The Japanese Economy: Harikari in Slow Motion

Motivated by three recent articles by Zero Hedge and Mike Shedlock: In Shocking Finding, The Bank Of Japan Is Now A Top 10 Holder In 90% Of Japanese Stocks, Bank of Japan Owns Over Half of Japanese ETFs; Why Stop There?, and Bank of Japan Corners 33% of Bond Market: All Japanese Bonds, 40 Years and Below, Yield 0.3% or Less, we decided to take a closer look at the Bank of Japan (BoJ), particularly its balance sheet.

There is widespread agreement that this will end badly. No one, however, has any idea whether it blows up this month, this year or whenever. In this article, we explain the the nature of the problem and possible signs of the tipping point being reached. When it does blow, the shock waves will cascade through all economies.

A Quick Introduction to Balance Sheets

A balance sheet is a snapshot in time of the economic health of an organization or company. In its simplest form it is a piece of paper with two columns. The left-hand column lists all the assets of the organization and their costs. The right-hand column lists all the liabilities of the organization and what their costs are.

Since assets (A) and liabilities (L) have no direct connection, the two sides of the balance sheet generally do not balance. In a healthy organization, the value of the assets exceeds the cost of all the liabilities. Accountants restore balance by adding a second section on the liability side called something like retained earnings (RE) or shareholders’ equity. Hence RE = A – L.

In a public corporation, RE is the worth of the company. Each share is a fractional claim on this worth. This is what a shareholder will be paid if the company is wound up, and is the intrinsic value of a share. If a company falls on hard times or makes bad investment or operational decisions, RE may shrink. When it reaches zero the company is technically insolvent.

One important thing to note is that liabilities, which represent money owed to creditors, have fixed conditions including total costs and interest payments. The value of assets, however, can change.

For example, if a bank makes a loan to a customer, the value of that loan appears as an asset on its balance sheet. Loans as assets, can, and often are, sold by the lender to another company. If the borrower defaults on the loan, the market value of the loan becomes whatever  settlement amount can be reached between the two parties, often through bankruptcy proceedings. It will likely be less than the nominal or face value of the loan and may be zero.

When balance sheets are used to asses the worth of a company, the assets must be “marked to market” to determine their real value as opposed to their “nominal” value which is what they were purchased for. This is the amount that would be received today if the asset had to be sold at the current market price.

Central Bank Balance Sheets and the Money Supply

The central bank controls the creation of money in a country. In early times, the value of money was its intrinsic value. Throughout history, gold and silver coins were used as money and their value was contained in the amount of gold and silver present in them.

When paper or fiat currency was introduced, the unit of currency had no intrinsic value since a small piece of paper with some ink on it was in itself worthless. So countries through their central banks, issued money as promissory notes to redeem them in gold at the bearer’s request. This was later changed to a promise to redeem the note in the legal currency of the land.

Today, an American citizen can take a $100 bill into any Federal Reserve bank or the Treasury department and ask them to redeem it. The official will cheerfully hand the claimant another $100 bill in exchange – well maybe not cheerfully. And the really neat thing about this is that the official can take the $100 bill handed to him in his left hand, transfer it to his right hand, and hand it back to the claimant, completing the redemption process! You can’t make these things up!

The point is that all paper or fiat currency is a debt instrument and appears on the central bank’s balance sheet as a liability.

Now central banks can’t just drop dollar bills from helicopters. If they did their balance sheets would be all liabilities (remember that each bill dropped is a debt owed to the holder of the currency) and no assets. The citizens might suddenly realize that their money was truly worthless.

This is the nature of modern money. The government declares by fiat that a $100 bill is worth $100. It works as long as citizens believe it.

In principal, the liability represented by currency is more than covered by assets that the central bank has acquired by using newly created currency. This is in fact the only way money can get into circulation. The central bank buys something of value. This value of the acquired asset covers the liability of the money the bank created to buy the asset.

The Central Bank in Action

At this point we should remind the reader of a property of bonds. The price of a bond moves inversely with its yield or the rate of interest it pays. This is standard bond theory and we won’t go into it. The important thing is that in the bond market, buyers of quantity force the price up. Sellers of quantity force the price down.

We wrote an essay, The Dilemma of the Impatient Trader, in which we explained how a trader in a hurry to acquire a large position will have to pay a premium to the current market prices. On the other hand, to be in a hurry to divest this position will require the selling at a discount.  The impatient trader loses money on both sides of the trade.

Since interest rates move inversely to the price, a central bank, when acquiring a typical large position in the billions or tens of billions of dollars, drives interest rates down. Selling the position will drive interest rates up. This is how central banks manipulate interest rates to affect economic activity.

The actual mechanism which the central banks only partly understand is that they are encouraging the acquisition of debt to increase current consumption and hence, economic growth. The fact that consumers may individually assess their needs for credit and decline further debt acquisition is anathema to them.

The global experience is that central banks have flooded the global economy with vast amounts of cheap – low interest rate – money through buying assets and forcing interest rates down. Credit market debt is at record heights globally and is saturated. At some point the damn must break. The common parlance is that central bank credit sheet expansion is unsustainable.

The Japanese Experiment

The BoJ through its monetary policy, has printed vast sums of money to buy assets. Relative to Japan’s GDP, Figure 1 shows that the BoJ has spent several times as much as the other major Western powers.

Figure 1. Total central bank assets of the ECB, the US Federqal Reserve, the Bank of England and the Bank of Japan.

Source: Gavyn Davies, Financial Times; thePOOG.

In currency amounts (yen)

BoJ Balance Sheet

most cases the assets have been the country’s sovereign debt but in recent history other assets have been acquired. The idea has that by buying assets with newly created money, this money would get into the economy and be used to create economic growth. This hasn’t happened but the banks keep trying. The BoJ has gone the farthest of all the banks not only acquiring the largest position of their country’s sovereign debt, but buying up appreciable quantities of stocks and exchange traded funds (ETF). An ETF can be thought of as a basket of stocks of a particular industry sector. In terms of the rate of growth of its economy, japan is the most indebted country on the planet (the highest debt to GDP ratio).

When Greece began its financial crisis, interest rates of its debt skyrocketed. This was the market’s assessment of the risk of sovereign default. Although a country’s central bank has some ability to determine the interest rates on its sovereign debt, the bond market has the ability to override this. In the case of Japan, if the BoJ continues on its present course, at some point the bond market will reprice the assets on its balance sheet through rising interest rates.

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