Politics Hijacks Monetary Policy in Japan
Financial markets have always been wary of political interference in the running of central banks. Profligate politicians cannot be trusted to ensure price stability. Independent central banks have tended to preside over stronger exchange rates and lower inflation than those subject to political pressure. While central banks wish to achieve low, stable rates of inflation, the onset of deflation is an unwelcome development. This is precisely the situation that has enveloped the Bank of Japan (BoJ) since the bursting of the bubble economy in December 1989.
The Bank of Japan Act was revised in 1998. The amendments gave the BoJ a significantly higher degree of independence from political interference. The BoJ’s critics had claimed that the institution had already been seeking excessive independence prior to 1998. This has resulted in a lack of accountability: the BoJ has repeatedly rebuffed calls by politicians to pursue aggressive monetary easing to break the vicious cycle of deflation. The patience of politicians now appears to have reached breaking point: the mandate of the BoJ is now centre stage of the debate in Japan’s upcoming general election on 16 December.
The LDP Claims Deflation Has Ruined Public Finances
The backdrop to the 16 December election is simple: the Liberal Democratic Party (LDP) has accused the BoJ in being too timid in the fight against deflation, making it virtually impossible for the government to control public finances. Part of the problem about rising public debt is, however, deeply-rooted in history in the reluctance of the LDP during the bubble years to raise consumption taxes. There will be doubling of the sales tax from 5% to 10% by 2015. The LDP wants the BoJ to be held accountable for reaching an inflation target of at least 2% in the interim.
Bank of Japan Leadership to Change in April 2013
There are some key replacements due in April 2013 to the BoJ’s board, including the governor and his two deputies. Any replacements to the Board of the BoJ require the ratification of both chambers of Japan’s parliament. Given that the LDP does not control the Upper House, it is unlikely that radical new appointments can be made. The balance of power on the Board at the BoJ will, however, change in April, potentially inducing significant changes in the conduct of monetary policy.
The inability of Japan’s leaders to deliver the structural reforms required to arrest the structural decline in competitiveness is infamous. This has resulted in some commentators claiming that fears of political interference in the running of the BoJ are overblown. At the same, there is a growing acceptance that Japan’s old economic model cannot simply be resuscitated overnight. Bold measures need to be instituted to revive the economy’s competitiveness. The most obvious starting point is to weaken the exchange rate and then initiate supply-side reforms.
“Endaka” Has Been Disastrous for Japan
The era of endaka (“strong yen”) has been a disaster for Japan. It imported massive deflation and has helped to crush the profitability of Japan’s exporters. The strong yen also persuaded companies to engage in massive off-shoring of productive capacity in Asia. Initially, the corporate sector attempted to offset the rising yen by boosting domestic capital spending. Rising capacity growth in Japan, however, only served to put further downward pressure on prices, thereby accentuating the effects of imported deflation.
The strong yen was also a bad omen for Japan’s banking system. Short-term interest rates were being cut during the 1985-89 period to prevent excessive yen appreciation, helping to produce a bubble in both real estate and equity markets. This distorted the value of collateral offered by borrowers, fuelling reckless bank lending. A significant bad loan problem developed, taking many years to resolve.
It is hardly surprising that driving the exchange rate down will rank as an important starting point for the next government.
Japan Faces Upward Pressure on Funding Costs
Despite spiralling debt-to-GDP ratios, Japan has seemingly defied the odds and managed to keep her sovereign cost of funding very low. This is largely attributable to low inflation and the overwhelmingly domestic source of funding. This situation cannot, however, last indefinitely: increasingly adverse demographics will lower the level of household savings, forcing the government to turn to new sources of funding. This could involve possible overseas sources.
Given the forward-looking nature of financial markets, the fiscal sustainability of Japan will eventually come under the microscope. The recent experience of the periphery countries in the Eurozone provides an excellent example of what happens to the sovereign cost of capital if that country’s public finances are deemed to be on an unsustainable path. Even the United States is not immune from this potential predicament. Financial markets will not tolerate the issue being “kicked down the road” forever.
How Will Japan Weaken the Yen?
The BoJ has, over the years, engaged in significant amounts of foreign exchange intervention, particularly versus the US dollar. These interventions have not, however, succeeded in arresting the chronic appreciation of the yen, along with its accompanying imported deflation. One of the reasons why the BoJ did not succeed in breaking the yen’s appreciation was that its foreign asset purchases were offset by sterilisation through open-market operations. Any future measures to weaken the yen via foreign asset purchases must be unsterilized to have a lasting effect on the exchange rate. This strategy is, however, not without risks.
Inflationary Expectations Will Be Crucial
One of the major reasons for the stubborn strength of the yen is the persistence of high real interest rates in Japan due to deflation. If inflationary expectations can be driven upwards, then the high real yields underpinning the yen’s strength will be undermined. The implications for the real economy could critically hinge on the behaviour of inflationary expectations. The financial sector in Japan holds the overwhelming bulk of Japanese government bonds (JGB’s). Rising inflationary expectations could produce a sharp rise JGB yields, imparting significant portfolio losses on Japan’s financial institutions. Capital losses at Japan’s financial institutions could undermine their ability to extend credit to the private sector.
The current Japanese Administration is committed to tightening the structural fiscal policy by 4% of GDP by 2016. There appears to be little appetite to tighten policy further due to the political reluctance to invoke higher sales taxes. Ironically, the threat of further sales tax hikes would enhance the chances of the BoJ’s inflation target being met, as well as raising inflationary expectations.
Paying the Price for Two Decades of Poor Economic Management
The roots of Japan’s long-lasting economic malaise lie firmly in the poor policy management in the aftermath of the Plaza Agreement in September 1985. The aim was to drive the US dollar lower versus the yen and deutschmark under the guise of international policy coordination. This would supposedly correct the chronic US current account deficit and Japan’s surplus. The Japanese government agreed to reflate the economy through easier monetary and fiscal policies. The spectacular rise of the yen forced the BoJ to undertake an easier policy than warranted by the economic cycle. It helps to explain why the corporate sector in Japan went on a borrowing binge. The subsequent deleveraging lasted from 1990 to 2005. Corporations simply engaged in debt repayment at the expense of hiring and capital spending.
With the benefit of hindsight, the BoJ should have tightened policy earlier than December 1989. Some of the more extreme misallocations of capital during the post-Plaza era in Japan may have been avoided in this scenario. The BoJ was then blamed for not easing policy quickly enough in the aftermath of the bursting of the bubble. The BoJ could soon be a de facto department of the Japanese government. Financial markets do not traditionally view politically-dominated central banks favourably. Thus far, Japan has seemingly managed to avoid the gloomy predictions surrounding uncontrolled government borrowing. If the LDP succeeds in bringing the BoJ under greater political accountability, the benign backdrop for JGB’s could soon be coming to an end. This could have profound implications for global bond markets.
Summary and Conclusions
The upcoming Japanese general election on 16 December could reduce the political independence of the BoJ by making it accountable for achieving an inflation target. The aim is to force the BoJ into more aggressive policy measures in another effort to break the vicious cycle of deflation, which has supposedly ruined Japan’s public finances.
Important leadership changes are due in April 2013 on the Board of the BoJ. The replacements will require approval from both Houses of the Diet. The replacements could prospectively induce important changes to the conduct of monetary policy, including measures to produce a weaker exchange rate.
The era of “endaka” (strong yen) has been disastrous for Japan’s economy, forcing the corporate sector to hollow out domestic production. It also distorted borrowing costs for the corporate sector in the late-1980’s, resulting in a 16-year balance sheet recession from 1990 to 2005.
Raising inflationary expectations will be crucial in attempting to drive the yen lower by reducing real yields. A sharp rise in inflationary expectations could raise JGB yields, producing large portfolio losses for Japanese financial institutions.
The massive challenge facing Japan’s goes back to poor policy conduct during the bubble economy: indirect taxes should have been increased and monetary policy tightened earlier. Severe capital misallocation would have been avoided. Ironically, the BoJ may now pay a high price for asserting its independence after it had bowed to political pressure from the LDP in the late-1980’s to keep the bubble economy going.
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