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.
MONOGRAM CAPITAL MANAGEMENT