The concept of a creature dining on its own tail – suggesting a self-generated growth cycle – is a macabre one. So how about blowing it up to its logical limit: A whale eating its own tail?
In fact, this “whale of a tale” – excuse the puns – is exactly what is happening in Japanese financial circles.
The Bank of Japan recently became the nation’s top holder of stocks, owning more than US$430 billion’s worth. That means Japan’s monetary authority is now the nation’s investment “whale” – pulling the title away from its Government Pension Investment Fund, or GPIF.
It’s an awkward milestone with timely lessons for the wider world as it flirts with similar issues as the “Japanification” of the globe’s third-biggest economy.
Two years ago, the BOJ’s balance sheet surpassed the size of Japan’s $5 trillion economy amid governor Haruhiko Kuroda’s quest to end deflation.
It’s hard to exaggerate how unprecedented this dynamic is – particularly for a highly developed Group of Seven economy.
Explaining the arrangement also is proving plenty awkward for Tokyo policymakers. Look no further than Kuroda. He continues to downplay the usefulness of “helicopter money,” even as his BOJ operates as the globe’s laboratory for its application.
Kuroda and Finance Minister Taro Aso dismiss “Modern Monetary Theory,” which posits that a country in charge of its own currency can essentially borrow to its heart’s content with few serious consequences.
But if MMT does not define Japan Inc.’s current reality, what does?
Nationalizing markets
Already, the government with the largest debt burden has thrown fiscal stimulus worth more than 40% of gross domestic product at a Covid-19-wracked economy. And Prime Minister Yoshihide Suga’s administration is cobbling together another huge $700 billion-plus rescue package.
Yet the real intrigue involves what’s afoot at BOJ headquarters.
The conventional narrative is that Kuroda’s team has been passive as deflationary forces return. And indeed, there have been no splashy interest rate changes or major bond-purchase shifts.
In reality, the BOJ is working quietly behind the scenes to pump ever more liquidity into the economy. Hoarding stocks is a growing part of the strategy.
Is it working? Japan, after all, is essentially nationalizing equities.
The GPIF, the globe’s biggest public fund, holds at least $430 billion of shares – just a hair less than the BOJ. This corporate welfare on an unprecedented scale is warping market dynamics. It’s reducing the Nikkei 225 Average’s usefulness as a pricing mechanism for risk.
But should we be surprised? A similar thing has already occurred in the Japanese government bond, or JGB, arena.
The BOJ holds at least 50% of JGBs, deadening trading activity. Since 2018, there have been countless days when not a single government security traded hands. That’s complicating the process of pricing debt – ie assessing proper yield levels relative to benchmark government bonds.
Now Japan is witnessing what Keita Matsumoto of Citigroup Global Markets Japan called the “JGB-ification’ of stocks,” threatening the “market’s function in the long run.”
BOJ drifting off course
One commonly heard gripe is about BOJ mission creep. In recent months, a number of BOJ officials have privately groused that under Kuroda the central bank forgot its mandate is to be “a lender, not a spender.”
The BOJ could, for example, set up lending facilities where financial entities could gain capital to buy shares. The BOJ decided to cut out the middleman and buy exchange-traded funds directly.
The BOJ isn’t alone, of course. In Washington, the Fed is doing its worst to commandeer Wall Street. How else can you explain stocks racing to record highs as Covid-19 cases rally toward the 15 million mark and millions of jobs are lost.
Yet Tokyo is the vanguard of what of Bank of America strategist Michael Hartnett calls markets “divorced from reality.” These central bank policies, he worries, are creating “fake markets.”
These fake markets arguably serve a short-term purpose by creating the veneer of financial stability. In the Nikkei’s case, the BOJ’s largess in November produced the biggest one-month rally since 1994 – a 15% gain. The same with the broader Topix index, which surged 11% last month.
Such boosts are pushing unrealized gains for the BOJ’s balance sheet into the stratosphere. At one point in November, analysts at NLI Research Institute put the central bank’s windfall at over $96 billion.
This, of course, allays fears about unrealized losses if the Nikkei or Topix plunges. And the dynamic changes the market’s incentive structure.
If the BOJ were a hedge fund run by, say, Ray Dalio of Bridgewater Associates fame or Paul Singer of Elliott Management, they might be taking profits, creating two-way trading in Japanese stocks. Instead, the BOJ is simply adding to its purchases on a steady basis.
This amounts to a giant pyramid scheme, of sorts.
Any hint the BOJ might “taper” stock buying might now generate the same shockwaves as reduced bond purchases. It’s crucial that Kuroda & Co devise an exit strategy – or at a minimum, send a signal that its “whale” status comes with a time limit.
Where is the off-ramp?
Among the potential “side effects,” warned strategist Norihiro Fujito of Mitsubishi UFJ Morgan Stanley Securities, is weakened corporate governance.
The idea being that rising stock values take the onus off CEOs to innovate, hone competitiveness and restructure, much the way a weaker yen can breed complacency.
This can be seen in how BOJ policies are thought to be shielding Japan Inc. from government reforms meant to pressure executives to raise their game.
Case in point: Suga’s plans to force telecom carriers to cut mobile phone fees and prod regional banks to consolidate and create more economic space for small-to-medium-size companies.
Like clockwork, said analyst Scott Seaman of Eurasia Group, this “quest to enhance productivity and competition has sparked concerns that his policies will fuel deflationary pressures, making it more difficult for the BOJ.”
All this, of course, means the BOJ is under even more intense pressure to add fresh stimulus to the economy. In other words, more bond and ETF purchases and even greater risk of what investors call moral hazard.
Of the BOJ’s ETF-buying program, Goldman Sachs strategist Kathy Matsui said: “We believe it will continue to serve as a source of demand to help cushion sharp downdrafts in the stock market.”
Mutations underway
The worry, longer-term, is that Tokyo is creating the financial version of Frankenstein’s monster. Such creatures, tend to get away from you over time, coming back to damage the broader system.
The BOJ’s stock-hoarding ways, though, may explain why the Nikkei trades at 37 times future earnings compared to the Dow Jones Industrial Average’s 25 times. This price-to-earnings ratio divide could indeed reflect the BOJ’s more aggressive ETF purchases than Jerome Powell’s Fed.
Part of the game is the bet that the BOJ might not find an exit strategy. Who, after all, might have believed in 1999, when the BOJ first slashed rates to zero, that it would still be there in 2021? Further skewing the bet is the BOJ experiments with quantitative easing and negative rates.
Now, as the yen creeps higher versus the dollar – by 4.2% so far this year – there’s every reason to believe that the BOJ might expand its balance sheet even further. The last thing Japan’s Covid-rattled economy needs is a rising exchange rate. Such headwinds would exacerbate deflationary pressures and crimp corporate profits.
These headwinds are sure to overwhelm any improvements in corporate governance. And it doesn’t help that Japan is now being pummeled by a third wave of infections.
That has Suga’s team rolling out another fiscal jolt – this latest one amounting to $708 billion. “In order to protect the lives and livelihoods of the people, this package has been compiled to maintain jobs and businesses, restore the economy, and develop new opportunities for growth like green and digital areas,” Suga said December 7.
Expect, too, for Japan’s whale of a central bank to turn the yen-printing machines up another notch. That means bigger BOJ purchases of government and corporate bonds, bigger stock purchases by way of ETFs – and bigger questions about free-market mechanisms.