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Analysis
Japanese QE to continue as inflation rise slows

Japanese QE to continue as inflation rise slows

Abe's impatience spurs reform drive

by David Marsh and Pooma Kimis in Tokyo

Mon 28 Jul 2014

Japan seems likely to tolerate a further weakening of the yen as US monetary policy gradually tightens over the next 12 months and the Bank of Japan (BoJ) maintains large-scale purchases of domestic government bonds well into 2015.

This probable scenario is emerging at the same time as signs that an impatient Shinzo Abe, the Japanese prime minister, is accelerating his structural reform drive as well as maintaining an all-out effort to end the country’s 15 years of deflation.

Amid faltering progress towards the 2% inflation target pursued by Haruhiko Kuroda, the BoJ governor, Abe is pressing ahead with changes in corporate governance, corporate taxation and pensions investments that officials say should significantly improve the economic landscape in the next few years.   

Core inflation on a year-on-year basis, excluding the effects of the April increase in consumption tax, was 1.3% in June, after 1.4% in May and 1.6% in April (a six-year high). The slowdown, officials say, was largely due to the ‘base effect’ of relatively high year-ago numbers. These effects will become progressively less important towards the end of the year.

An important reason for the overall rise in inflation towards the 2% target since 2012 has been a weakening yen, which fell 20% in 2013 in trade-weighted terms. Weak Japanese exports in recent months, the continued Japanese trade deficit, the phasing out of QE in the US and the need for further anti-deflation momentum all point to yen weakness beyond the present ¥102 to the dollar in coming months. 

Officials say central bank purchases of Japanese government bonds (JGBs), at present around ¥7tn a month, equivalent to 70% of regular issuance since the latest quantitative easing (QE) programme started in April 2013, are likely to continue beyond the two year cut-off of April 2015 that some had seen as a possible exit date.

Core inflation is likely to pick up towards the 2% level from the fourth quarter, in line with more buoyancy in the economy. But the BoJ says it will not end asset purchases until inflation expectations are stabilised around 2% on a sustainable basis – something that appears unlikely for at least 12 months.

The government is encouraged by last week’s International Monetary Fund upgrading of the Japanese GDP growth outlook to 1.6% this year from 1.3%, even though the US forecast was cut to 1.8% from 2.2%. The euro area outlook was seen unchanged at 1.1%.

Ministry of Finance (MoF) officials are stepping up efforts to market JGBs to central banks and other global public investors (GPIs), part of a wider effort to reap investment benefits from ‘Abenomics’. However officials accept that foreign purchases of JGBs will take off only after a rise in longer term interest rates from present levels below 1%.

A return to more normal JGB interest rates of above 3% – which will prove loss-making for present holders such as the BoJ – is not likely for at least two years. Part of the BoJ/MoF strategy of encouraging Japanese private sector portfolio shifts away from JGBs into equity-type assets is that the BoJ can bear such losses far more easily than other investing institutions.

One of the most important moves concerns redeployment of assets held by the $1.2tn government pension investment fund (GPIF), where decisions are imminent on investing more in domestic equities rather than government bonds. 

GPIF officials are due to report by the end of next month how the fund can shift towards domestic equities as well as international bonds, mirroring allocation patterns of foreign pension funds such as in Canada. According to a MoF briefing paper, the GPIF has 60% of its holdings in domestic bonds, against 12% each in foreign and domestic equities, and 11% in foreign bonds. The Canadian Pension Fund Investment Board, by contrast, has 55% in foreign equities, 30% in domestic bonds, 10% in domestic equities and 5% in foreign bonds.

Takatoshi Ito, the Tokyo university professor who led a panel of experts advising Abe on pensions reform, has argued that the domestic bond share should fall to 35%. Yasuhiro Yonezawa, from Waseda University, the new chairman of the GPIF investment committee, says that Ito’s recommendations go too far, but the 60% domestic bond weighting is ‘a little too high’.

The GPIF shake-up is part of a broader rebalancing which has seen private sector domestic institutions move out of government bonds and into more entrepreneurial investments to take advantage of the BoJ’s role as backstop JGB purchaser. The BoJ increased its government bond holdings by ¥55.5tn to ¥183.4tn in the nine months to December 2013, while private sector financial institutions reduced their holdings by ¥35.3tn to ¥599.8tn.   

The authorities want the GPIF and other conservative investment institutions to use changes in corporate governance rules and move into equity sectors that reward risk-taking, return on equity and shareholder activism. The government will expand the GPIF’s budget so it can hire more and better qualified investment staff – a process that will produce better results only over an extended period.

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