OMFIF report: At the edge of the shock – Japan's problematic monetary future

OMFIF Report – Press Release

21 September 2016

London

Japan’s monetary and financial system is living on the edge of a shock with the potential to rock a global financial system still worryingly fragile in the aftermath of the global financial crisis. This is the main finding of a new report by John Plender, released on 21 September by the Official Monetary and Financial Institutions Forum.

Almost four years after the launch of ‘Abenomics’ – Prime Minister Shinzo Abe’s three-pronged programme aimed at reviving Japan’s economy – Japan remains stuck in an atypical debt trap. The country’s aging demographic profile and history of excessive rates of corporate saving lie at the heart of an unsustainable build-up of debt that has necessitated increased public spending and caused the government to borrow as a substitute for tax receipts.

Abenomics has failed to reverse this reality radically. Expansionary monetary policy – its first ‘arrow’ – has been unable to break the economy out of deflation or substantially boost economic growth, while fiscal policy and structural reforms, the second and third arrows, have proved even less effective. Japan’s economic performance is expected to remain weak, posing challenges for debt sustainability.

Plender, chairman of OMFIF, an independent platform for dialogue and research, identifies three potential scenarios out of the debt trap, all of them problematic.

The first is ‘business as usual’, with more quantitative and qualitative easing. However, this is unlikely to kick-start growth and reduce Japan’s debt to GDP ratio. More worryingly, there are important risks related to the unknown consequences of these unconventional policies.

The second scenario involves a debt write-down to address the deflationary threat connected to the alternative of running budgetary surpluses to service the debt. Aside from being difficult to implement due to political constraints, such a policy would increase financial instability and capital flight. This in turn could result in an important shock to economic growth.

The third scenario calls for debt monetisation through a de facto write-down of the Bank of Japan’s holdings of Japanese government IOUs. This ‘monetary financing-lite’ option could help shrink the debt to GDP ratio, though it would raise concerns surrounding the principles of central bank independence and intergenerational fairness.

Plender concludes that all three scenarios encompass significant risks of financial stability that could spill over to the rest of the world. ‘The build-up of public debt and rising financial instability will ultimately lead to a crisis when confidence in the central bank’s ability to manage monetary conditions evaporates. These are the kind of circumstances in which a yen collapse could spark an inflationary surge. Linkages in today’s global markets make international repercussions inevitable.’

In a foreword, David Marsh, OMFIF managing director, said: ‘In the world of central banking, success and failure often lie debilitatingly close together. In the case of Japan, the line between liberation and downfall is more than usually thin. Over the next few years, the stakes will get still higher.’

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