Japan: What is the Bank of Japan Up To?

The BOJ's surprise move appears to be a change of tact, aimed at several monetary policy goals.

But under a ZIRP (zero interest rate policy) regime, the monetary base and short-term government bills are almost complete substitutes. This means that; a) "unsterilized" currency market intervention has essentially the same impact as "sterilized" intervention on the exchange rate, and b) that the increased current account balances have per se have no economic effect, as they play no part in the creation of credit.

The bottom line is that foreign exchange traders are correctly assuming that despite the new tactics, the BOJ is effectively giving them a green light to trade the yen higher.

Aggressive buying by foreign investors has provided the only buying demand for Japanese equities since April, leaving Japanese stock prices very susceptible to a change in perceptions by foreign investors.

Essentially, "what the foreigners giveth, they can also taketh away". This plus the assumption of continued yen appreciation means that the export-related, international blue-chips will continue to underperform the Topix on a relative basis until the top in the yen is confirmed.

Conversely, Japan's small cap stocks continue to mark new rebound highs, ostensibly because of still active individual investors (day traders) buying TSE 2 and JASDAQ stocks not subject to "daiko henjyo" by the domestic corporate pension funds, and the shifting relative value perceptions of foreign investors.

In addition, mining stocks have been outperforming the Topix as a whole, reflecting; a) sharp gains in the underlying global precious metals and industrial metals markets, and b) sharp gains in the mining and non-ferrous sectors in the US market. Ironically, the best performing stocks in the sector have the weakest balance sheets, in keeping one pattern of this rally, where the buying tide is especially favorable for the leakier boats.

After using over JPY13.5 trillion in an effort to keep the yen from appreciating, the BOJ apparently has changed tactics. On Friday of last week, it made a surprise and unusual decision at its Policy Board meeting to ease monetary policy further by raising the upper limit on the target of current-account deposits by¥2 trillion to ¥32 trillion yen, for a new range of ¥27-¥32 trillion yen. This is the first easing of its policy in nearly five months.

What is the BOJ up to? Just weeks ago, Governor Fukui was denying there was a need for such steps. The stock market evidently liked what they saw in the BOJ policy move, while the Yen shot up to the ¥108/US$ level, or well above the ¥115/US$ level the BOJ had fought so hard to maintain with massive currency market interventions to date.

1. They want to offset the deflationary impact of a stronger yen, as a strong yen does work to reduce GDP growth as well as corporate profit growth.
2. They hope they can keep a lid on the spike in long-term bond rates, and to show the markets they are as committed as ever to maintaining their quantitative easing measures.
3. Since the G7 pronouncements have apparently made it more politically difficult to aggressively intervene, they appear to be trying a different tactic, as inevitably the stronger yen will illicit howls of protest from corporations and their supporters in the government.

But economists have long maintained that currency market intervention, particularly "sterilized" intervention, does not work if the economic fundamentals do not support it. Moreover, there is essentially no difference between "sterilized" and "unsterilized" intervention under a ZIRP (zero interest rate policy) regime. The level of the yen-both under sterilized or unsterilized intervention-is only relevant to the extent the level of the yen is a function of interest rates, but the monetary base (defined as banknotes and coins in circulation plus current account balances at the BOJ) and short-term government bills are almost complete substitutes under ZIRP. Thus it makes no difference whether the intervention is sterilized or not.

Ergo, foreign exchange traders correctly assumed that by changing tactics, the BOJ was giving them a green light to trade the yen higher. This makes us even more convinced that the Japanese yen is heading through ¥100/US$ and could very well challenge its prior high of ¥79/US$.

By the same token, the amount of clearing balances at the BOJ have no economic effect, as they play no part in the creation of credit. The BOJ is just pushing harder on the same string they have been pushing on all along, given the current liquidity trap.

There may be several trillions of yen sloshing around in the BOJ's current accounts, but precious little will find its way into the real economy unless the banking sector can resume its traditional role of being a money multiplier for the economy. As the graph at right shows, the money multiplier continues to shrink. Here, news that Resona Bank is aggressively moving to pare down its NPLs with a massive ¥1.79 trillion write-down is encouraging news, but the rest of the banking sector needs to follow suit. Consequently, the Bank of Japan has actually done little other than stand on the sidelines and give the stock market a good "gambatte" cheer.

Foreign investors have yet again given Japanese equities a very welcome rally. Since April of this year, foreign investors have been net buyers of Japanese equities by ¥5.3 trillion, according to Tokyo stock exchange statistics (MOF statistics show ¥6.9 trillion of net buying).

At the same time, they have been net sellers of Japanese government and corporate bonds by some ¥3.22 trillion, indicating that some yen asset switching from bonds to equities has taken place.

But foreign investors have been virtually alone in their bullish stance on Japanese equities. During the same period (April- September) domestic investors have been net sellers of Japanese equity by ¥5.2 trillion, including ¥2.4 of net sells by the trust banks, ¥820 billion by individuals, and even some net selling by the brokers on their prop accounts.

When foreign investors first became net buyers of Japanese equities in April, there was a strong feeling that Japanese stocks had significantly lagged the global rebound in equities. The last couple of weeks however have seen a subtle change in aggregate net buying by foreign investors. During the third week of September, foreign investors turned net sellers of Japanese equities for the first time in 24 weeks, and the Nikkei 225 promptly corrected 7.4% from a high of 11,033 on 19 September.

Because the yen could well continue appreciating despite the BOJ's efforts, Japan's export-oriented, international blue chips will continue to underperform on a relative basis. Thus such stocks should be avoided until the yen's appreciation peaks.

Conversely, both the Topix 2 and the JASDAQ have outperformed the larger indices during this recovery, and should continue doing so. It is in the small stocks where individual investor buying can have the most favorable impact, as there is less volatility from cross-holding unwinding by domestic institutions on the one hand, and possible foreign investor selling on the other.

In addition, Japanese stocks often take a hint from trading trends in the US market. During the past three months, the best performing sectors in the Dow Jones US indices have been minin and non-ferrous metals, as investors have switched gears and are now trying to discount inflation, not deflation, and continue to expect a weaker US dollar.

Over the past three months, selected mining and non-ferrous metals companies have also been outperforming the Topix, including Furukawa Co., Nittetsu Mining, Mitsui Mining and Smelting and Mitsubishi Materials. Ironically, one pattern seen during the current rally in Japanese stocks has been that the companies with the weaker balance sheets have out-performend their peers. This we see as a reflection of a more sanguine view of bankruptcy risk. That said, balance sheet quality still matters, especially after the current overly bullish market sentiment in Japan fades. Thus while it may mean forfeiting some short-term relative performance, we continue to believe that the "quality" stocks (i.e., those with a sound balance sheet) will in the end prevail.