The Bank of Japan's Shell Game

The BOJ is keeping markets guessing about how it will handle the upcoming postal system time-deposit crisis.
Author:
Publish date:

With this column, we introduce Todd Kobayashi, chief market strategist for Commerz Futures (a division of Commerzbank) in Chicago. Kobayashi, who began his career as an institutional futures broker at Prudential Securities and E.D.F. Man, focuses on trading interest rates and currencies. As always, tell us what you think.

The

Bank of Japan

is struggling to refine its monetary policy. With the short-term interest rates it normally uses to conduct policy already at 0%, the bank feels it is doing all it can to foster growth. To date, the BOJ has been unprepared to make the philosophical leap to a more proactive and aggressive monetary expansion, something many observers feel is necessary to cement the country's recovery.

High-level policymakers, including those at the

Federal Reserve

and the

International Monetary Fund

, are in increasing agreement about what must be done. First, the BOJ must extricate itself from its zero-interest-rate policy. How does it do that? By creating a modest inflationary expectation in the market, thus enabling the bank to regain control of normal monetary operations. Second, the bank must enact this policy on a massive scale and with clear determination.

Despite the fact that the bank is not going willingly down that path, a major structural event looms on the horizon -- one that could finally force the BOJ's hand and force it to reflate its own money supply.

Beginning in April, a significant portion of Japan's high-yielding postal savings time deposits will begin to mature. The maturing deposits historically have earned between 7% and 8% and, if rolled over, would now earn only about 1.75%, assuming the funds were reinvested in 10-year Japanese government bonds. This is no trivial matter: The amount of money in the postal savings system managed by the

Trust Fund Bureau

of the

Ministry of Finance

is huge. This totals some Y225 trillion ($2.14 trillion), of which as much as Y49 trillion ($466 billion) could be drained from the system in the next two years.

Japanese investors have wondered for some time how the postal system will finance such a potential outflow of funds. The major fear is the possibility that the postal system will be forced to begin selling its holdings of JGBs to meet the redemptions, thus pushing interest rates higher.

An Earlier Scare

The BOJ recognizes the effects on long-term interest rates that could result: Recall the period between November 1998 and January 1999 when the postal system merely announced it would suspend the buying of JGBs in the coming year. Interest rates tripled from 0.8% to a high of 2.4% -- and that was simply due to a cessation of buying.

The BOJ tried to address these fears by announcing, on Nov. 5, that if market bids for the JGBs sold by the postal system fall short of the total being liquidated, the BOJ would buy the balance, thus cushioning the blow to the market by the huge sales. The twist was that it would pay for the bonds through repurchase agreements that mature in three months or less. The money for the purchases, in essence, would be printed by the BOJ.

By using repurchase agreements, the BOJ is trying to disguise the potential for monetary expansion. At this point, you should be asking yourself how this shell game can work. How can the postal system rebuy JGBs from the BOJ -- if the money flows out of the postal system because it doesn't like today's low rates?

The BOJ is moving the shells on the table, trying to keep the market from guessing which shell the pea lies under.

The answer is that it cannot. This is only possible if the investors whose time deposits expire choose to reinvest those funds with the postal system. If the holders of maturing deposits elect to move their funds to the domestic stock market, to overseas stock or bond markets or even within the domestic banking system, the postal system would be unable to rebuy some of those holdings. If the repurchases do not occur, the money the BOJ used to buy the JGBs from the postal system will result in a net addition to the money supply.

The BOJ is moving the shells on the table, trying to keep the market from guessing which shell the pea lies under. The key question for the market becomes what percentage of the funds that mature will be reinvested with the postal savings system. That is an unanswerable question that spells uncertainty: Uncertainty moves markets.

Let's take a relatively conservative figure and assume that only 25% of current time-deposit money is not reinvested. That would mean Y12.25 trillion ($116.5 billion). In addition, the regular purchases by the postal system of Y200 billion a month would also have to cease by early next year as the postal system begins repaying depositors rather than accumulating funds. That totals another Y4.8 trillion over two years.

Add them together, and the net two-year change from the present situation would be an additional Y17.05 trillion ($162 billion). The effect of that significant drainage from the system can only be made worse by the uncertainty in determining the amount. The market may be left to fear much worse than the above.

What can the government do? The BOJ has taken the first step, but in doing so, it will face a choice. If it sticks to its current adamant policy of refusing to underwrite the government's debt, the BOJ would be forced to sell its accumulated JGB repurchases to the market if the postal system is unable to rebuy the JGBs when the repos expire. The effect of this would likely be much higher long-term interest rates in Japan, which could stifle growth.

The BOJ's other choice would be to keep the repurchased JGBs on its books -- effectively expanding the money supply. The likely effect here would be a much weaker yen. A weaker yen is exactly the policy that is being encouraged by the Fed, the IMF and many private-sector economists. A weaker yen would encourage exports and potentially help Japan's budding recovery.

Many analysts wonder what it will take to get the BOJ to further expand the money supply. I suspect the potential interest-rate rise associated with the outflow of funds from the postal savings system could be that defining event.

Todd Kobayashi is the chief market strategist for Commerz Futures in Chicago, focusing on interest rates & currencies. He previously worked in a similar capacity at Nikko Securities and began his career as an institutional broker for Prudential Securities and E.D.F. Man. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

TKobayashi@CFutures.com.