No News from Japan

Sometimes no news is more telling than one might initially think and although it was hardly earth shattering for the market that the BOJ chose yesterday to keep its main benchmark rate sitting at 0.1% it does highlight the extraordinary difficulties Japan currently face in terms of sparking its economy back into some kind of forward momentum.

(quote Bloomberg)

The Bank of Japan held interest rates near zero and said it remains committed to fighting deflation as gains in the yen risk stunting the recovery from the country’s worst postwar recession. “I hope that price declines will be overcome as soon as possible,” Governor Masaaki Shirakawa told reporters in Tokyo after his board kept the overnight lending rate at 0.1 percent. “It will take time before we can see prices rising to favorable levels,” he said, adding that the central bank will maintain an “extremely accommodative financial environment.”

Japan’s credit rating outlook was lowered by Standard and Poor’s today, highlighting concern that the world’s biggest public debt will lead to higher borrowing costs in a country already facing falling prices and a strengthening yen. Finance Minister Naoto Kan said today that the BOJ can do more to battle deflation, and people with knowledge of the matter have said it may consider expanding an emergency loan program or increasing purchases of government bonds. “It’s highly probable the central bank will come under pressure to ease policy further as the economy loses steam,” said Teizo Taya, a former central bank board member and now adviser to the Daiwa Institute of Research in Tokyo. “The bank will likely consider expanding the lending facility, while it will try to avoid increasing bond buying as much as possible.”

The statement by the governor Shirakawa really tells it all and one can only second his hope that price declines will soon hit the shores of Japan. Yet, this seems more and more unlikely which is also why the BOJ seems to be moving straight back into full out QE mode at the same time as its peers are set to try, albeit with great difficulty, to restore some kind of normal monetary conditions over the course of 2010. 

The BOJ consequently seems to be silently conceding that it will have to cooperate tightly with the MOF in trying to bring some kind of momentum back to Japanese soil. In this concrete case it will mean keeping open the taps to create a bid for the steady flow of Japanese government bonds.

(click on graphs for better viewing)

The core-of-core index has now fallen since January 2008 with the total accumulated decline in the core nominal price level of 6.8%. Now, I don't need, I think, to spell out what this implies for debt and growth dynamics in Japan which just seem to perennially stuck at the moment.

The problem for Japan is really that it is fighting a losing battle on two fronts. Firstly, and quite as most observers would expect Japan is having great difficulty in terms of building up domestic demand (see graph here). Secondly however and much worse; conventional wisdom would have that as the risky assets began to fly back in March 2009 and as the global economy showed the first tepid signs of emerging from the death bed so should the JPY weaken and Japan ride, through the carry trade effect, the global upturn on exports. Yet, this has not been the story so far and while Japan indeed is exporting a lot to service the runaway train China, the new found reluctance of the JPY to react to global risk sentiment is preoccupying.

Measured against the Euro and using the period 2004 to 2009 (more or less) as the base average value the JPY is now 10% and 17% stronger against the Euro and the Buck respectively.

Finally, to add injury to insult S&P moved in Monday with a nudge as it threathened to downgrade Japan's sovereign debt rating less it gets its fiscal book on the mend. As a mitigating factor S&P mentions Japan's strong net external position which acts as an important dam towards the rising flood of public sector debt. Yet, unless Japan succedes in pushing the JPY down on a sustainble basis against its main competitors this dam will break sooner rather than later. Needless to say that if the BOJ decides to abide completely from the implied domestic pressure to continue funding deficit spending, S&Ps hands will be effectively forced. One thing is for sure as Societe Generale's chief Japan economist Takuji Okubo is quoted by Bloomberg;

"The market should be braced for the BOJ keeping its current rate unchanged for a very, very long time".

Indeed, and thus as the big talking point in the rest of the world remain fixed on exit strategies and the need (and peril) of fiscal consolidation Japan continues to be stuck in the mire. My own personal feeling is that it might very well be the BOJ leading the pack of global central banks rather than the other way around, but for now the fact that there is no news from Japan is exactly what makes it news.

Exit/Enter QE?

If the theoretical discussion in the context of monetary policy, through most of 2009, has been centered on the different tools disposable to central banks in the form of unconvetional measures it seems almost certain that 2010 will be all about putting theory into action. Most notably is of course the much debated concept of exit strategies from quantitative easing (or enhanced credit support in the case of the ECB), what it means to really exit, how to exit, and when to exit.

Starting with the last point the G3 central banks have pretty all indicated that the latter part of 2009 and beginning of 2010 would see a gradual, but firm exit from quantitative easing and thus, essentially, unwinding of asset purchases and extraordinary liquidity provisions. In terms of how and without going too much into details all three central banks have clearly communicated how they intend to unwind QE if and when they see it fit. Finally, and on the first point it is naturally much more difficult since you can really only answer this question ex-post.

As I argued recently communicating an exit strategy may be quite simple not least since this task appeals to the more technocratic discourse which central banks master with ease, but actually performing one in practice may not be so easy. Recent evidence seem to vindicate this point.

Consider then the 12-month loans from the European Central Bank set to end with the last allotment the 15th of December where the ECB, according to Bloomberg, will lend as much as 150 billion euros ($227 billion). Now, the fact that demand for this tender will large is not so important but that it comes at this point in time when markets and the economy seem decidedly fragile is quite another;

(quote Bloomberg)

The ECB, which may detail conditions for the loans tomorrow, will lend banks 150 billion euros ($227 billion) in the Dec. 15 tender, according to the median of 19 economists in a Bloomberg News survey. That’s double the 75.2 billion euros banks drew in September, though less than half the 442 billion euros allotted in the first tender in June. The ECB will offer the loans at a fixed 1 percent, its current benchmark rate, 18 of the economists said.

The ECB has already signaled this month’s 12-month loans are likely to be the last as it starts to scale back its emergency lending to banks. With financial markets jittery after Dubai last week said it would seek to delay debt repayments, and Greece’s ballooning budget deficit pushing up its borrowing costs, European banks may take the opportunity to stock up on the ECB’s cheap cash.

“Take-up could potentially be very large, it’s the last opportunity to get into what could be a nice little earner,” said James Nixon, co-chief European economist at Societe Generale SA in London, who expects demand to total 200 billion euros. “Given the wobbles about Greece and Dubai, the ECB will cross their fingers and hope the 12-month tender goes off without too much of a problem.”

Clearly, today's ECB meeting will tell us a lot, not least in relation to whether the ECB will be offering this final tender at a fixed rate or, in foresight of excess demand, deploy a variable rate. As Societe Generale points out in their latest ECB watch, Trichet and co seem very eager to remove liquidity as soon as possible as they consider the risk that banks' operations may become too dependent on them. Naturally, I agree with this position, but as ever the ECB risks facing some hard questions in the context of e.g. a double dip recession in Germany, a blowout in Spain or Greece (which is coming), or if suddenly an event akin to the Dubai unravelling enters the stage to disrupt markets. Especially on the second point, it will be very interesting to see how intra-Eurozone spreads react to the unwinding of bank funding as I have long suspected (as well as many others) that the liquidity provided by the ECB has been used to fund the widening fiscal deficits in the Eurozone.

Elsewhere in the G3 or more specifically, at the BOJ any talk of an exit from QE was temporarily halted this week as the BOJ held an emergency meeting where the central bank responded to the increasing woes of the government by committing to a 10 trillion yen ($115 billion) program to supply loans to commercial banks at the prevailing refinancing rate of 0.1%.

(quote Bloomberg)

The central bank yesterday said it will offer three-month loans to commercial banks at 0.1 percent under the new facility. Governor Masaaki Shirakawa stopped short of boosting the monthly target for government-bond purchases from 1.8 trillion yen, a step analysts said may be taken within months.

The decision followed escalating warnings from Prime Minister Yukio Hatoyama’s government about the danger of prolonged consumer-price declines, exacerbated by the surge in the yen to a 14-year high. By contrast, Shirakawa, who met with Hatoyama today, in recent weeks raised his economic assessment and announced plans to end some emergency lending programs.

Shirakawa’s announcement “aimed to explicitly show the BOJ’s stance to cope with deflation and strong yen pressures proactively with minimum action,” said Junko Nishioka, chief economist at RBS Securities Japan Ltd. in Tokyo, who previously worked at the Bank of Japan. “We look for the bank to be eventually pushed into taking further actions to satisfy the government.”

As is readily clear, the decision by the BOJ to re-enter, as it were, QE follows mounting worries in the government about an annual deflation rate of some 2% and a JPY trading close to 80 to the USD which is not fun when you are dependent on exports (not to mention that Japan has also lost competitiveness to its main Asian rivals). It is of course particularly interesting to note the idea of the BOJ "satisfying" the government which seems a farcry from the situation in Europe where Trichet couldn't give a sh'te about the cries from Eurozone government leaders. In this way, we should not be surprised to see the BOJ announcing that it is about to step up the purchase of government bonds. Gleen Macquire from Societe Generale (who is very good on Japan mind you) estimates, according to Bloomberg, that monthly government-debt purchases need to exceed 2.2 trillion to 2.5 trillion yen to have a "meaningful effect.

Of Theory and Practice

The two examples above show that while exit strategies may be very nice and handy in theory, they are bit more difficult to initiate in practice. In this respect, it is important for me to emphasize that I am no QE apologist who simple believes that liquidity provisions should be provided indefinitely and without a critical view of the underlying circumstances. However, at this point in time the central banks may be playing a dangerous game, especially in the case of the ECB where I would expect it to be a bit more difficult to simply turn on the tab again if it turns out that the initial decision to exit was premature. In this sense, it is the strenght as well as the weakness of the ECB that it tends to climb onto a very high horse in relation to regime changes and major policy reversals (although to be fair, the ECB has repeatedly stated that it is not committed either way).

In any case, I will be following the QE exit stragies played out before us in real time with some interest since they are bound to provide important precedence for future policy makers.

A Cautious BOJ Stands Pat

As the discourse is slowly but surely tilting towards exit strategies, by part of central banks, from ultra low interest rates and unconventional measures the BOJ opted to day to maintain a very cautious stance towards the incoming green shoots and whether they will prove enough to lift Japan out of the mire.

(quote: Bloomberg)

Officials kept the benchmark overnight lending rate at 0.1 percent, and maintained their emergency lending programs to banks and companies. While describing the economy as “showing signs of recovery,” an upgrade from the “stopped worsening” assessment last month, the Bank of Japan said in a statement in Tokyo today that it still sees “downside” risks to growth. Today’s statement reflected global doubts about the strength of a recovery from the deepest recession since the Great Depression. A Bloomberg News poll of U.S. households published today showed Americans plan to refrain from boosting spending even after the biggest drop in consumption in 29 years.

“Most countries are experiencing a recovery, but few can be confident about the sustainability of those recoveries,” said Yoshiki Shinke, a senior economist at Dai-Ichi Research Life Institute in Tokyo. “Japan will be the last country to raise its interest rate” because it has the added problem of deflation, he said. Bank of Japan Governor Masaaki Shirakawa told reporters in Tokyo today that while stimulus measures have helped the economy improve, “we’re not confident about the strength of private final demand after those effects fade.” He added that central bankers are monitoring the appreciating exchange rate, which is contributing to the drop in Japanese consumer prices.

Japan's problems are many fold but the most severe issues in the context of reading the tea-leaves of the recovery is the uncertainty attached to question of whether the current above par environment will linger beyond the last effects of the stimulus (which was front loaded due to the elections) as well as any inventory bounce which may come as Japanese companies rebuild their empty shelves in Q3.

It is difficult not to sympathize with the BOJ in its careful approach here since if you take a look at the underlying demand conditions they are, to put it mildly, sluggish! Only a week ago, I discussed the situation on the corporate level where companies were hit by falling top line sales on the domestic market and, as a result, only very carefully expanding capex. Moving on to other key economic indicators it is pretty poor reading if we look at the domestic economy in isolation.

By far, the most preoccupying problem has to be the fact that Japan's inflation rate is moving beyond sub-zero and essentially into the abyss which is a painful and almost, if you will allow me to be dramatic, tragic outcome after two decades of fight against this very malaise. Now, I know that we are observing one-off effects from high oil prices in the summer of 2008, but try to have a look a the actual numbers. Consequently the index that actually includes energy is currently running (in July) at a rate of decline of 2.2% whereas the index which excludes energy and fresh food is running at an annual decline of 2.6% and thus more than the headline gauge. Clearly, the BOJ would like to see this figure correct or even stabilize over the summer before contemplating tweaking nominal interest rates.

With respect to consumption, the figure tracked as a headline gauge for domestic demand on the consumer side is quite volatile, but it should not escape our attention that despite its volatility, it has been consistent below the 0% growth mark throughout 2009. Thus the average annual growth rate on a monthly basis has been -1.8% so far in 2008 which suggests as a simple yardstick the negative drift we need to apply to the evolution of domestic demand in Japan.

Finally there is the labour market where the unemployment rate has increased rather harshly since the beginning of 2009 following a mean reverting pattern around 4% throughout 2008. 5.7% which was the reading in July certainly won't make any headlines comparing to the eye-popping figure we are seeing in e.g. Spain or elsewhere, but it is worthwhile contemplating this in a relative sense and thus the effect it is likely to have on the behaviour of already cautious households.

Where Goes the JPY?

If the round-up above suggest, in a real economic context, the current shaky condition of the Japanese economy it seems that Japan now has a new issue to deal with; the unduly appreciation of the JPY. Now, of course these days it may be of less use to look at the JPY measured against G7 currencies rather than for example against China, but the graph below should still capture much of the essence.

I think it is very interesting here to observe that in a post-crisis context the JPY has gained about 20% against the Euro and Buck where it has been ranging since the latter part of 2008. Clearly, this has an effect on the real economy in so far as it reduces the competitiveness of Japanese companies relative companies in the US and Eurozone (not to mention the UK); and remember, deflation here is becoming a zero sum game since at the moment the US, the Eurozone, and the UK is also suffering from a bout of deflation or very low inflation.

Of course, this presents Japan with a whole new problem in the sense that while Japan could hitherto expect to get a double boost from an increase in risk aversion as carry trade activity took hold lowering the Yen and allowing Japan to export away, this route is getting increasingly crowded. More specifically, Bernanke has entered the scene and as analysts and commentators start talking about the new "victims" of the global carry trade punt in the form of those brave souls among central bankers who dare raise interest rates before movement in the G3, Japan cannot be certain to be the exclusive funding currency. It has a rival in the form of the USD and notwithstanding the obvious consequences for the global economy that Bernanke is putting up a 0% interest rate on the world's most liquid fiat instrument, Japan might find itself pinched here.

Of course, there is a solution here even though it seems unlikely at the moment, I believe, that it will come to pass.

It was still telling that the branch of RBS in Japan (RBS Securities Japan Ltd) was quoted, by Bloomberg yesterday, personified by chief economist Junko Nishioka for noting, rather dryly I'd might add, that the most efficient way to spur growth in Japan would be through a devaluation. Hmm, that would be fun wouldn't ... a devaluation amongst the G3! Once again, we are left guessing as to just what value of the benchmark USD/JPY that will jolt the MOF and BOJ into joint action; 90, 85, 80, 75 ...? I will leave my readers to do the rest of the guesswork, especially since yours truly has burnt his prediction powers once too many trying to call JPY intervention. So far though, most bets seem off as the incoming Finance Minister Hirohisa Fujii made it quite clear that there will no such nonsense of intervention to weaken the Yen. Also, if Macro Man is right and this is predominantly a Dollar story rather than a Yen story, then what can they do as MM put it earlier this week.

In a general sense, it shall be most interesting to following both intra G3 currency movements and FX in general if and when some economies venture into a decisive tightening mode over the second half of 2009. And for Japan, well she will try to muddle through of course. I am watching the inflation picture closely as well as of course we must watch the extent to which Japan can really couple on to the Asian growth spurt we are currently observing. With respect to policy decisions, I feel confident that the BOJ is locked in at this point to, if not continue QE, then at least to keep nominal interest rates at or very close to the zero bound.

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[1]: Note, if you correct for stationarity the co-relationship dissipates so I may be over-stepping my bounds here.