Japan’s troubled waters

It has been a week of turmoil for Japanese stocks. The Nikkei 225 index dropped some 7% May the 23rd only to recover some lost ground the following day. This occurred amidst an unprecedented central bank intervention to prop up the ailing economy. On April the 4th, the Bank of Japan, announced plans to buy up ¥ 7 trillion yen ($68 billion) of government bonds a month.

Yet this does not seem to have had the desired effect. Ordinarily, one would not expect bond prices to fall and yields to simultaneously rise. However, that is exactly what has happened. While yields on 10-year Japanese government bonds fell upon the BoJs announcement, they have since tripled in value. On May 23rd they reached as high as 1%.

Understandably, this is creating significant unease amongst ordinary fixed-income investors. Naka Matsuzawa, chief strategist at Nomura Securities, went as far as to say that: “the easing by the Bank of Japan has, in one sense, already failed.” Hedge funds and other investors have long eyed Japan’s burden of government debt, which is now at close to 250% of GDP. As well as dampening economic activity, rising rates would quickly push the cost of servicing government debt to unsustainable levels. Banks, too, are heavily exposed to any rise in JGB yields; just a 100 basis-point hike in rates from their current level would mean a loss of ¥10 trillion for banks overall. Such anxiety has untold political consequences. Japan continues to struggle with ballooning levels of public service debt. This, coupled with relatively stagnant economic growth, could create difficulties for the incumbent government.  At the very worst, rising bond yields could signal the beginning of a long-feared crisis in the market for government debt.

Yet it has been argued that bond yields have simply begun to return to a more stable trading range. Recent yield levels, of approximately 0.3% are historically low – even for Japan. Secondly, opponents of state bank intervention have noted that volatility in bond yields is to be expected in any market following massive intervention by the relevant central bank; even if said market has not responded as many had previously predicted it would.

Nonetheless, the government has called upon the Bank of Japan to restore calm to the market. Taro Aso, the finance minister, asked the bank’s governor, Haruhiko Kuroda, to communicate more effectively with the market given recent criticism of the bank’s communications strategy. On May the 22nd, Mr Kuroda predicted that the spike in rates, still low in historical terms, would not affect the stability of the wider economy. However, only two days later, on May 24th, Mr Kuroda was forced to promise to do more to stabilise the bond market.

Yet what options does the BoJ now have? Mr Matsuzawa, of Nomura, argues that a more efficacious approach would involve a strategic lessening of inflationary targets. Current central bank forecasts commit the bank to cut inflation to a mere 2% in two years.  Indeed, one member of the BoJ’s board has already proposed that the bank make its 2% inflation target a medium to long term goal, while committing to intensive easing in the next two years, and was voted down. However, to make such a change would weaken the bank’s commitment to ending deflation.

Yet whatever course the BoJ takes it will likely face criticism. In this sense its recent difficulties are not unlike those experienced by other major central banks. The Federal Reserve, the ECB, the Bank of England and more recently the BoJ have all faced suffered criticism since the onset of the financial crisis.

Sources: BBC News, The Economist and Japan Times

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