanese households continue to buy JGBs (indirectly through institutions where they deposit savings), there is no problem. Japanese effectively own 90 percent of the JGB market. But as the population ages and the workforce shrinks, household wealth is projected to decline. Therefore, Japanese people cannot be relied on indefinitely to buy all government debt the BOJ may wish to sell.

The government still has time to take corrective action. Inflation is under control, so there is no immediate need to normalize monetary policy. Rather than unwind, Inoue recommends the BOJ stabilize interest rates through yield curve control, creating time for policymakers to gain control over government finances. “I think that major fiscal consolidation measures are necessary. They should be made as soon as possible, before household assets disappear,” he advises.

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