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.


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.


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.


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.


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.



Less than meets the eye…

When is policy easing not much of policy easing? In China.

The Chinese cut the prime rate and the reserve requirement for banks last week by 0.25% and 0.5% respectively.

That brings the rate cut to 1.25% for the year and the reserves requirement cut to 2.5%.

On face value, this is quite an aggressive move after a 2% devaluation in the exchange rate a few months ago.

However, in our view, there is far less to the easing than meets the eye.

Here’s why:

The deposit base of Chinese financial institutions is approximately $20 trillion. Up to the end of September, the reserve ratio (RR) cut will have released about $407 billion of liquidity into the system. This combined with an incremental $105 billion coming from last week’s cut gives a year-to-date injection of approximately $512 billion.

However, as the following chart (October’s reserve data is not yet available, this data only goes through end of September and thus does not include the impact of last week’s RR cut) shows, in the period through the end of September the central bank lost $329 billion of foreign exchange reserves as capital flowed out of the country.


A loss of reserves represents a loss of domestic liquidity that must be offset against the RR cut to see the proper extent of liquidity injections from the central bank. Quite clearly, in the first nine months of the year 80% of the People’s Bank of China’s (PBOC) liquidity injections from RR cuts flowed straight out of the door; just about $80 billion of liquidity appears to have been injected net from a relatively swift policy easing. That amount is actually irrelevant in a $10 trillion economy under such banking system stress. It is almost certain that reserves declined again in October, probably offsetting more than half of that month’s RR liquidity release.

Moreover, with the GDP deflator and the negative producer price inflation, the nominal prime lending rate has not declined at a pace to even match the price deflation, leaving real lending rates higher than they were at the start of the year.

In addition, despite the devaluation, the real effective exchange rate is also higher over the last twelve months and since the beginning of the year.

All in all, less than meets the eye when you look at the true nature of Chinese monetary policy. Higher real rates, a higher effective exchange rate and a trivial increase in domestic liquidity. Why might that be so?

Well one reason, perhaps, is that the PBOC is trying to fight two fires with one extinguisher. The capital outflow puts downward pressure on the yuan such that the PBOC must defend it if it is to maintain the dollar currency peg. It needs high real interest rates to hold capital in, but the consequence of higher real interest rates for horribly leveraged domestic corporates on wafer thin (if any) margins are painful. It appears that the rate cuts and the RR cuts are intended to show willingness to support the economy under stress without also compromising the peg.

As always, something must give. Will the Chinese allow the system to fail for the sake of the peg? No, we don’t think so. It reinforces our view that the yuan will be devalued significantly in coming quarters. The paradox is that the more they cut rates… the faster capital flows away, the greater the pressure on the peg and the greater the stress in the system that necessitates even more RR cuts. It’s a vicious cycle where cuts necessitate more cuts; easier to let the yuan weaken.

Of course, when you get almost 30% of your imports from China, and their currency weakens, the Japanese will come under increasing pressure for an even more aggressive QE stance to show that they are doing something, anything, to address a deflation storm heading their way. A weaker yuan also implies a weaker yen.


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.


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.



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.


  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.



  • 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).



Euro capital flight could be good news for North America and the UK

March 12, 2015

This week the European Central Bank started its Quantitative Easing Program (“QE”), which boils down to an attempt to increase the amount of money in circulation while lowering interest rates, thus, on paper, boosting the economic activity of the region. As QE means more Euros in the global system, the Common Currency should underperform its peers. This debasement process has largely been anticipated by financial market operators, who have been selling the Euro and buying European stocks en masse. At time of writing, the Euro is 11% lower than at the beginning of the year, while European stocks are 14% higher.

Meanwhile European corporations as well as households have accumulated large balances of cash since 2008, which sit idle on account rather than being recycled back into the economy for productive usages. This, in turn, is a reflection of various structural effects, including the aging of the European population:  older people generally enjoy higher savings because they have accumulated more wealth than younger people. Increasing inequality also pushes the average savings rate up, as Keynes teaches us that propensity to consume is lower for richer people.

The pressure is mounting on these large cash balances to find a better home than European assets, which become less attractive by the day compared to foreign bonds, stock and real investments. This is because QE means that foreign currencies are likely to increase against the Euro while foreign assets in general, and bonds in particular, generally offer a better yield than domestic ones. Good European “signatures” such as the German government or the best corporations, already borrow at zero percent or even less (“lend us EUR 100, we will give you back EUR 100 in 10 years”), and with a massive new buyer in town these rates have little chance to increase any time soon.

The outflow or European money towards foreign assets (mostly bonds) has started (EUR 300bn over the last three months, net), and is accelerating. Deutsche Bank estimates that no less than a net EUR 10 trillion (yes, EUR 10.000 billion!) should exit the Eurozone by the end of the decade. In practice, this means that for every 10 Euros of wealth created, approximately 1 Euro will be sent abroad.

Where is all this cash going? Mostly to bonds in the US, Canada, and to a lesser extent the UK. Over the long run, this means (even) lower bond yields in these countries, and perhaps higher equity valuations. These jurisdictions are therefore better off for European QE too. In the meantime, investors looking for a bargain should stay clear of European bonds, where the upside is almost inexistent and where currency risk is high.


Eurozone QE: Mind the output gap

  • Eurozone output gap is highly correlated with core inflation
  • Slowing money circulation means QE is “pushing on a string”
  • Eurozone consumers unlikely to benefit from wealth effect

26 January 2014, London. Paul Marson, Chief Investment Officer at MONOGRAM Investment, comments on the correlation between the output gap and Eurozone core inflation, and how the benefits of QE will be offset by slowing money circulation:

How effective will the new Eurozone QE be? Eurozone core inflation [the ECB has no control over food and energy prices] is highly correlated with the output gap [gap between actual GDP and potential GDP]. Therefore, to increase inflation (and avoid deflation), you have to increase GDP growth and close the output gap.

Graph 1: Eurozone Output Gap v Eurozone Core inflation

26.1.2015 Eurozone QE Graph 1

However, QE is unlikely to close the output gap because for every 1% increase in the Money Supply from the ECB, there is an approximate 1% decline in the velocity of circulation of that money.  Put simply, Eurozone QE puts more money into the system but it circulates more slowly.  The net effect is that nothing changes. It really is pushing on a piece of string. 

Graph 2: Correlation between % change in Eurozone monetary base and % change in monetary base velocity

26.1.2015 Eurozone QE Graph 2

So the real hope of QE seems to be that an increased monetary base will lead to higher asset prices (especially in equities), and people will feel wealthier and spend more.  The trouble is, consumers in Japan and Eurozone have low holdings of equities (unlike the US and UK) and hence are unlikely to benefit from a wealth effect.

Euro QE finally launches but likely to be “Damp Squib”

  • QE in UK and US have failed to stoke consumer demand inflation
  • China continues to export deflation into the Eurozone
  • QE not likely to translate to increased private sector loans

London, 22 January 2015. In response to the European Central Bank’s (ECB) announcement of quantitative easing today, Paul Marson, Chief Investment Officer of MONOGRAM, argues the programme is unlikely to work:

The question is why the biggest private sector credit boom in history – prior to the financial crisis – did not generate consumer price inflation: at the start of the crisis, core inflation was just 2% in Europe and the US. The answer to this is crucial, and explains why quantitative easing in the US/UK has raised asset prices – but not consumer inflation – and why euro QE is likely to be unsuccessful in achieving the ECB’s inflation objective.

Graph 1: UK core inflation and five year annualised inflation following QE

26.1.2015 Damp Squib Graph 1

“That underlying core inflation rates in the US and UK are lower today than when QE started is due to tide of disinflation originating from China. Chinese manufacturing goods supply is growing much faster than Western and Chinese demand for manufactured goods. This means a glut of supply which increasingly pushes down manufactured goods prices. Since China accounts for 17.1% of the total increase in world merchandise export (excluding the Eurozone) from 2002-2012, it is increasingly exporting deflation. Inflation is low, and getting lower, because the world is awash with supply – a “positive supply shock” is more powerful than the modest “positive demand shock” coming from QE.

Graph 2: Chinese manufacturing sector supply/Western demand mismatch

26.1.2015 Damp Squib Graph 2

“The problem confronting the ECB is that peripheral banks have substantially increased their holdings of [non-productive] government debt and substantially reduced (productive) loans to the private sector, amidst ongoing balance sheet shrinkage: the ECB hopes to take those bond holdings down and encourage private lending, a policy that is unlikely to have meaningful effects from exceptionally low current bond yield levels. It is more likely that bonds will replace the bonds they sold with more government bonds!”

Graph 3: Change in PIIGS MFI Assets from 2008

26.1.2015 Damp Squib Graph 3

Swiss Franc Surge: Do They Know Something We Don’t?

• Franc rise will have massive impact on exports of goods and services which are 66% of Swiss GDP and imports which are 52% of GDP
• Could this be a sign of impending euro quantitative easing on an exceptional scale?

London, 13 January 2015. Paul Marson, chief investment officer of MONOGRAM, comments on the Swiss central bank’s surprise announcement that it has abandoned its currency peg with the euro:
“Today’s announcement is puzzling. Switzerland’s economic situation isn’t that different from September 11, when the peg was bought in to stave off deflation. Core inflation is 0.3% today, and was 0.2% in 2011. Arguably there may be greater demand for Swiss francs from capital flight from Russia, but such a currency rise will have a big impact on Swiss growth and inflation and on company earnings [Swiss companies will largely not have hedged currency exposure, in expectation of a continuing cap].

“With imports 52% of GDP and exports 66% of GDP, the currency really matters in Switzerland – and this will really damage Swiss exporters. Import prices will weaken, once again raising the spectre of deflation and growth is likely to weaken: the very same concerns that the Swiss National Bank (“SNB”) raised in 2011 would appear to apply today.

“Maybe the SNB knows something we don’t? One explanation is the possibility of euro QE on a greater than anticipated scale, perhaps the SNB decided not to fight the ECB and is unwilling to see a further substantial balance sheet expansion (and suffer the practical difficulties that coincide with the eventual unwinding of those positions)? Perhaps ECB quantitative easing has forced the SNB to throw in the towel after a CHF 307 bn (398%) increase in the monetary base since mid-2011? After all that balance sheet expansion, the CHF is stronger, growth little better and deflation risks almost identical: one has to wonder, was it worth it?”

Swiss Franc/ Euro Exchange rate

15.1.2015 Swiss Franc per Euro