Abeconomics: the perils of success

by George Hatjoullis

Kuroda-seiki-kohan00-6-1b

Kuroda-seiki-kohan00-6-1b (Photo credit: Wikipedia)

“Mr Kuroda also said he was not concerned by the gyrations in Japanese bond markets that have followed the policy announcement”,(http://on.ft.com/11Z4KHo).

Well perhaps he should be. The perils of market failure have been discussed in a previous blog and the risk of one in the Japan government bond market is high.

The policy objective is 2-in-2; to achieve 2% inflation in two years. The starting point is structurally negative inflation expectations. The purpose of this policy is to force inflation expectations positive. What if the BoJ is successful? Current holders of the vast outstanding stock of JGBs (i.e. every financial institution in Japan) must wonder if this is a wise investment at current yields and given a positive inflation outlook. If they all hit the revolving door at the same time (try to sell) there will be carnage and material book losses. The market could fail which could lead to all sorts of unintended and unwelcome consequences.

There is no evidence that the Japan financial institutions have yet materially started to adjust their asset positions. Indeed, the depreciation of the yen, the rally in the Nikkei and the gyrations in the JGB market are most likely driven by non-domestic investors up until now. Japan institutions are too large and too procedural to move quickly. Moreover, these same procedures being common to all institutions create a tendency for all to move together. If and when this happens the revolving door could see some carnage and Mr Kuroda should be concerned.

How can this be managed by the BoJ? Under the present policy framework it cannot easily be managed. The BoJ will buy JGBs in line with money policy targets at the prevailing market price. It will be buying into a falling market and creating mark-to-market losses on its own balance sheet. This will quickly become a source of concern at the BoJ. The only way to even approach stabilisation is to go to the next step, which was avoided, and embrace debt cancellation. The method has been described in an earlier blog.

In essence, the BoJ gives the Ministry of Finance a unilimited overdraft and the MoF retires outstanding debt at par. This is direct debt monetization and every textbook will tell you potentially very inflationary. Yes, indeed, and that is the whole point of course. It has the added advantage that it allows the MoF to drain some of the outstanding debt from Japan institutions and limit the risk of market failure. It is not a perfect solution nor without problems. However, when trying the generate positive inflation expectations at the same time as having such a large outstanding stock of government debt in the hands of your financial institutions, you need to think a little outside of the conventional box. Mr Kuroda’s indifference is not the best response.

Once the Japan institutions start to collectively adjust then we could see some interesting dislocations in Japanese financial markets. If it all goes smoothly dollar yen may achieve 120 rather sooner than many appreciate. The Nikkei is also comfortably on target for 18000, as already suggested in a previous blog. The impact of potentially huge flows on international markets could be considerable and generally asset positive of course. So far the price responses have been more in anticipation. However, the rosy picture could be upset somewhat by a disorderly exit from JGBs.

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