Abe’s warning

Japanese Prime Minister Shinzo Abe warned his counterparts at the G7 meeting in Japan that the world may be facing another “Lehman’s moment” (alluding to severe stresses in the financial system, indicated in his view by the weakness of commodity prices).

Once again, when we thought it would not be possible, Japanese policymakers surprise us with the paucity of their true understanding. It’s not Commodity Prices that worry us – they are simply the manifestation of an underlying process of rebalancing that the Japanese have correctly identified. It’s the perilous state of the Japanese banks and the ongoing damage being inflicted by Japanese monetary policy that is, to us, of most concern.

Mr Abe said, “We agreed on the perception that we are facing serious risks, that the world economy is facing serious risks”.

In that regard, he’s right, but the most worrying point is that Japanese Banks pose a substantial and worsening threat to Global Financial Stability. Here’s the picture:

Firstly, Yen 80 trillion of annual QE by the Bank of Japan (fully 15% of GDP each year) has left the Bank of Japan (BoJ) owning 27% of the outstanding STOCK of Japanese Government Bonds. They were purchased from banks that held them with a nice running “carry” (the difference between the cash rate they paid on their deposits liabilities used to fund them and the yield on the bonds themselves) that has now disappeared. Japanese banks, as a direct consequence of the Bank of Japan, now have approaching 20% of their entire ASSETS in cash and deposits:

Needless to say, those assets earn nothing.

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Secondly, Japanese licensed banks have 9.6% of their assets in Central Government Bonds – the yield on those bonds is now below the deposit rate paid to new deposits. That’s not good for earnings, when you pay a higher rate out than you get on your investment.

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Thirdly, the general loan rate for new loans is fast converging on the deposit rate paid to new deposits, and the margin on loans to the real economy is evaporating:

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Fourthly, banks are being “squeezed” from one side by the BoJ and “squeezed” on the other side by depositors: the level of cash in circulation in Japan relative to GDP is marching ever higher.

It stands at 18% versus 7% in 1990 and has trended higher continuously in the last 25 years:

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So, to recap:

  • Japanese banks hold extraordinary levels of non-earning cash on their balance sheets (in fact, the interest rate on the Yen 280 trillion of excess reserves held in the current account at the Bank of Japan is negative)
  • Government bonds yield less than the rate paid to depositors
  • New loan rates are barely above the rate paid to new depositors
  • The economy is becoming increasingly “cash based” – cash / GDP is way beyond international comparison
  • Non-Performing Loans, NPLs, as in China, are being concealed and understated

We’d say the likelihood of a “Lehman’s moment”, as Mr Abe notes, can’t be ignored… But we’d go further and urge Mr Abe to pay closer attention to the destruction of the Japanese Banks being propagated by the Bank of Japan’s QE policy. Any further QE, or a move to increasing negative official rates, just exacerbates the problem. Hopefully Mr Abe showed some charts like these and didn’t overplay the decline in commodity prices.

The Bank of Japan’s monetary policy is sowing the seeds for a systemic Japanese banking crisis – the TSE banks index is down 39% y/y for a reason.

Japan responds

As we have noted in our written material several times since the Chinese authorities buckled last August under the weight of enormous domestic capital outflows, when China accounts for approximately 20% of your exports and 25% of your imports you have to respond… and respond the Bank of Japan did. Initially by suggesting the imposition of capital controls in China and now with firm action by a shift to negative interest rates.

The Bank of Japan has set itself the target of 2% inflation – despite QE amounting to 15% of GDP annually that has left them holding 26% of the stock of outstanding Japanese government debt (up from just 7% in early 2013). Japanese core inflation (Inflation excluding food and tax effects) still stands at a meagre 0.1%.

What’s going wrong?

Well, quite simply, that QE doesn’t work in Japan in the way you might argue it works elsewhere.

Here’s the picture:

Firstly, injections of monetary liquidity – through asset purchases – are offset entirely by a decline in the velocity of circulation of money – in short, more money does less, leaving you where you started.

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Secondly, the liquidity injected simply ends up in the “current account” at the Bank of Japan – that is to say, banks hold the cash in the form of mountainous reserves at the central bank.

The level of current account deposits at the Bank of Japan stands at a mind-boggling Yen 253 trillion (up 42% y/y) – that is approximately half of GDP.

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The Japanese system is incomparably awash with liquidity and one strong product of that has been a sharply weaker yen (the effect on equity prices and subsequent wealth effect on consumption – the transmission channel for QE in the USA – is negligible when Japanese households have just 10% of their assets in equities versus 53% in cash). The channel through which Japanese QE works – and Japanese QE is on a scale that dwarves that in any other country besides China (where state-approved bank balance sheet expansion effectively replicates QE) – is through an explicit policy to drive the yen down and thereby import some inflation whilst giving Japanese exporters a bit of a boost.

However, along come the Chinese in the middle of the largest credit bubble in history and throw a “spanner in the works” with a weaker yuan.

The yen has appreciated approximately 12% against the yuan since last August. That hurts. It hurts a lot and is a substantial headwind for Japanese QE.

The only thing to do, according to the Bank of Japan right now, is make interest rates negative and force that Yen 253 trillion of liquidity out into the economy via bank lending.

Why? Because the appreciation of the yen is pushing inflation the wrong way, if left unchallenged Japan will slip back into core deflation very quickly.

Core inflation responds with about a ten month lag to the exchange rate.

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Moreover, the exchange rate impacts the output gap (gap between actual and potential output) and that also drives inflation.

An appreciating exchange rate turns the output gap negative and that pushes down on inflation.

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So, easy to see why the Bank of Japan responded. They said it was to encourage banks to lend those reserves, but we know better.

It’s just the first little warning shot in an open currency fight with the Chinese.

With the yuan under severe pressure as a consequence of persistent and ongoing domestic capital flight, and a devaluation of 20%+ extremely likely, it’s just the start. The Bank of Japan will, in due course, be stepping up its bond purchases and pushing rates further into negative territory in a determined – and ultimately successful – effort to drive the yen down sharply.

More fuel to the global deflationary fire.

 

MONOGRAM CAPITAL MANAGEMENT

The IMF, Japan and the failure of Abenomics

July 31, 2015

The IMF, after playing a major role in the complete collapse of Greek activity and the exploding Greek debt burden with its insistence that fiscal austerity solves every problem from Ghana to Greece, has now turned its attention back to Japan.

“The Bank of Japan needs to stand ready to ease further, provide stronger guidance to markets through enhanced communication, and put greater emphasis on achieving the 2 percent inflation target in a stable manner”  – IMF 2015 Article IV consultation with Japan

The failure of “Abenomics” to deliver a steady and sustained 2% plus inflation rate can easily be explained by the chart below. It shows the Output Gap i.e. the gap between actual output and potential output in the economy and the inflation rate. The recent spike in inflation was a one-off impact from tax increases that is fading away. Inflation has now slipped back to where it should be.

2015.29.07.IMFJapanFailureofAbenomics

Japanese inflation is highly correlated with the economic cycle; when activity accelerates and the Output Gap closes we see inflation follow (and vice versa).

So, what is needed to get inflation sustainably higher in Japan is sustainably higher economic growth that removes the Output Gap and turns it positive i.e. gets the economy running above its potential.

The answer from the IMF/Bank of Japan to that challenge? Quantitative Easing (QE), of course… lots of it.

  • The Bank of Japan now owns 22% of outstanding Japanese government debt versus just 7% two years ago.
  • The Bank of Japan’s balance sheet is now 60% of GDP, almost double the size two years ago.

The chart below shows the growth in Bank of Japan Assets (QE purchases of assets) dwarfing the net issuance of equity in the Non-Financial Corporates sector and net issuance of government debt. An increase in QE and Bank of Japan asset purchases would give a further significant boost to asset price inflation (stay long Japanese equities), but we very much doubt it will boost activity and shrink their Output Gap.

2015.29.07.IMFJapanFailureofAbenomics2

Why?

Well, take a look at the assets of Households and Liabilities of the corporate sector:

  1. Japanese Households hold very little of their assets in equities and bonds and so the economy gets very little benefit from any wealth effect arising from an increase in the value of these securities. They own lots and lots of cash primarily.

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  1. Japanese Non-Financial Corporates have less than half their financial liabilities in equity, with almost 30% in loans and bonds where yields are near the zero level already.

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Conclusion:

  • Expect the Bank of Japan to expand QE further (from 80 trillion yen, 16% of GDP a year at present) – keep pushing that string until it budges…
  • More QE = more local asset inflation = weaker Yen (until such time as the US market heads south, at least).

 

MONOGRAM CAPITAL MANAGEMENT