The Bank of Japan has embarked on a massive campaign of money-printing quantitative easing (QE) in the hope of kick-starting the country's moribund economy. The big questions for investors are: will it work? What are the consequences if it does? And how can you profit from it?
We know what QE has meant for markets in the West. Low bond yields, surging stock markets and record high prices for prime real estate all offset by low growth and weak currencies. And what the Bank of Japan has just announced under new chief Haruhiko Kuroda is nothing short of full-blown, Western-style QE.
Many have failed to recognise this as yet. After all, Japan invented' QE more than a decade ago, and it hasn't worked there so far. Others feel (quite rightly) that Kuroda's move smacks of desperation. Still others notably hedge-fund manager Kyle Bass think that Japan, where government debt now amounts to 237% of GDP, has run out of road.
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This is all true. However, while these concerns imply that Japan now faces some sort of implosive endgame, the exact opposite is more likely to be true.
Japan's aggressive QE plan
Kuroda's approach is twofold. He describes it as expanding both the quality and the quantity of QE. In other words, the Bank of Japan is increasing both the volume and the range of assets it will buy.
Over the next seven quarters, the central bank will grow the monetary base by an aggressive 60trn-70trn per year. It will also buy 50trn a year of Japanese government bonds (JGBs). This is more than twice the size of the US QE programme (relative to GDP). Moreover, the Bank of Japan is to stick with it for almost two years. By then, the new money printing will amount to more than 15% of GDP.
But will it work, given that previous attempts have abjectly failed? Why didn't Kuroda's predecessor, Masaaki Shirakawa, try the same thing? Can Japan afford it? What does it all mean for markets, the yen and inflation? Most esoterically of all, will it cause JGB yields to spike upwards, and will the implied losses bankrupt the nation's banks?
US dollar/yen exchange rate
To answer these questions we need a firm understanding of the issues, particularly the definitional nuances so often skirted over by the press. Once you grasp those, all will become clear.
How is it all supposed to work?
First, a little history: macro-economists have long known about John Maynard Keynes's zero bound' when interest rates get as close to zero as they can get. This is where the potential for a liquidity trap' lurks the situation where central banks can no longer stimulate the economy by cutting interest rates.
What does that mean in practice? A central bank manipulates an economy by loosening or tightening monetary conditions. The looser monetary policy becomes, the easier it is for people and businesses to borrow, spend and invest, boosting nominal growth. If inflation threatens to take off, the central bank can tighten policy to slow spending.
According to the International Monetary Fund, monetary policy is so successful at quickening or slowing the pace of economic growth that fiscal policy (as a counter-cyclical economic tool), with its lags and inefficiencies, is almost redundant in the normal course of events.
But all that goes out the window when the banking system breaks down. Banks are the channel through which central banks transmit monetary policy. If the Bank of England lowers its base rate from 5.5% to 0.5% (as it has during the current crisis), then it pretty much expects banks to reduce borrowing costs by the same amount. Yet the rates charged on many types of borrowing, from credit cards to small business loans, have not fallen.
In some cases they are actually higher than they were pre-crisis. Even the rates on home mortgages (which are secured against an asset, and so are less risky) have failed to fall by anything like as much as base rates were cut.
This is what happens when banks are broke: the monetary-policy transmission mechanism fails to work. As a result, households and small businesses, who have no alternative source of credit but the banks, face a credit crunch. And because it can take many years to fix a busted bank, such credit droughts can last a long time six years on average.
Japan's coming bond collapse
This is now familiar territory in Britain. But for some Japanese it's been the backdrop of their entire lives. There are bank managers who have never made a new loan, and businesses get by without bank credit.
Japan's banks couldn't let any of their zombie borrowers' (firms with no hope of repaying loans) fail because they didn't have enough capital to absorb the losses. On the other hand, borrowers could afford to pay hardly any interest, so banks' profit margins got squeezed and all new lending stopped as the banks dedicated their resources to dealing with legacy loans.
Bank loans fell from 120% of deposits to 100%, to 80%, to around 67% now. Banks lend' the rest of their deposits to the government by buying JGBs $1.7trn-worth at the last count. This is where the banking system's vulnerability to a significant rise in JGB yields lies. A reflationary policy like the one Kuroda now espouses, if successful, will most likely trigger just such a JGB collapse.
Wouldn't that bring down the banks? No. Banks account for their assets in one of four ways, depending on when they plan to sell them. Firstly, there are the interest-rate securities that traders on the prop desk' buy and sell all day long; these are trading assets. Secondly, at the other end of the scale, there are loans that, once made, cannot be called until maturity (in other words, the bank can't tell the borrower to pay it back early).
In between, there are two other types of security. There are those that the bank intends to hold to maturity (HTM); and there are those that the bank might hold or might sell, depending on circumstances. The latter are called available-for-sale (AFS).
It is the AFS securities that interest us here, because that's what most of the Japanese banks' JGBs will be: bonds they might hold to maturity, but could sell sooner if it suits. My point is that if the value of JGBs was suddenly to plummet (and yields rocket), due to an increase in inflationary expectations, it would definitely not suit the banks to sell.
The great appeal to banks of government bonds is that, come maturity, you always get your money back. Sure, that paper money may have been devalued. But you will not suffer a nominal default: a domestic government bond will always be repaid. So it would be bizarre if a bank had to show a loss' on its books for a government bond that (before maturity) was trading at a lower price than the bank had paid for it.
This is why changes in AFS asset values do not get reported in the bank's annual profit-and-loss statement. Instead, the unrealised gain or loss is recorded under other comprehensive income'. This item is not included in banks' capital ratios. So it cannot influence whether a bank is insolvent or not.
And under our intent accounting' system, if an AFS asset's value falls, and the bank decides it has no intention of selling it, it can re-designate it as HTM. As a result, it would be held at book value and no profit or loss would be calculated until it matures.
For instance, at one stage of the 2007-2009 crisis, Bank of America reported a $1.4bn profit on its standard income statement. Yet it showed a loss of $3.9bn after adjusting for unrealised losses in its portfolio of mainly AFS assets. But because this was recorded separately under other comprehensive income', few investors, let alone the press, even noticed. And quite right too, since the losses were never realised: Bank of America is still with us today. Likewise, it is very unlikely that Japanese banks have much to fear on this front either.
Can Kuroda succeed?
Of course, this all presupposes that Kuroda will succeed in his quest to reinflate Japan. Can he? Our own experience in Britain, and even more so in America, suggests that QE really has saved our economies from enduring savage depressions. QE boosts the money supply. Nominal broad money supply in turn is closely related to nominal GDP. So it seems that artificially keeping broad money supply propped up via QE also keeps GDP from collapsing.
A glance at countries unable to do QE such as Ireland, Greece, Portugal, and now Cyprus seems to prove this point. In Ireland, the M3 broad money supply shrunk by 28% peak-to-trough and so did the size of the economy (in nominal terms ie, not adjusted for inflation).
But while expanding the broad money supply is exactly what we mean when we say QE', that's not what the term meant when it was first coined by Professor Richard Werner to describe Japan's actions at the start of the millennium. Hence the confusion over whether QE new' will actually work or not.
When central bankers want to loosen monetary conditions, they talk about cutting interest rates. But that's not actually what they do. They drive rates down by buying T-bills (very short-dated government bonds). Banks don't like holding long-term government bonds in case they make unrealised losses on their AFS assets, as noted above.
Instead, they pile into the market for shorter maturities, to the extent that we call trades in short-dated bonds the money markets because it's pretty much only the banks and the central bank involved.
The average maturity of the JGBs held by Japanese banks is two and a half years. That's because they bought all the shorter-dated bonds, and had to move further down the maturity curve (in other words, buy longer-dated bonds) than they would have liked. Clearly, the longer to maturity a JGB has to go, the more likely it is that the bank plans to hold it to maturity, and the less likely it is ever to realise a loss.
As the Bank of Japan bought T-bills from the banks to reduce rates, it boosted the banks' deposits at the central bank. Normally, banks lend these deposits out to earn interest. The resulting flood of new funds pushes borrowing costs down for the rest of us. But in Japan in the late 1990s (just as we saw in Britain in 2008-2009), this was not happening. Once rates hit the 0% level in Japan, the central bank was lost for ideas.
Macro-economists (mainly American and mainly neo-Keynesian) suggested that the Bank of Japan simply keep on buying the same quantity of T-bills that it usually took to lower rates by, say, 0.5%. And so the name quantitative easing' was born.
However, if the problem is an insolvent banking system, then the banks won't re-lend the proceeds of their T-bill sales. Instead, they just keep the money in their deposit accounts at the central bank. As a result, Japan's bank reserves ballooned during QE between 2000-2006, and bank lending continued to shrink.
In other words, Japan's version of QE was just conventional monetary policy gone mad. Albert Einstein described madness as repeating the same action over and over, yet expecting a different outcome. With this version of QE, the Japanese were effectively still trying to cut interest rates, long after rates had already hit zero. The Japanese were aware that there was an alternative strategy: unconventional monetary policy.
This involved printing money and buying bonds not from banks, but from investors, which would automatically boost the money supply (because investors can't hoard their money at the central bank). But Shirokawa didn't approve of such wild notions. He saw these strategies as regressive (they take from the poor and give to the rich, as we've seen in the West).
He also believed it would be akin to monetising government spending (ie, printing money to fund government borrowing), and that it would be very damaging to international relations. As an unelected bureaucrat he believed that such decisions were not his, but parliament's, to make.
Depression averted, but at what cost?
Neither Federal Reserve chief Ben Bernanke, nor Bank of England governor Mervyn King, entertained such concerns. Both believed it was in their remit to do anything they could to prevent depression. Whatever your views on this and the Austrian school of economics think it's a disaster their version of QE, though given the same name as Japan's, was completely different.
When the central bank buys long-dated government bonds from an investor, the proceeds boost the investor's bank deposits. Since bank deposits are money, Western-style QE directly boosts money supply and nominal GDP. Depression is averted; but at what cost?
Whatever the cost, Kuroda and his prime minister, Shinzo Abe, have decided that, after all these years, it's worth paying. Kuroda didn't just promise to keep pumping up bank reserves (the main component of the monetary base). He has also made a huge departure with the past.
The Bank of Japan had always bought a small amount of longer-dated JGBs, enough to keep broad money supply growing marginally over the last 20 years. But it never bought more than there were notes and coins in circulation. This arbitrary rule was to defend against accusations of monetisation.
Kuroda, however, has dumped this rule, firmly announcing his intention not only finally to emulate British and American approaches to QE, but to catch them up with alacrity. Until now Japan's money supply has barely grown,its economy has withered, andits stock market slumped butits currency and bond markets have strengthened. All of that is now set to go into reverse.
Ten Japanese stocks to buy now
As discussed above, QE new' will artificially boost Japan's money supply. As we have seen in the Anglo-Saxon economies, this will spill over into riskier assets and boost both stock prices and prime land values. Meanwhile, the dilution of the yen caused by this overt printing will continue to weaken the Japanese currency, lifting exporters' profit margins.
At first, this will result in both Japan's trade and current account balances deteriorating (as it is forced to spend more on imports and yen flow overseas), but what's waiting in the wings will make it all worthwhile.
Japanese corporate investment and tax revenues have pretty much halved over the last two decades. A return to corporate profitability will boost the tax take, thus reducing the government deficit.
Now, in itself, the weak yen only really helps export manufacturers names worth considering include car maker Honda Motor Company (JP: 7267) and Panasonic brand-owner MEI (JP: 6752). So for Japan the most likely route to full-blown recovery is via rising land prices and increased investment.
Both depend on increased bank lending. Unlike most Western banking systems, Japan's is coming out of a long, drawn-out post-crisis resolution phase. Bank capital, if not excessive, is adequate. What's missing is the opportunity to lend at nice, fat profit margins. Bank loans have slumped to just two-thirds of thelevel of deposits, so could grow by 50% from here without relying on wholesale funding (borrowing from the money markets).
Commercial land prices are currently at less than a quarter of peak values of 20 years ago. So they could double and double again before they hit their old highs. This would benefit both the banks themselves options include Mitsubishi UFJ (JP: 8306) and Sumitomo Mitsui (JP: 8316) and real-estate companies Mitsubishi Estate (JP: 8802) and Mitsui Fudosan (JP: 8801).
But before that happens, the country must reverse the catastrophic drop in investment it has suffered. This is where the exporters come back into the picture. Exporters stopped investing because the weak yen eroded their excess profits, leaving nothing to reinvest. Capital was run down and GDP growth all but vanished. Yet still the currency didn't weaken, so still there was no excess to reinvest.
But now, QE new' is weakening the yen. Once currency hedges have expired, that'll mean a huge jump in earnings for exporters, enough to fund desperately needed new investment. Banks, always wary of lending against real estate, will flock to lend to machine-tool companies Mori Seiki (JP: 6141) and Amada (JP: 6113) robotics specialists FANUC Corp (JP: 6954); Yaskawa Electric (JP: 6506) and other beneficiaries of capital expenditure.
James Ferguson has just launched The MacroStrategy Partnership LLP with ex-UBS veteran Andy Lees, and has over 25 years' experience as a stockbroker and market strategist. He is a regular contributor to MoneyWeek. Find out more at www.macrostrategy.co.uk.
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