On March 9, the central Bank of Japan
(BOJ) signaled that the era of free money, known
as "quantitative easing", would soon begin to wind
down. This change has spurred broad international
commentary focused mainly on the timing of Japan's
return to normal interest-rate-directed monetary
policy and the broad implications of this return
for both Japan's economy and the global economy.
Much more significant, the end of
quantitative easing will pull an enormous amount
of liquidity from Asian and US stocks and bonds,
prompting widespread asset price depreciation and
yen revaluation.
The era of
quantitative easing The BOJ first
implemented quantitative easing in March 2001. At
that
time, nominal official interest rates had in
effect reached 0%. This left the BOJ no scope to
reduce official interest rates further to thwart
the spread of deflation and a building liquidity
crisis in Japan's financial system.
Because interest rates had become
zero-bound, the BOJ began to pump liquidity into
the economy and banking system by selling yen in
the foreign-exchange market, by buying Japanese
government securities and, most interesting, by
funneling cash directly to Japan's commercial
banks via their reserve accounts at the central
bank.
Quantitative easing initially had no
discernable impact on Japan's economy. Deflation
became increasingly acute, the economy remained
very weak and the accumulation of bad loans by
Japan's banks accelerated. After the spectacular
failures of several corporations and financial
institutions, the BOJ ramped up its
quantitative-easing program in 2003 under the
guidance of a new governor, Toshihiko Fukui.
Fukui greatly increased the BOJ's
intervention in the foreign-exchange and
government-securities markets (yen sales and
purchases of Japanese government bonds). He used
much of the excess liquidity generated by this
intervention to funnel more money into the reserve
accounts of Japan's commercial banks. By the end
of 2003, balances in these accounts increased from
about 6 trillion yen (US$51 billion) to more than
30 trillion yen ($256 billion), where they stayed
until late 2005.
The intention behind
flooding Japan's commercial banks with liquidity
was twofold: to avert a systemic financial-system
crisis, and to encourage banks to start lending
money to Japanese corporations. The flood of
liquidity greatly improved balance sheets across
Japan's financial system. This was important
because the size of problem loans in the financial
system had become enormous, prompting foreign
banks to shun Japanese banks because of very high
counterparty risk (risk of bank failure).
Unfortunately, this liquidity had no impact on
bank lending, and domestic credit in Japan
continued to contract.
The $300 billion
question: Where did the liquidity go? The
cash available to Japan's financial institutions,
via their reserve accounts with the BOJ, was not
limited to just the nominal increase in liquidity
in these accounts from 50 trillion yen to more
than 300 trillion yen. Rather, this excess
liquidity was made continuously available to the
financial system, like an inexhaustible fountain,
for nearly three years.
Though this open
monetary tap provided more than enough liquidity
to increase the supply of domestic credit, demand
for domestic credit remained very weak. Total
credit in Japan contracted, in nominal terms, by
4% in 2003 and 3% in 2004. Domestic credit stopped
contracting in 2005, when total credit growth was
flat, before finally beginning to grow in February
and March of this year - the first such growth
since 1998.
The flood of cash into Japan's
financial system didn't go anywhere in 2003 and
2004. Financial institutions used this cash to
bolster their own balance sheets - a process that
greatly improved the creditworthiness of Japan's
banks. This sharply reduced counterparty risk for
foreign banks, which began earnestly to tap into
Japan's never-ending supply of liquidity. Using a
Japanese bank as a counterparty, foreign banks
borrowed huge amounts of yen at very low interest
rates in 2005. This yen was swapped for foreign
currencies and invested in other Asian countries
as well as in the United States.
Quantifying the amount of yen that global
investors borrowed from Japanese banks and
subsequently invested in other countries during
2005 is extremely difficult. Such swaps are
generally conducted off-balance-sheet, meaning
they are neither directly monitored nor controlled
by the BOJ. However, exchange-rate movements
between the yen and other currencies during 2005
offer some insight into the magnitude of these
swaps.
In 2005, the yen depreciated by 16%
against the South Korean won, 13% against the
Malaysian ringgit, 11% against the Indian rupee,
10% against the Indonesian rupiah, 9% against the
Thai baht and 20% against the US dollar. This
broad depreciation of the yen was not driven by
trade flows - Japan had a current-account surplus
of 18 trillion yen in 2005. Nor was it driven by
the net outflow of domestic investment into other
countries.
According to official
statistics, Japanese investors bought about 17
trillion yen ($145 billion) worth of foreign
securities in 2005. This was partially offset by
foreign investors who bought about 10 trillion yen
($85 billion) of Japanese securities last year.
This inflow of foreign investment helped push
Japanese equities up by 25% in 2005. The net
outflow of investment from Japan was only 7
trillion yen ($60 billion). Subtracting this from
the 18 trillion yen current-account surplus leaves
a combined trade and investment surplus in Japan
of 11 trillion yen ($94 billion) in 2005. Under
normal circumstances, this surplus should have
produced yen appreciation.
When the
music stops Because the BOJ has not
intervened in the foreign-exchange markets since
the first quarter of 2004, off-balance-sheet
Japanese swaps offer the only explanation for the
depreciation of the yen last year. These swaps
must have exceeded Japan's combined trade and
investment surplus of 11 trillion yen by at least
15 trillion yen, possibly 25 trillion. In other
words, foreign entities borrowed between 25
trillion and 35 trillion yen ($214 billion to $300
billion) from Japan's banks in 2005 to invest in
other countries.
Much of this money
probably found its way into equity markets across
Asia. Likely candidates are South Korea, India,
the Philippines and Singapore, where the stock
markets jumped 59%, 36%, 25% and 17% higher,
respectively, last year despite generally
deteriorating political and economic fundamentals.
Excess Japanese liquidity probably also found its
way into Turkish and Brazilian equities and
fixed-income securities, which also performed
spectacularly in 2005 despite broadly
deteriorating investment fundamentals.
Another likely place where excess Japanese
liquidity roosted in 2005 is the US bond market.
US bond yields remained remarkably low in the face
of rapidly rising short-term interest rates last
year. This performance has defied explanation by
policymakers at the US Federal Reserve, including
both former chairman Alan Greenspan and current
chairman Ben Bernanke. The fountain of liquidity
that supported stellar stock- and bond-market
performances in many countries in 2005 will soon
be shut off.
In announcing the policy
change to end quantitative easing on March 9, BOJ
governor Fukui emphasized that outright purchases
of Japanese government securities by the central
bank would continue and that official short-term
interest rates would not change much this year.
According to Fukui, this would ensure that Japan's
economic recovery gathers pace during the year.
Fukui also mentioned that the BOJ had
already begun to reduce the banking system's
excess reserves and that these reserves would
decline from 30 trillion yen to about 6 trillion
yen by the end of June. Because these reserves
were never used to fund credit growth in Japan,
their reduction will have little impact on the
Japanese economy. However, the heavy use of these
reserves to fund investments in other countries
implies that their rapid reduction will have
significant negative consequences for asset
markets worldwide.
As Japan's excess
liquidity is mopped up, investors that borrowed
Japanese yen to fund investments in other
countries will find it impossible to renew their
swaps. Because international currency and
interest-rate swap liquidity is very concentrated
in tenors of one year or less (the life of a swap
is called its tenor), the majority of these swaps
will mature this year. Consequently, investors
will be forced to sell the equity and fixed-income
assets that these swaps financed. In addition,
these investors will have to buy yen to repay
their yen loans.
The end of quantitative
easing is another factor that will propel a sharp
correction in global investment asset values this
year. It will also produce substantial yen
appreciation against most currencies.
Jephraim P Gundzik is president
of Condor Advisers, Inc. Condor Advisers provides
investment risk analysis to individuals and
institutions globally. Please see
condoradvisers.com for more information.
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