Forget the Fed, prepare for Tokyo 'taper'

If (or when) America's central bank finally embarks on its taper, how will this affect markets? Or the central bank itself? That is a question investors and analysts are frantically debating now, as the next US Federal Reserve decision looms.

But this intellectual exercise is one that investors might do well to ponder on the other side of the world, too. The Fed is not the only bank to have embarked on extraordinary monetary policy experiments in recent years; the Bank of Japan has recently conducted policies that make the Fed's experiments look almost tame and have had a big impact on Asian markets.

Thus far, nobody in Japan is yet actively discussing when the BoJ might embark on an exit. On the contrary, the BoJ has pledged to keep policy ultra-loose for a long time, as part of Abenomics. But the question of future strategy should not be ignored, however distant it may seem. For as the monetary experiments have become more extreme, they have created distortions which could be as difficult to unwind as in America, if not more so. And that not only creates future economic risks, but rising political challenges too.

To understand this, take a look at a fascinating little paper on the BoJ written by Kazusama Iwata, former deputy BoJ governor, and Ikuko Samikawa, chief economist at the Japan Centre for Economic Research*. This analysis starts by pointing out that Abenomics has changed Japan's monetary stance in both obvious, and not-so-obvious ways.

The visible piece of the equation has been a flurry of asset purchases by the central bank, to pump liquidity into the system; Iwata and Samikawa project, for example, that by the end of 2014 the BoJ will hold Y190,000bn of Japanese government bonds, double the level in 2012. This has made the BoJ the biggest single buyer of JGBs and caused the entire monetary base to double in a mere two years.

But what is less noticed is a shift in the maturity profile: because the BoJ has been buying long and super-long instruments, the maturity of its holdings has risen from less than three years before Abenomics, to around seven years today.

In an ideal world, this shift should have flattened the yield curve. In practice, though, this monetary policy impact has been partly undermined by the fact that the Ministry of Finance has increased its issuance of long-term bonds. This suggests, as Iwata and Samikawa observe, that "greater co-ordination between monetary policy and JGB management policy [is] required". Or, if the BoJ policies are to really work, it would help if the finance ministry stop shooting this in the foot.

But the really big issue lies in the future. The jump in maturities means that if - or when - the BoJ wants to normalise policy, it will not be able to shrink its balance sheet swiftly by letting its bond holdings expire; instead, when rates rise, the BoJ will probably be stuck holding lossmaking JGBs. Worse still, that blow will come at a time when the fee that the BoJ pays banks for their excess reserves also rises dramatically due to rate hikes.

The net result, then, is that "the BoJ's national treasury payments may be zero for around three years at least", when QE ends, as Iwata and Samikawa write. "The reduction in national treasury payments will lead to a national burden." Or, more bluntly, the end of Abenomics, in terms of monetary policy, will almost certainly blow a hole in the BoJ balance sheet.

Now, this looming danger does not necessarily mean quantitative easing was a mistake; if it ends deflation, balance sheet losses will be a small price to pay. But the real point, as Iwata and Samikawa observe, is "the BoJ needs to explain to the Japanese people in advance" about the future losses and "make prior arrangements in allocating the risks, costs and benefits", to preserve the BoJ financial health. For unless this happens, there is a real risk that either public trust will suddenly crack or the bank will be so terrified about suffering losses that it never tries to find an exit at all.

Of course, a cynic might suggest that even if there is a public conversation the BoJ is unlikely to do anything for years. This is a country where a BoJ governor was assassinated nine decades ago when he tried to bring ultra-loose monetary policy to an end; and where a senior BoJ official committed suicide over a loss-producing financial rescue.

But, if nothing else, Iwata and Samikawa have done the Japanese establishment a favour by highlighting these issues; and for reminding investors that the Fed is not the only source of ultra-abundant liquidity in the global financial system. On the contrary, whatever happens next with the US taper may turn out to be nothing more than the first act in a five-act global drama.

*Quantitative and Qualitative Monetary Easing Effects and Associated Risks; JCER Financial Research Report: General Remarks

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