The Japanese yen has been fluctuating wildly. Photo: AFP

In its quest to defeat deflation, the Bank of Japan has filled its boots – and then some.

It has hoarded more than half of all government bonds. It has cornered the stock market via exchange-traded funds. It has expanded its balance sheet to exceed the nation’s entire $5 trillion economy.

And nothing has worked.

The modest amount of inflation Governor Haruhiko Kuroda generated since 2013 disappeared in a Covid-19 fog, putting the BOJ back to square one.

Now, the BOJ may have happened upon a stealthy Holy Grail to revive Japan’s animal spirits once and for all: its very own digital currency.

Tokyo goes Beijing

On the surface, the BOJ’s July 2 announcement that it would begin experimenting with a digital currency had “China” written all over it.

The People’s Bank of China is racing out a digital yuan that some industry observers think could land in wallets by year end. It would be the globe’s first central bank digital currency, or CBDC, and it represents a wakeup call for officials from Washington to Tokyo.

Internationalizing the yuan is central to President Xi Jinping’s ambitions to raise China’s footprint. Done well, a digital yuan could quickly travel abroad through China’s Belt and Road Initiative, its Asian Infrastructure Investment Bank, state-sponsored promotion of 5G and artificial intelligence technologies and ubiquitous brands like Alibaba and Tencent’s WeChat app.

All things considered, the digital yuan “is about to rule the world,” says Sasha Ivanov, founder of the Waves cryptocurrency platform.

That unnerves Tokyo. A decade on, Japanese officials still haven’t gotten over China surpassing their economy in annual output terms. The game plan has been to deepen financial ties with Washington.

How will that matter five years from now if a digital yuan helps Beijing take a chunk out of the dollar’s role in global trade?

The real promise 

Japan, though, faces a bigger challenge in the short run: reversing the deflation that has been lowering living standards for two decades now. A digital yen might do just that.

The BOJ has been running some version of quantitative easing for 19 years. Since March 2001, it has been flooding commercial banks with ever-growing tidal waves of liquidity to boost lending and create a “wealth effect” by inflating assets from stocks to real estate.

In March 2013, Kuroda was hired to turbocharge that effort. He bought ever-bigger blocks of bonds, ETFs and printed titanic amounts of yen to lower exchange rates.

Yet, inflation barely perked up. The reason? Traction.

Because companies, banks and households alike lack confidence that the economy will be better off five to 10 years later, consumer spending underwhelms, wages remain stagnant and CEOs don’t share buoyant profits with workers. The BOJ thought the answer was bigger liquidity jolts.

Could digital liquidity be the jolt that Japan needs?

Here lies the problem the BOJ faces.

Andy Haldane, chief economist at the Bank of England, sees it is in the nature of what theorists call the “zero lower bound barrier”. As Japan and other authorities have found, consumers don’t react as expected when interest turns negative. All too many respond by pulling cash out of bank accounts and saving.

Central banks tend to be good at shepherding investors this way or that. They’re less well equipped to tame the herd psychology toward caution that can result from crisis-policy steps, like during a pandemic.

This psychology can involve switching to gold. Or it can be households and businesses deciding not to make big purchases in the belief that financing will be cheaper six months out.

All this costs the BOJ and other central banks the “multiplier effect” that makes monetary policy so potent.

Confidence control valve

A digital currency would be a game-changer, Haldane argues, by giving authorities greater control over household withdrawals. Central banks could at times literally limit or ban consumers from withdrawing cash. Or, taxes could be imposed.

Severe stuff, admittedly. The point, though, is that a digital yen would enable Japan some control in times of financial turmoil.

There’s also a Covid-19 imperative at play. Shun Otokita, a member of the lower house of Japan’s parliament, points to public fears about touching banknotes. “In the world after corona, not only will digital currencies increase, but so, too, will the importance of cryptocurrencies and blockchains,” he says.

Economist Carlo De Meijer, founder of the financial services consultancy that bears his name, notes that cash-free blockchain technology will lead the way in the post-pandemic world. That will include payment apps that help “…fight the spread of the coronavirus in public institutions, hospitals, universities and the financial sector.”

For central banks, digital currencies have the potential to weed out other ills. Whereas private crypto assets can lack transparency and basic security features – there is still debate over who invented bitcoin – central bank-issued ones can be tightly regulated. They can police money laundering, terror financing and tax evasion.

They could also boost economic confidence. The real power behind a digital currency, Haldane reckons, is how it can supersize the microeconomic levers at central bankers’ disposal.

It “would preserve the social convention of a state-issued unit of account and medium of exchange, albeit with currency now held in digital rather than physical wallets,” he argues. “But it would allow negative interest rates to be levied on currency easily and speedily.”

In Covid-19 times, not only would digital yen be a fast and efficient way for the government to dole out cash assistance, it would also help ensure households actually deploy the funds. Only once an initial payment is fully spent would consumers get additional allotments.

Making it happen

The good news is that the BOJ is seeing this light.

The evolution in thinking can best be seen in the musings of BOJ Deputy Governor Masayoshi Amamiya. In February, he urged caution about even studying the idea of a digital yen. “Unlike emerging economies,” he said. “we cannot and should not jump immediately.”

But now Amamiya finds himself confirming a project that is rapidly gaining steam. Still, technical challenges abound.

One: Japan’s smartphone penetration is just about 75%. Tokyo would have to find a way to up that number in order to ensure a high usage rate for a BOJ digital app.

Another: What the BOJ calls “resilience.” Japan is highly susceptible to natural disasters and resultant power outages. Those who rely on a digital currency could, in emergencies, find themselves penniless.

Japan has little time to waste, though. China’s digital yuan is already in the testing phase in four cities. Japan needs to get its digital yen into the hands of a test group as soon as possible.

Tokyo’s ability to keep pace with Beijing – and put deflation in the rear-view mirror once and for all – depend on it.