Bank of Japan's monetary policy: Japan and Australia

Bank of Japan's monetary policy: Japan and Australia

Last year on December 26th, Shinzo Abe assumed office as Japan’s current Prime Minister and immediately began fulfilling his electoral campaign promises of bringing sweeping economic reform and output growth to the world’s third largest economy. After suffering decades of lacklustre output and many failed attempts to induce growth, Abe’s policies, both currently implemented and in the pipeline, are the biggest things to hit Japan since Godzilla itself.

Government stimulus packages, including a $USD117 billion injection announced in January to assist public works and provision of aid to small businesses, reformation of the nation’s long-standing power sector monopoly, and talks of a Trans Pacific Partnership that will serve to boost Japan’s net exports merely act as a sidekick (albeit a very important one) to Japan’s open ended security purchases – more commonly known as quantitative (monetary) easing.

The Bank of Japan’s open-ended purchasing of approximately ¥7.5 trillion ($USD 60 billion) of long-term securities per month is perhaps the most radical, prominent, and promising economic policy implemented by the Japanese central bank in recent history to revive their long stagnant economy. Shifting away from benchmarking an economic growth figure, the Bank of Japan has its sights firmly set on achieving a 2% inflation goal within the next two years through this security-buying scheme. If all pans out as planned, Japan’s persisting deflation problems that commenced in the early 90’s could come to an end by 2015.

Indeed, this policy draws many parallels to the quantitative easing implemented by the US Federal Reserve. Japan and the USA, with nominal interest rates at 0% and 0.25% respectively, have been forced to implement this alternative monetary policy measure as they sit on or approach the zero-bound limit for interest rates. The US Federal Reserve, currently experiencing its third round of quantitative easing (QE3) is buying $USD85 billion of securities every month and the BOJ is purchasing the equivalent of $USD60 billion. Relatively, however, Japan’s monetary policy measures are much more substantial given that their GDP is roughly 40% that of the US’s.

Quantitative easing is a far-reaching monetary policy that serves to stimulate growth in the economy on the whole, both directly and indirectly. The increased cash balances of the financial institutions that the BOJ purchases securities from result in increased lending for business and household consumption, in turn, leading to higher aggregate demand domestically.

Another primary factor of economic stimulation stemming from the monetary easing is the depreciation of the nation’s currency against their trading partners. This depreciation is derived from a reduction in foreign capital inflow into the country, due to the lower interest rates, resulting in reduced demand for the Japanese yen. This fall will result in a lower demand for the yen, and therefore, weaken the nation’s currency – especially against other countries that have not implemented quantitative easing such as Australia. A weaker currency against trade partners makes exports more attractive internationally, and imports less attractive domestically, and will eventuate to an increase in net exports and output. This increase in economic growth, combined with the increase in the supply of money, allows a nation to avoid any problems of deflation that it may have been potentially facing.

The government’s demonstrated commitment to achieving the 2% inflationary target through open-ended purchases demonstrates to domestic consumers and international trading partners that the Japanese government is committed to jump starting this economy and achieving this goal at all costs. Such a commitment has boosted consumer and business sentiment. A survey conducted by Bank of America Merrill Lynch found that every Japanese regional fund manager questioned expected the economy to strengthen over the next twelve months. This expectation of growth will lead to greater current consumption and further strengthening of Japan’s economy. Additionally, the expectation of rising prices of goods and services mean that Japanese consumers would rather consume now rather than later. This further boosts current economic output.

Japanese markets have reflected the positive sentiment held by investors of the comprehensive economic reform. The Nikkei has risen over 50% since November 2012 – when it was clear that Shinzo Abe was going to win the election. Additionally, the IMF has recently revised its growth forecast for Japan. Initial projections estimated annual output growth to be 0.4% in 2013 and 0.7% in 2014, however, recent estimations following the BOJ’s monetary easing commencement increase estimates to 1.6% and 1.4% in 2013 and 2014 respectively.

Monetary easing brings forth many risks and for a nation that has the highest debt to GDP ratio in the world, slight miscalculations, mismanagements or perhaps external influences from unforeseeable events can catastrophically impact the economy. A few normal risks assumed by central banks when undertaking such a monetary policy include: hyperinflation (if not properly managed), financial institutions not passing on their excess funds to domestic consumers and businesses, unwillingness to consume domestically even at the lower borrowing rate, or investing in areas that yield no economic growth for the nation such as international security investments.

A short to medium term risk that Japan faces is the nation’s downward pressure on wage levels. A survey conducted by Reuters in February found that 85% of companies planned to keep wages stable, or lower them, this year. This stagnation and decline of wages leads to less disposable income and consequently reduced consumption by consumers in Japan. In the long term, Japan faces the colossal task of controlling and reducing their enormous debt. In 2012, Japan possessed a 230% debt to GDP ratio, and with the BOJ purchasing ¥7.5 trillion worth of securities a month (in addition to the outflows due to implementation of other Keynesian economic stimulus measures), the IMF predicts that this ratio will rise to over 250% by 2016.

Christine Lagarde, head of the IMF, expresses concern over countries such as Japan implementing loose, alternative monetary policy measures without focusing on reducing their expanding balance sheets. She warns that if inflation spikes or investors lose faith in the program’s viability, this could result in huge losses for the already heavily indebted nation.

Japan is our second largest export market, thus, the reforms in the Japanese economy significantly affects our own output growth. Depreciation of the yen against the Australian dollar makes our exports more expensive for Japanese consumers to purchase, however, Australians will find Japanese imports more affordable. As a result, our net exports of $AUD30 billion between Australia and Japan stand to decrease. Both Wayne Swan and the RBA have expressed concern regarding a depreciation of the currency by our trading partners. While this is something that is out of the RBA’s control, they are hoping that continued growth in the US will strengthen their dollar (and raise other currencies anchored to it), and that this will result in an increase in our net exports – offsetting losses from Japan. In the short term, however, this could potentially result in a further depression of Australia’s non-mining export sector.

In the financial sector, the injection of cash into the Japanese economy could result in a spill over into our financial markets. Japanese investors are looking to achieve greater returns, and the yields offered by Australian markets are markedly higher than those in their home country. Capital inflow into Australia increases the demand for our dollar, and further increases the AUD.

While not a perfect policy, the $USD1.4 trillion injection into the Japanese economy over the next two years is widely hailed as the much needed shock to revive a largely flat lined Japanese economy. While it is much too early to conclude on the effectiveness of the BOJ’s monetary easing, we must bear in mind that this is not the sole tool used by Japan to fix their broken economy. Monetary easing must be combined with ‘ambitious growth and fiscal reforms to ensure sustainable recovery and reduce fiscal risks’, and as advised by Lagarde, there is indeed a limit to how effectively monetary policy can be used solely to prop up an economy. For this policy to work, close monitoring of the key indicators – especially consumer and business sentiment – is critical. Ensuring that their soaring debt levels do not become unmanageable in the process of stimulating economic growth is something that the Bank of Japan needs to be perpetually wary about. Their long-term growth is dependent on ‘healthy public and private finances’ and the Japanese government needs to devise methods of both managing and reducing its record amounts of debt if it wants to maintain global competitiveness and achieve it’s economic potential into the future.