Taking Stock of Japanese Unconventional Monetary Policy ......©IPAN 2014 Page 1 of 18 Taking Stock of Japanese Unconventional Monetary Policy Six Months On By Julien Terragnolo IPAN

IPAN Research Brief No.01/2014 by Julien Terragnolo

©IPAN 2014 www.ipan.in Page 1 of 18

Taking Stock of Japanese Unconventional

Monetary Policy Six Months On

By

Julien Terragnolo IPAN Senior Fellow

NOTE: This paper forms a part of IPAN Research Briefs. International Policy Analysis Network

holds exclusive rights over its publication, use and distribution. Unauthorised use of this

document in any form is strictly prohibited. The views expressed here are of the Author and don’t

reflect those of International Policy Analysis Network (IPAN).

Disclaimer by the Author: The author owns a mutual fund portfolio invested in bonds

from emerging markets including from the BRICs.

http://www.ipan.in/



The monetary policy decision of April 2013

On April 4, 2013, the Bank of Japan announced a round of intensified quantitative easing aiming

at overcoming the persisting deflationary trend. Specifically, the Bank of Japan adopted a

consumer price index (CPI) inflation target of 2 percent by doubling the monetary base, doubling

its holdings of Japanese Government bonds, and trading up the yield curve by more than doubling

the average remaining maturity of Japanese Government bond purchases from an average 3 years

to 7 years. The Bank of Japan decided to expand the monetary base by 60 to 70 trillion yen

annually from 138 trillion yen as at year end 2012 to 270 trillion yen at year end 2014, to

purchase 50 trillion yen Japanese Government bonds per year, and to extend eligible maturities to

40 years. To stimulate real estate prices, the Bank also decided to purchase 30 billion yen

Japanese Real Estate Investment Trusts.

Whereas the world's major central banks embarked on unconventional monetary policy since

2008 in a fairly similar magnitude, the IMF estimates that the monetary policy decision will lead

to a distinctively larger relative size of the balance sheet of the Bank of Japan than that of peers.

Balance sheet size as a percentage of GDP

Source: IMF, Article IV consultations, IMF Country Report No. 13/253, August 2013.

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The long term trend of Japanese debt looking backward

The numbers of the above asset purchase program compare with a nominal GDP of 476 trillion

yen in 2012, i.e. 5.6 trillion US dollars.1

In other words, the Bank of Japan decided to increase the

monetary base from 29 to 57 percent of GDP by purchasing roughly an annual amount of

Japanese Government bonds corresponding to 10.5 percent of GDP, i.e. between three quarters

and a year of Government deficit at the level of the past 4 years. The latter is the outcome of a

long term downward trend in GDP and tax collections caused by deflation (see annex I), as well

as of the increase in spending partly stemming from aging and age-related expenditures (see

annex II). Over the period 1994-2013, nominal social security spending grew at a compounded

rate of 4.6 percent annually (annex II), whereas nominal GDP growth was nil. Over the same

period, the nominal revenues of the Japanese governments fell by 15.5 percent from 51 to 43

trillion yen, while public spending rose by 37 percent from 74 to 101 trillion yen. Whereas 31

percent of fiscal spending was financed by deficit in 1994 (23 trillion yen), this proportion

increased to 61 percent in 2012 and 57 percent in 2013. This corresponds to a progression of

fiscal deficit from 4.6 percent of nominal GDP in 1994 to 13.7 percent in 2012 and 11.7 percent

in 2013 (annex I).

According to data from the Bank of Japan, national government debt amounted to 292 trillion

yen,2

i.e. 59 percent of nominal GDP, in 1994, and grew at an annual compounded rate of 6.6

percent to 991 trillion yen in 2012. According to the IMF, Japanese gross central government

debt reached 238 percent of GDP in 2012.

Forward looking estimates of Japan's debt sustainability and implications for

monetary policy

Under the hypothesis of a minor fiscal consolidation efforts (improvement of the primary balance

by 3.5 percent of GDP by 2020), assuming that the current monetary policy would reach its goal

of a 2 percent inflation rate and that it would pass through entirely to interest rates in a gradual

increase 2 percent increase in long interest rates, gross government debt would reach 365 percent

of the Japanese GDP in 2030, according to the IMF's sensitivity analyses.

Under the hypothesis of large fiscal consolidation efforts (improvement of the primary balance by

11 percent by 2020), assuming that the current monetary policy would reach its goal of a 2

percent inflation rate and that it would pass through entirely to interest rates in a gradual increase

2 percent increase in long interest rates, the debt-to-GDP ratio would be flat and reach 247

percent of GDP in 2030, according to the IMF's sensitivity analyses.

Making the assumption that the real GDP growth rate would increase gradually to 1.1 percent by

2020 and 1.6 percent by 2030 (versus the 0.8 percent trend over the period 1994-2013), that

1 Translation at the 2012 average mid point USD:JPY rate of 79.80 as provided by www.oanda.com.

2 http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$nme_a000_en&lstSelection=9

http://www.ipan.in/

http://www.oanda.com/

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2



social security spending would remain stable in spite of demographic trends, that additional

consolidation efforts would be front loaded, and then stabilized, resulting in a nil primary balance

by 2018 and a 2.2 percent surplus by 2030, that deflationary pressure would persist for a decade,

and that long term yields would gradually rise from 0.7 percent in 2013 to 4.3 percent in 2030,

i.e. assuming progressively widening credit spreads rather than inflation premium, the OECD

calculates that the Japanese gross debt-to-GDP ratio would remain stable and reach 235 percent in

2030.

According to the author's calculations, under the static assumptions that:

Monetary policy would attain its goal immediately of increasing inflation by 2 percent;

Long term interest rates would remain stable because of quantitative easing and the impact

of monetary supply (financial repression hypothesis)

Real growth trend would stick to its past trend of 0.8 percent;

Nominal GDP would grow by 2.8 percent annually;

Tax revenues would increase by 2.8 percent annually along with GDP;

Real spending would be flat, assuming a rationalization of healthcare and social security

spending given an aging population, leaving no space for additional fiscal consolidation,

and that nominal spending would therefore grow at 2 percent annually (i.e. at an 80 bps

lower rate than Government revenues), fiscal deficit would slowly decrease from 11.6

percent of GDP in 2013 to 9 percent in 2030, translating into a debt-to-GDP ratio of 270

percent in 2030.

In 2011, Moody's found that Japan would need a 3 percent nominal growth rate to keep its debt

under control. However, the assumption that the growth trend would remain stable, although

labor supply would be decreasing (annex V) and although there is some historical evidence of a

negative relation between growth and debt levels above 90 percent of GDP, is rather optimistic.

In other words, it is the author's opinion that even in an optimistic scenario; the Bank of

Japan is compelled to extraordinary quantitative easing and some degree of financial

repression (annex IV).

Some observers pointed to the peak in Japanese households without savings (31 percent in July

2013, up from 26 percent a year earlier) to argue that the Japanese debt level would become

unsustainable as a sign of the country's creeping impoverishment, if wages were not to rise. This

process is likely to be self-sustained as unemployment hit a 10-year low and the job openings-to-

applicants ratio reached a 10-year high by mid-2013:

http://www.ipan.in/



Source: Bank of Japan, Outlook for Economic Activity and Prices, November 1, 2013.

Current impact of Japanese quantitative easing on interest rates

As at October 31, 2013, Japanese monetary base had expanded by 46 percent year-over-year.3

Inflation expectations increased slightly following the central bank's announcement of April 4,

2013 of its intent to double the monetary base and reach an inflation rate of 2 percent, however

financial markets were not immediately persuaded that this objective would be met.

Inflation expectations

(In percent)

Source: IMF, Japan Selected Issues, July 12, 2013, on the basis of implied CPI based on inflation

swap bid and ask prices retrieved from Bloomberg.

However, the increase in inflation expectations by 0.5 percent between April and July 2013

tracked the actual increase in year-on-year inflation.

3

http://www.boj.or.jp/en/statistics/boj/other/mb/base1310.pdf

http://www.ipan.in/

http://www.boj.or.jp/en/statistics/boj/other/mb/base1310.pdf



Source: Reuters.

Year-on-year inflation

(In percent)

2.5

2

1.5

1

0.5

0

-0.5

-1

Corporate Goods Price Index Corporate Service Price Index

Source: Bank of Japan. http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$graphwnd_en

To date, the inflation objective of 2 percent appears to have been met within 6 months from the

announcement of the monetary policy decision. This is resulting in negative real interest rates, as

inflation is not passing through to bond yields. To the contrary, nominal bond yields are on an

unambiguous downward trend.

Yields of 10-year Japanese Government bonds in 2013

(In percent)

http://www.ipan.in/





(In percent)

Source: Reuters


(In percent)

Source: Reuters.

The impact of the new monetary policy on corporate spreads is ambiguous at this point. Highly

rated issuances are experiencing minimal yield compression, whereas as lower quality investment

grade bonds are experiencing an increase in spreads corresponding approximately to the decrease

in bond yields of Government bonds. In other words, the accommodative monetary policy is only

http://www.ipan.in/



passing through to the borrowing conditions of the highest grade issuers, and is not benefitting the

lower grade issuers.

Japanese 5-year corporate spreads in 2013

(In basis points)

300

250

200

150

100

50

0

March April May June July August September

AA A BBB

Source: Asian Bonds Online.

http://asianbondsonline.adb.org/japan/data/bondmarket.php?code=Credit_Spread_Corp_vs_Govt

Japanese 10-year corporate spreads in 2013

(In basis points)

90

80

70

60

50

40

30

20

10

0

March April May June July August September

AA A

Source: Asian Bonds Online.

http://asianbondsonline.adb.org/japan/data/bondmarket.php?code=Credit_Spread_Corp_vs_Govt

Current impact of Japanese quantitative easing on stock markets

In spite of significant volatility, the coincidence of strong stock market performance with

quantitative easing, which is also commonly observed in the United States, is also prevalent in

Japan, no matter how the benchmark is composed. Nikkei 225 is a price-weighted index (i.e. is

http://www.ipan.in/

http://asianbondsonline.adb.org/japan/data/bondmarket.php








the sum of the prices of each share composing it, which overweights lower capitalizations with

respect to a market cap weighted index). S&P Japan 500 is a market cap weighted index of large

and mid cap Japanese stocks. Both exhibit the same trend. Between April 4 and November 10,

2013, the performance of Nikkei 225 and S&P Japan 500 is of 17 percent and 19% percent

respectively, suggesting that larger cap stocks take slightly more advantage of quantitative easing

than less visible mid and small caps.

Nikkie 225

Source: Yahoo finance, own calculations

S&P Japan 500

Source: Yahoofinance, own calculations.

800

850

900

950

1,000

1,050

1,100

1,150

1,200

Trend

Announcement of monetary policy

decision

Trend

Announcement of monetary policy

decision

10,000

11,000

12,000

13,000

14,000

15,000

16,000

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Relative valuation of large Japanese banks:

Price-to-earning ratio in 2013

Source: Yahoo finance, own calculations.

Stock price as a multiple of trailing diluted earnings per share as of September 30, 2013.

The stocks of the largest Japanese financial institutions are not penalized by the low/negative real

interest rate environment.

Current impact of Japanese quantitative easing on real estate

The data on residential and commercial land price history released by the Bank of Japan on

November 1, 2013, in its Outlook for Economic Activity and Prices suggested a stabilization of

real estate prices as at July 1st, 2013, after 20 almost uninterruptedly bear years. It remains

premature to tell whether the monetary policy decision of April 2013 inverted the trend.

Evolution of real economy indicators since the monetary polic y decision

of April 2013

Since Japan halted nuclear energy production, Japan's energy imports have soared, hence the

emergence of a trade deficit against traditionally high surpluses. As at August 30, 2013, the

Japanese trade deficit over the last 12 months amounted to 87 billion US dollars according to The

http://www.ipan.in/



Economist. This new trade deficit cannot be construed as the manifestation of the J-curve effect

as quantitative easing did not result in large devaluation. The announcement of quantitative

easing resulted in the depreciation of the currency by about 5 percent.

Evolution of the exchange rate of the yen in 2013

100%

98%

96%

94%

92%

90%

JPY/USD JPY/EUR JPY/GBP CNY/JPY

Source: Yahoo finance, own calculations.

According to the Bank of Japan's Outlook for Economic Activity and Prices of November 1,

2013:

The annualized quarter-over-quarter real GDP growth rate increased from 0 in the first

quarter of 2013 to 4 percent in the third quarter;

Business confidence rose from 50 to 53;

Private consumption increased slightly;

The output gap closed from approximately -2 percent to 0;

The year-over-year variation of unit labor costs (hourly cash earnings) left negative

territory where it had been hovering most of the time since 1999 and became slightly

positive (+1%);

The steady downward trend of labor force participation stopped. Down from 62.5 percent

in 2000, it is now stable at 59.6 percent;

Corporate profits increased by 17 percent year-over-year for large manufacturing

enterprises;

Fixed investment, which was down 15 percent from its peak in 2008, started picking up.

According to statistics from the International Labor Organization, employment rose by 0.5

percent year-over-year by 290,000 units by August 30th, and by 640,000 units since March 2013,

i.e. by 1 percent.

http://www.ipan.in/



Conclusion on the first six months of intensified quantitative easing

Given Japan's high debt level and unfavorable demographic prospects, the main risk to its

economy is an increase in Government bond yields. However, unconventional monetary policy is

resulting precisely in the opposite, while coinciding with a reversal of a long dated trend of

decline in real economy indicators across the board. Given that the low/negative real interest rate

environment does not appear to hurt systemic financial institutions, there is no indication that the

Bank of Japan would need to deviate from its unconventional monetary policy. In the long run,

monetary policy should not be expected to guarantee growth: to keep the growth trend even, total

factors productivity will need to offset the decrease in labor force.

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Annex I

Japanese fiscal deficit history

Actual Government

revenues (¥ bn)

Actual

Government

Expenditures

bn)

(¥

Deficit (¥ bn)

Deficit (% of GDP)

1994 51,030 73,614 -22,584 -4.6%

1995 51,931 75,939 -24,008 -4.8%

1996 52,060 78,848 -26,788 -5.2%

1997 53,942 78,470 -24,529 -4.7%

1998 49,432 84,392 -34,960 -6.8%

1999 47,235 89,037 -41,803 -8.3%

2000 50,713 89,321 -38,609 -7.6%

2001 47,948 84,811 -36,863 -7.3%

2002 43,833 83,674 -39,841 -8.0%

2003 43,282 82,416 -39,134 -7.8%

2004 45,589 84,897 -39,308 -7.8%

2005 49,065 85,520 -36,454 -7.2%

2006 49,069 81,446 -32,376 -6.4%

2007 51,018 81,843 -30,824 -6.0%

2008 44,267 84,697 -40,430 -8.3%

2009 38,733 100,973 -62,240 -13.1%

2010 41,487 95,312 -53,826 -11.2%

2011 42,833 100,715 -57,883 -12.2%

2012 42,346 107,511 -65,165 -13.7%

2013 43,096 100,537 -57,441 -11.7%

Source: Bank of Japan and own calculations. 2012 and 2013 are based on forecasts of the

Ministry of Finance.

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Annex II

Breakdown of Japanese public spending year-over-year variation by

budget posts

(In percent)

Social Security

Public works

National Debt Service

Tax grants

1994 1.9 -3.5 -2.1 -13.5

1995 6.9 -3.1 -4.5 1.9

1996 3.4 -3.6 25.5 13.4

1997 2.3 -10.3 -1.0 11.0

1998 1.8 17.8 11.1 -7.6

1999 21.5 -0.5 14.5 -13.0

2000 -7.3 -8.2 5.8 19.9

2001 9.4 -9.1 -26.2 6.0

2002 1.8 -15.3 -1.4 -1.4

2003 0.4 2.1 -0.4 5.2

2004 2.9 -12.0 12.7 1.0

2005 1.6 1.9 7.0 -3.8

2006 -0.2 -8.1 -3.7 -0.2

2007 2.9 -5.9 6.9 -8.0

2008 6.7 -4.6 -0.6 3.6

2009 27.3 20.7 -3.8 6.4

2010 -1.6 -30.5 6.0 14.3

2011 5.4 1.9 0.4 3.7

2012 -8.1 -8.1 1.8 0.4

2013 10.4 15.6 1.4 -1.2

CAGR 1994-2013 4.2 -3.8 2.0 1.5

CAGR 1994-2011 4.6 -4.5 2.0 1.8

Source: Bank of Japan and own calculations. 2012 and 2013 are based on budgets of the Ministry

of Finance.

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Annex III Nominal and real GDP growth rates in the long term

Nominal GDP (¥ bn)

Nominal growth (%)

Real growth (%)

1994 495,612 1.0 n.a.

1995 504,594 1.8 2.7

1996 515,943 2.2 2.7

1997 521,295 1.0 0.1

1998 510,919 -2.0 -1.5

1999 506,599 -0.8 0.5

2000 510,834 0.8 2.0

2001 501,710 -1.8 -0.4

2002 498,008 -0.7 1.1

2003 501,889 0.8 2.3

2004 502,760 0.2 1.5

2005 505,349 0.5 1.9

2006 509,106 0.7 1.8

2007 513,023 0.8 1.8

2008 489,520 -4.6 -3.7

2009 473,933 -3.2 -2.0

2010 480,002 1.3 3.4

2011 473,276 -1.4 0.3

2012 474,604 0.3 1.2

2013 489,317 3.1 2.8

CAGR 1994-2013 0.0000

CAGR 1994-2011 -0.0019

CAGR 1995-2012 0.8

Source: Bank of Japan and own calculations. 2012 and 2013 are based on forecasts of the

Ministry of Finance.

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Annex IV

Linear projection of future Japanese Government debt

Nominal Government

Nominal

Government

Nominal

Nominal

Deficit

Annual growth

assumption

revenues (¥ bn)

+ 2.80%

spending (¥ bn)

+2.00%

GDP (¥ bn)

+2.80%

deficit (¥ bn ) (% of GDP)

2013 44,303 102,547 503,018 -58,245 -11.6

2014 45,543 104,598 517,103 -59,055 -11.4

2015 46,818 106,690 531,582 -59,872 -11.3

2016 48,129 108,824 546,466 -60,695 -11.1

2017 49,477 111,001 561,767 -61,524 -11.0

2018 50,862 113,221 577,496 -62,358 -10.8

2019 52,286 115,485 593,666 -63,199 -10.6

2020 53,750 117,795 610,289 -64,044 -10.5

2021 55,255 120,151 627,377 -64,895 -10.3

2022 56,803 122,554 644,943 -65,751 -10.2

2023 58,393 125,005 663,002 -66,612 -10.0

2024 60,028 127,505 681,566 -67,477 -9.9

2025 61,709 130,055 700,650 -68,346 -9.8

2026 63,437 132,656 720,268 -69,219 -9.6

2027 65,213 135,309 740,436 -70,096 -9.5

2028 67,039 138,015 761,168 -70,976 -9.3

2029 68,916 140,776 782,480 -71,860 -9.2

2030 70,846 143,591 804,390 -72,745 -9.0

New debt 2013-2030 ¥ 1,176,968 bn

National government debt in 2013 ¥ 991,601bn

Total debt 2030 ¥ 2,168,569 bn 270% of GDP

Source: 2013 revenue and spending figures: Forecasts of the Ministry of Finance as reported by

the Bank of Japan; 2013 national government debt figure: Statistics of the Bank of Japan at

http://www.stat-search.boj.or.jp/ssi/cgi-bin/famecgi2?cgi=$nme_a000_en&lstSelection=9

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Annex V

Decline of working age population by 2050 versus 2010

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References

Andy Sharp and Chikako Mogi, "Japanese Households Without Savings Climb to

Most Since ’63", Reuters, November 7, 2013

Bank of Japan, Outlook for Economic Activity and Prices, November 1, 2013.

Bank of Japan, press release on the introduction of "Quantitative and Qualitative Monetary

Easing", available at

https://www.boj.or.jp/en/announcements/release_2013/k130404a.pdf

Bank of Japan, statistics on the real economy released on October 18, 2013 and available at

http://www.boj.or.jp/statistics/pub/sk/data/sk4.pdf


Chikafumi Hodo and Tetsushi Kajimoto, "Japan needs 3 percent nominal GDP

growth: Moody's", Reuters, August 24, 2011

ILO statistical database, available at

http://www.ilo.org/ilostat/faces/home/statisticaldata/data_by_subject?_adf.ctrl-

state=tfy7mpmgy_4&_afrLoop=212941732280962

IMF, Japan Selected Issues, July 12, 2013

IMF, "Japan 2013 Article IV Consultation", IMF Country Report No. 13/253

OECD, Guillemette, Y. and J. Strasky (2013), "Japan's Challenging Debt Dynamics", OECD

Economics Department Working Papers, No. 1085

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http://www.ilo.org/ilostat/faces/home/statisticaldata/data_by_subject?_adf.ctrl-state=tfy7mpmgy_4&_afrLoop=212941732280962





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