The United Kingdom's June 23 referendum has already undone much of the fleeting economic progress that Abe made over the past two years. The vote sent Japan's 20-year bond yields tumbling into the negative realm, where they have joined other Japanese bonds with life spans of less than two decades. At the same time, the value of the yen is being nudged upward as buyers exchange their pounds for yen to purchase Japanese bonds. The strengthening currency, in turn, has effectively made imports cheaper. Now Japan is teetering on the verge of deflation, and its consumer price index has sunk back to -0.4.
Each of these developments runs counter to the goals of Abenomics, designed to pull the Japanese economy out of a two-decade slump characterized by low inflation and sluggish growth. With similarly bleak projections for 2016 — experts predict that Japan will see anemic growth of less than 1 percent this year — Abe will undoubtedly pursue his economic strategy with renewed vigor, using what time he has left in office to try to turn the program's luck around.
A Short-Term Fix
Abe will likely focus his efforts on the first two arrows of Abenomics — aggressive monetary easing and flexible fiscal policy — because they target Japan's most immediate economic problems. Indeed, rumors of an impending stimulus that had persisted for months were confirmed in May when Abe announced his plan to add money to the Japanese budget, earmarked for fiscal spending, once the country's July 10 parliamentary elections concluded. Some have even suggested that he would pump in as much as 10 trillion to 20 trillion yen ($95 billion to $191 billion). With the elections over and the Brexit putting additional strain on the Japanese economy, Abe will waste no time in pursuing the massive cash injection, even if it means overlooking the objections of Japanese Finance Minister Taro Aso, who in March said fiscal stimulus would not be necessary. On July 12, Abe ordered the Ministry of Economy, Trade and Industry to come up with a draft proposal for the measure by the end of the month.
Further monetary easing by the Bank of Japan is probably in the cards as well. Over the past four months, two of the bank's more hawkish board members who often voted against the policies of Bank of Japan Gov. Haruhiko Kuroda have been replaced. Their successors, Makoto Sakurai and Takako Masai, are considered far more dovish and, by extension, more amenable to the monetary easing that Kuroda and Abe advocate. The question, therefore, is not if the bank will follow the first arrow of Abenomics, but how.
The Bank of Japan's most likely course of action will be to expand its current quantitative and qualitative monetary easing policy in two ways. The first will be to grow its financial base by 90 trillion to 100 trillion yen per year (as opposed to its original target of 80 trillion yen per year). Narrowing in on the "qualitative" aspect of its approach, the bank will also increase its purchases of exchange-traded funds, which now total 3 trillion yen annually.
In addition, the bank could choose to ramp up its purchases of Japanese government bonds, but that tactic may not be sustainable in the long run. The Bank of Japan already holds 33.9 percent of those bonds, a figure that could climb to 40 percent by the end of the year. On the surface this might seem to imply that the bank has plenty of room to keep buying up bonds, but in reality it may have an increasingly hard time locating willing sellers. Besides the central bank, the biggest owners of Japanese government bonds are regional banks (25 to 30 percent), life insurers (15 to 20 percent) and pension funds (10 percent), each of which has good reason not to divest all of its bonds. In fact, life insurers — ever the risk-averse investors — have actually increased their purchases of government bonds in recent years.
Of the three, banks will remain the largest sellers of Japanese government bonds. Banks have already seen the value of their bond holdings decline from roughly 165 trillion yen in 2013, when the central bank's quantitative and qualitative easing policy was first implemented, to 95 trillion yen in April. The bonds' share of Japanese banks' total assets dropped by half over the same period, from 20 percent to about 10 percent. Because banks still need government bonds to use as collateral in the market, this share cannot fall much further than it already has. Though the Bank of Japan ruled in October 2015 that homeowner loans and other financial assets could be used as collateral in place of bonds, it is clear that the number of bonds left for sale in the market is rapidly diminishing.
Evaluating the Central Bank's Options
Considering that the Bank of Japan plans to buy 80 trillion yen worth of government bonds each year, the math simply does not add up in the long run. If its purchasing patterns continue, the central bank will reach the limits of its bond-buying program in 2017, which would require bank officials to either issue more bonds or scale back their acquisitions. Either way, the Bank of Japan will need an exit strategy, and one that leads to a more sustainable solution. So far, Japanese officials and financial observers have put forth several options:
- Enact negative interest rates. The Bank of Japan introduced a three-tiered interest rate program in January that included a negative rate on banks' excess reserves. Following in other major banks' footsteps by applying negative interest rates to additional holdings is likely one of the Bank of Japan's next moves as it rebalances its quantitative and qualitative monetary easing policy. Similarly, negative interest rates and taxes on deposits are a plausible option.
- Boost domestic bond purchases. Another possible measure would be to expand the central bank's purchasing program to include more domestic bond assets, such as municipal bonds and corporate bonds. This, however, would be more of a stopgap measure since these markets are very small in Japan. The central bank is already shooting to buy 3.2 trillion yen in corporate bonds each year.
- Increase other domestic asset purchases. The Bank of Japan's exchange-traded funds purchasing program has already secured it a 60 percent share in the country's exchange-traded funds market. Even so, it could enlarge its stake by reducing restrictions, buying stocks directly or purchasing land (or similar assets). This option would be highly unorthodox and widely unpopular, but it would unlock a substantial asset market.
- Ramp up foreign asset purchases. An equally unorthodox proposal, the purchase of foreign assets would require coordination with the Japanese Finance Ministry, since Japanese law says the Bank of Japan can directly buy or sell currencies only under the ministry's direction. This would have a powerful impact on the bank's ability to influence the yen's value.
- Inject helicopter money. Direct cash transfers to the public, dubbed "helicopter money" in reference to Milton Friedman's famous parable, are another possibility. So far, Kuroda and other Japanese officials have maintained that helicopter money is illegal, but it is gaining traction in policy debates nonetheless. One practical way to implement such cash transfers would be through perpetual bonds, on which the government does not have to pay a principal or interest. This style of fiscal policy has been frowned upon in the developed world because it carries a risk of hyperinflation. Indeed, Japan is hesitant to use the tactic because Tokyo did something similar in the 1930s, leading to high levels of hyperinflation.
Regardless of what the Bank of Japan decides, it is becoming increasingly clear that Kuroda's current strategy will not work for much longer. The bank will probably have to settle on a new approach before Kuroda's position at its helm comes to an end in 2018 — and before Abe's final term at the head of the Liberal Democratic Party concludes. No matter how things play out, the transition will have a profound effect on Abe's last two years in office.
This is the second installment of a three-part series examining Japanese Prime Minister Shinzo Abe's strategy to stimulate economic growth in Japan. The three-pronged approach, known as "Abenomics," has largely stalled in recent years, and its future does not appear to be much more promising.