BOJ resists government bond fund scheme

The policy board of the Bank of Japan meets today under intense pressure to curb a sharp rise in long-term interest rates that could thwart chances of recovery in the world's second-biggest economy.

Rates for the benchmark 10-year Japanese government bond (JGB) have been rising since December because of a prospective market glut in JGB issuance. Last week rates reached 2.44 per cent, the highest in 18 months. The rise has contributed to a strengthening yen against other key currencies.

The culprit is massive fiscal spending to boost the economy, set against a declining base of tax revenue due to the protracted recession. Last December, Japan unveiled a 81.86 trillion yen (about HK$5.53 trillion) budget for this year, beginning in April, up 5.4 per cent over the initial budget for last year. The Ministry of Finance (MOF) plans to issue 31.05 trillion yen of new JGBs this year. Government tax receipts have dropped year on year by another 5.4 per cent in December, and with only three months remaining in the financial year, revenues are less than 60 per cent of the budgeted amount.

So far the central Bank of Japan (BOJ) has strongly resisted calls to increase purchases of JGBs on the secondary market, and, more controversially, directly to monetise the debt by underwriting JGBs.

US Treasury Secretary Robert Rubin last week stepped in by suggesting that the central bank expand the money supply.

This was music to the ears of senior politicians of the ruling Liberal Democratic Party. Ichizo Ohara, an economic adviser to Prime Minister Keizo Obuchi and a harsh critic of BOJ governor Masaru Hayami, has been urging the BOJ to purchase up to five trillion yen in government bonds for two years. More prodding came on Monday from Chief Cabinet Secretary Hiromu Nonaka, who expressed 'hope' that the BOJ policy board would discuss the problem today. Mr Nonaka later called on the US Government to reciprocate the 'help' given by Japan in financing the huge US budget deficits of the 1980s through Japanese buying of US treasuries by purchasing JGBs.

The central bank has portrayed this political pressure as a threat to its cherished independence, enshrined in the new BOJ Law in April. Mr Hayami has compared today's Latin American or Russian-style debt monetisation proposals to the hyperinflation that resulted in Japan after the BOJ succumbed to underwriting massive JGB issuance in the 1930s and 1940s to finance military expansion. Price stability was only restored with the Dodge Plan introduced in 1949 under the Allied occupation, and both the Public Finance Law of 1947 and the new BOJ Law specifically prohibit the central bank from underwriting government debt with a maturity of more than one year.

'Purchasing JGBs can't be an option,' Mr Hayami told the Diet (parliament). 'It would be detrimental to fiscal discipline and generate vicious inflation.' Concerned about the deteriorating 'quality' of its assets and its overall credibility, the BOJ wants to cut, not increase, its JGB holdings. At the end of January, the central bank held 51 trillion yen worth of government securities, or 64.25 per cent of its entire assets.

The BOJ is also perturbed about its seven trillion yen in loans to Deposit Insurance, more than twice the value of its foreign-exchange holdings. The money is used to strengthen Japan's shaky banking system, but the BOJ wants the insurance firm to raise its own funds on the market.

Most of the money to replenish depleted capital of the private banks, out of 25 trillion yen 'set aside' last year by the Diet, is supposedly still to come from the BOJ. Fourteen of Japan's 16 leading commercial banks planned to apply for a combined seven trillion yen in public funds to be injected in March to cover their bad-loan losses.

But where does the prudence of the central bank leave the crisis in public finance and the real economy? Public-sector debt is on an explosive trajectory. According to the MOF, government debt this year will reach 108.5 per cent of gross domestic product, second only to Italy (117.5 per cent of GDP) in the Group of Seven leading industrialised nations. Eisuke Sakakibara, vice-minister of finance for international affairs, said 'our net debt, including the social security fund, is less than 40 per cent of GDP, the lowest of all the Group of Seven'.

The International Monetary Fund, however, estimates that Japan has unfunded pension liabilities of more than 100 per cent of GDP, more than offsetting the lower debt figure; while Japan's system of unemployment benefit is thought to be inadequate and in need of significant extra fiscal outlay. Unemployment is now higher than in the US, and the Obuchi cabinet will discuss today the growing problem of the homeless.

Richard Jerram, economist at ING Barings (Japan), estimates that if other current public liabilities, such as bad loans made by the Fiscal Investment and Loans Programme run by the MOF, and the colossal debt from the old Japanese National Railways, were included in gross government debt, it would already rise 'to around 150 per cent of GDP'.

The real economy shows every sign of entering a deflationary spiral. January marked the 13th consecutive month of a 'credit crunch'. Average household spending last year saw the largest drop in 24 years. Real wages fell by 2 per cent, and retail sales were down 4.7 per cent last year. Industrial production slid for the first time in five years, down 6.9 per cent to a 23-year low.

Economists argue that with fiscal expansion having reached its limit, the only option is monetary policy. Here the problem is that the official discount rate set by the BOJ has stood at a rock-bottom 0.5 per cent since 1995, and nominal rates cannot move below zero. The solution to this Keynesian 'liquidity trap', according to Paul Krugman of the Massachusetts Institute of Technology, is to deliberately create inflation by 'printing money' to create negative real interest rates. Having the central bank underwrite JGBs, or buying JGBs from the market without resale agreement, would be one means of increasing the amount of yen in circulation to attain this end.

Mr Jerram of ING Barings, and more recently economists at Lehman Brothers, have enthusiastically espoused Mr Krugman's argument on the need for 'inflation targeting', but as yet there is no sign of the BOJ embracing such a radical policy departure.

To achieve a negative real interest of about minus 2 per cent, Mr Jerram estimates that the BOJ would have to expand the monetary base by between 25 and 30 per cent. 'The bad news is that it is consistently below 10 per cent and appears to be slowing down. So we think the BOJ could do more,' he said.