The Unintended Consequences of Extreme Japanese Monetary Policy & Why Invest in Japan?
Unexpected consequences as the Bank of Japan adopts Negative Interest Rate Policy, but why we see opportunities in Japan regardless
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This Insight is an extract adapted from the Panah Fund letter to investors for Q1 2016.1
TABLE OF CONTENTS
The Limits of Experimental Monetary Policy and the Unintended Consequences of Japanese NIRP
Since 2009, ‘extraordinary’ monetary policies such as Quantitative Easing (QE) have become increasingly ordinary. QE was originally envisaged as emergency intervention to prevent a collapse of the global financial system, but since then major central banks have started to use such measures more regularly. This is supposedly in an attempt to avoid deflation by stimulating aggregate demand, which they perceive to be inadequate. In the absence of a fiscal response from the governments of most large economies (which have instead embraced austerity in the years since the Great Financial Crisis), central bankers have felt obliged to act.
Recently, however, there has been growing unease – although apparently not yet within the major central banks – that unconventional monetary policy has other economic and social consequences that are still poorly understood. Such side effects might include asset price inflation, increased income inequality, higher debt levels, and an uncertain impact on financial institutions and savers (e.g., from Negative Interest Rate Policy). Furthermore, some commentators have noted that monetary policy is not having the impact that the central bankers originally expected, which in turn casts doubt on the entire monetary policy framework that they are using.
Is the world really experiencing a demand shortfall, or is there actually a surfeit of supply? Doesn’t QE actually create price deflation by encouraging the creation of excess capacity (e.g., shale oil bankrolled by junk debt, or e-commerce funded by cash flow-insensitive Venture Capital firms)?2 By keeping interest rates low and increasing debt, aren’t we just borrowing demand from the future? Debt levels around the world are already extremely high; is it really possible for global lending to increase without having a proper debt restructuring first?3
Central banks have so far managed to sidestep such questions and criticisms. Instead, they have chosen to emphasise that they still have plenty of monetary policy measures at their disposal. Meanwhile, ‘Keynesians’ are hoping that governments will step up and take advantage of historically low interest rates to borrow more and stimulate the global economy.
There are already discussions that in future recessions, policymakers might well opt for a radical combination of fiscal and monetary policy. This would likely take the form of central banks moving to overtly fund government infrastructure spending and/or ‘helicopter money’ programs (i.e., ‘handouts to the masses’). While some might argue that there are countries that badly need to upgrade inadequate infrastructure (e.g., the US and the UK), there is of course the risk that markets will choose to see such extreme measures as invalid and unsustainable, the last resort of deeply indebted and desperate governments.
The first quarter of 2016 brought some new developments in monetary policy. On the last trading day of January, the Bank of Japan (‘BoJ’) unexpectedly cut interest rates into negative territory,4 and in early March, the European Central Bank (‘ECB’) then cut rates by 10bps to -0.4% and increased its asset purchases.5 Nevertheless, ECB president Draghi then immediately indicated that in Europe, rates would likely not be pushed any further into negative territory.
Moreover, BoJ governor Kuroda’s decision to cut rates into negative territory – just ten days after he publicly rejected this course of action – did not go to plan. Indeed, rather than pleasing the markets, we think that recent central bank interventions have served to emphasise the unintended consequences and thus the effective limits of monetary policy.
Governor Kuroda reportedly pushed the BoJ policy board to adopt NIRP6 in an attempt to depreciate the Yen before Japan’s spring wage negotiations. A weaker Yen should theoretically boost Japanese exporters of corporate profits, leading to a greater willingness to raise workers’ wages, which should in turn boost consumption (one of the goals of Prime Minister Abe’s economic policy, i.e., Abenomics). However, the Yen did not react as expected, initially weakening slightly before appreciating strongly against the US Dollar. A two-day rally in Japanese equities was immediately followed by a precipitous stock market decline. Japanese bond yields collapsed into negative territory, and the price of gold spiked.
The Japanese stock market plunged because investors focused on the side effects of NIRP that governor Kuroda had chosen to ignore. Negative rates create a squeeze on net interest margins for the Japanese banks:7 these lenders come under immediate pressure to cut lending rates,8 but they cannot immediately push deposit rates into negative territory.9 In such a scenario, the banks are not incentivised to lend, which defeats the avowed purpose of introducing negative rates in the first instance.
Indeed, a round of company visits to Japan in February revealed a shocked and demoralised banking sector desperately trying to implement IT fixes which would allow their computer systems to handle interest rates below the zero bound. Elsewhere in the financial sector, it is unclear how life insurance companies will be able to achieve their target returns and retain adequate capital in the long run, given the decline in interest rates and the dramatic flattening of the yield curve.10
Some observers have drawn an interesting comparison between the effects of QE and NIRP on debtor countries, which potentially stand to benefit from such policies (e.g., the US), and creditor nations which are harmed (i.e., Japan). The US’s indebted consumers might well get some relief from lower interest payments, but Japan is an ageing society of savers. Retiring baby-boomers tend to live off their savings, and as yields collapse, they are more likely to reduce consumption and increase savings to maintain their income.
Even if financial institutions and savers can be persuaded to ‘boost growth’ by increasing their allocations to more ‘risky assets’ such as real estate (the Japanese real estate market is already running hot, especially in the major cities), this will probably store up problems for the future as real estate prices run beyond fair value.
The markets seem to be sending a clear message that NIRP is inappropriate for Japan. It is unclear, however, whether the ideologues in the central bank will heed this warning or will choose to double down on a flawed policy.11
In the near-term, for perhaps the next couple of BoJ policy meetings, it is conceivable that political expediency will trump the egos and neo-monetarist ideology in the central bank. It seems improbable that governor Kuroda sought political approval for NIRP before the event, and since the policy had the opposite reaction to that intended (i.e., the Yen has risen while equities have fallen), his credibility has been damaged.
Prime Minister Abe seems to be preparing to call a double election in July 2016, which will likely be framed as a referendum to postpone the consumption tax hike (from 8% to 10%) which is currently scheduled for April 2017.12 Negative rates theoretically cause particular problems for the regional banks in Japan.13 Mr Abe will not want to see any pressure on the core rural constituency of his Liberal Democratic Party (‘LDP’). Recent economic data has been weak, and the BoJ could use this as a justification for further easing.
If Mr Kuroda does wish to ease monetary policy further in April or June (the next two policy meetings), we think he is more likely to increase asset purchases rather than cut rates further into negative territory.14 The BoJ is currently expected to buy >80% of Japanese Government Bonds (JGBs) issued in 2016,15 and the institution already owns ~30% of the outstanding stock of bonds.16 It is unclear how many more bonds the BoJ can buy. Even if JGB purchases are scaled up slightly, there will probably be an emphasis on increased BoJ buying of J-REIT and stock market ETFs. That said, Mr Kuroda is particularly fond of surprising the markets, so nothing can be taken for granted.
Monetary reflation was the second of the ‘three arrows of Abenomics’, the reform program launched by Prime Minister Abe after his landslide election victory in December 2012. In reality, the most visible part of the ‘Abenomics story’ has been aggressive monetary stimulus to weaken the Yen and boost corporate profits, thereby driving up equity prices and increasing wages and consumption, all in pursuit of an elusive 2% inflation target.17 This strategy seemed to be working until mid-2015, but since then the Yen has rallied and equity markets have fallen.
With monetary policy now failing to impress, do the original first and third arrows of Abenomics – fiscal stimulus and structural reform – now have a role to play?18 Given lacklustre growth, the Japanese government does seem likely to embrace fiscal stimulus in the run-up to the election, probably in the form of a JPY 5tn supplementary budget. Already we are seeing calls within the LDP for increased spending on kindergartens, regional projects, interest-free mortgages and new high-speed rail lines.
Now that ten-year bond yields have fallen into negative territory, some believe that the Japanese government is effectively getting paid to borrow money, and that it would be self-defeating not to spend more! There has even been talk of introducing ‘consumption vouchers’ to younger taxpayers, i.e., coupons which would expire within a certain timeframe unless spent, which could presumably be funded by larger BoJ bond purchases.
Clearly, Japan has reached an important juncture for fiscal discipline. Indeed, with the central bank now completely dominating the JGB market,19 Japan finds itself at the bleeding edge of monetary policy experimentation and is moving closer towards debt monetisation.
What will this mean for the Japanese Yen? For now, the currency is being supported by a strong trade balance (mostly thanks to weak hydrocarbon prices) and a favourable relative rates dynamic (due to an unexpectedly dovish US Federal Reserve). A more sceptical market re-evaluation of Abenomics has helped to boost the Yen, as it has led to a reversal of foreign equity inflows with accompanying currency hedges.
Any further steps in the direction of extreme monetary policy, however, would likely push the Yen weaker over time - perhaps dramatically so.
Why Invest in Japan?
Given the rather unpredictable macro-economic backdrop, why bother investing in Japanese equities at all?
Despite all the uncertainties, we still believe we can find extremely good investment opportunities in Japan. The lazy ‘Abenomics trade’ (i.e., buy exporters and sell Yen) might well have expired in the middle of 2015, but Japan remains among the most under-analysed and under-owned markets in Asia.
As of end-March 2016, we count ~2,950 ‘investible’ companies listed in Asia Pacific countries outside Japan with a market capitalisation of US $250mn or more, compared to 1,250 such listed companies in Japan.20 67% of the Asia Pacific ex-Japan companies are covered by at least two sell-side analysts or more, but only 59% of Japanese firms of the same size have any analyst coverage. At the other end of the spectrum, more than 84% of Indian companies with a market cap of >$250mn are covered by at least two analysts. Although sell-side analyst coverage is clearly not a perfect proxy for market efficiency, all else being equal, one should expect to find more opportunities in those markets which have a lower coverage ratio.
Moreover, we still find that Japanese companies consistently account for ~60 of the top 100 ‘cheapest stocks’ on our ‘deep value + cash flow value’ screens. That is not to say that all cheap companies make good investments! However, we still believe that the combination of value and potential market inefficiencies (i.e., low analyst coverage) are a powerful combination. There are still plenty of interesting opportunities in Japan for investors who are willing and able to go the extra mile.
So far, it would appear that the most important contribution that Abenomics has made to the Japanese equity market belongs to the third arrow of ‘structural reforms’, more specifically the new stewardship and corporate governance code initiatives.
There have been some interesting corporate governance developments in recent months, culminating in the recent battle between Third Point’s Daniel Loeb and Seven & i Holdings’ octogenarian CEO Toshifumi Suzuki. Leaving aside such high profile cases, we have found that many of the companies we meet in Japan are taking a more constructive attitude towards minority shareholders. For instance, companies with surplus cash increasingly feel obliged to raise dividend payout ratios, or else explain to investors why they are not doing so.
We are also optimistic that greater involvement by Japanese pension funds in the stock market should reinforce the trend towards improved corporate governance. In this brave new world where cash yields nothing, we think that the distribution of excess cash should give an important boost to returns in the coming fiscal year, especially now that Japanese stocks have sold off with the strong Yen and are trading at more attractive valuations.
Panah has owned various cheap Japanese real estate companies for most of the last 18 months, which we think has made sense from both a bottom-up and top-down perspective. ‘Supportive’ BoJ policy means that real estate stocks probably still have further to run, although a comprehensive set of company visits to Japanese real estate companies in February indicated that the cycle is fairly mature, and peak earnings might be close. Fundamentally, wage rises are needed to justify further gains in residential real estate prices, while office rent increases are dependent on healthy corporate profit growth (which is more difficult with a strong Yen).21 We are thus starting to reduce the size of our real estate positions. More recently, after the surprise introduction of NIRP, we see the value in hedging via short stock positions on Japanese life insurance companies.
Panah’s larger and more important company holdings in Japan are in off-the-radar ‘value’ investments with reasonable growth and near-term stock-specific catalysts, yet little or no sell-side coverage despite market caps in excess of US $1bn. One of these three stocks operates in the real estate sector, and we recently wrote a profile of the investment case.22 We hope to write about the other two companies in future letters.
Thank you for reading.
Andrew Limond
The original source material has been edited for spelling, punctuation, grammar and clarity. Photographs, illustrations, diagrams and references have been updated to ensure relevance. Copies of the original quarterly letter source material are available to investors on request.
E-commerce and other ‘tech’ firms are able to push down prices for consumers by offering subsidies funded by investors (mostly Venture Capital firms); this destroys profits for traditional retailers. The Financial Times recently published a digest of such developments among ride-hailing and e-commerce firms in China.
Thoughtful commentators such as Stephen Jen, Richard Koo and William White have all raised valid queries of this sort. William White recently gave an interview on this topic.
The details are as follows: it is in fact only the outstanding balance (the so-called ‘policy rate balance’) which will incur negative interest rates of -0.1%; the ‘basic (current account) balance’ of banks’ liquid assets held at the BoJ (accumulated during previous rounds of QE and making up the vast bulk of reserves) will continue to earn interest at +0.1%; while reserve requirements beyond this level (the ‘macro add-on balance’) will earn 0% interest rates. (This three-tiered system is similar to that of the Swiss National Bank.) Under this new system, negative interest rates should only affect ~4% of Japanese banks’ current account balances, although this proportion would increase if the BoJ cuts interest rates further into negative territory in the future.
The ECB increased bond purchases from EUR 60b to 80b per month. Corporate bonds are now also eligible.
NIRP was voted through with the slimmest of margins (five to four) by the BoJ policy board.
In this regard, negative rates theoretically have the opposite effect to QE asset purchases, which served to steepen the yield curve, thereby supporting bank profits and allowing them to rebuild their balance sheets.
Note that the Bank of Japan bought corporate bonds at negative yields for the first time in January 2016, thereby crowding out bank lending at positive rates.
In a cash-based society such as Japan, it would be difficult – as well as potentially politically-explosive – to push headline deposit rates on savings accounts into negative territory. Nevertheless, it seems likely that banks will move to opportunistically increase service charges over time. This then increases the risk of deposit flight. It is perhaps unsurprising that the sale of safe-boxes has risen dramatically in Japan since the introduction of NIRP!
Supporters of the BoJ’s monetary policy experiments of course argue that the central bank has not yet done enough.
In reality, Mr Abe’s ultimate intention – inspired by his maternal grandfather Nobusuke Kishi, a rightist and PM from 1957 to 1960 – still seems to be to push for an amendment to Article 9 of the Constitution (rejecting war as a way to settle international disputes), which requires two-thirds support in both houses of the Diet.
There are fewer lending opportunities in the regions, so they park a larger proportion of their cash with the BoJ.
Mr Kuroda recently stated that negative rates might eventually be cut to as low as -0.5%. Note that several of the members of the BoJ policy committee who voted against negative rates are due to be replaced in the coming months, which seems likely to lead to a more pliant policy board by the middle of 2016.
Bond purchases by the BoJ are currently running at JPY 80tn per annum, with ~95tr of JGB issuance expected in 2016. The BoJ’s ETF purchases are currently running at JPY ~3.3tn per annum.
The BoJ owns ~30% of outstanding JGBs when measured in aggregate duration risk at end-Feb 2016; this will likely rise to 40% of the market by end-2016.
There was a hope that healthy corporate profits would eventually trickle down into higher salaries, which would in turn boost consumption. Wages have seen some upward pressure from demographic and structural factors (especially in sectors such as construction), but sadly much of the inflation created appears to have been forex-related. This has served to erode household purchasing power rather than to boost it.
Three new arrows were announced in 2015: a strong economy; support for families; and social security.
Japanese bond market liquidity has evaporated, and JGB-traders now reportedly bid for new issues based on what they think the BoJ will buy off them the following week. The interbank loan market has also been disrupted.
In this case, we include the following Asia Pacific ex-Japan countries: Australia, China, Hong Kong, India, Indonesia, Korea, Malaysia, New Zealand, the Philippines, Singapore, Taiwan and Thailand. We exclude banks and also firms with inadequate liquidity.
The Japanese REIT sector (where the fund currently does not have any investments) is a rather more tricky proposition. Most liquid J-REITs trade at a substantial premium to NAV, as the BoJ has been supporting the market with direct purchases and has also persuaded investors to see the J-REITs as financial instruments and buy them for their yields (typically >2.5%), much higher than JGB yields which are now negative out to a ten year maturity. In January, the BoJ changed the conditions for its J-REIT purchases, and is now permitted to buy up to 10% of each outstanding issue (up from 5%), suggesting that more support from direct purchases will be forthcoming.
For more information, see the Panah Fund letter to investor for Q3 2015, as well as the following Seraya Insight: ‘Two Case Studies: a Japanese 'Deep Value' Investment & a Thai 'Special Sit' Turnaround Opportunity’.
