Japan
Where Is QE without ZIRP?
November 26, 2008

By Takehiro Sato | Tokyo

Easing Has Not Gone as Far as Expected

The decision to cut rates and pay interest on excess reserve deposits at the central bank spurred expectations that Japan, like the US, would see a period of QE (quantitative easing) without ZIRP (zero interest rate policy). However, the money-market operations by the bank since the November reserve accumulation period got underway suggest at this point that these expectations are not going to be fulfilled. We must stress ‘at this point’, because the policy pattern in the past has been for modest beginnings to result ultimately in extensive easing. The complementary deposit facility that pays interest on excess reserves is a measure to enhance provision of liquidity at year-end and fiscal year-end when demand for funds increases, and runs only until next April. We think that this system is likely to be ended in April-June next year, as the bank reinstates ZIRP, contrary to its initial intentions. Therefore, our view would not be altered even with the smaller-than-anticipated easing measures at this stage.

The BoJ’s Stance Does Not Make Clear Whether it Wants to Provide Greater Liquidity or Not

We cannot be alone in having the impression that the bank’s recent dialog with markets, including the rate cut at the end of October, has not been smooth. The cut was largely in line with our scenario, but came in abruptly, in contrast to the non-committal messages from the bank’s leadership up to that point. If a rate cut was going to be made, it would have had greater appeal coming in conjunction with the cuts made in concert in the US and Europe on October 8.

The payment of interest on excess reserves was also a move that, as part of the steps to enhance liquidity provision, had been flagged by the governor to the administrative staff in the last but one MPM in September. Given the goal of greater liquidity provision, it would be natural for market participants to associate the result of supplying copious liquidity via extensive twist operations with allowing the overnight rate to drop below the target level to an extent, as in the US. In fact, the effective FF rate of around 0.5% has risen from about 0.25% in early November but is still well below the policy target of 1.0%.

However, the Fed does not have flexible fund absorption facilities corresponding to issuance of ‘bills sold’ in the BoJ’s case, and faces a special situation where funds bearing no reserve deposit interest such as the GSEs due to restricted alternative investment opportunities are to be deposited with super-low interest in the FF market. As a result, the Fed has raised the interest paid on excess reserves in stages from the original FF minus 75bp to FF minus 35bp and then to the same level as the FF rate. Even so, under conditions of quantitative easing, the FF rate is still trending far below the targeted level, and the markets are reacting calmly, not interpreting the Fed’s recent increases in the reserve deposit rate as stealth rate hikes. In sum, the markets are showing a level of trust in the approach of the Fed, which is undertaking tough measures in quick succession to supply abundant liquidity. (The December FOMC meeting was originally scheduled for only one day, but has now been extended to two days (December 15-16, announced on November 20). It appears that further unconventional measures to achieve monetary easing will be discussed.)

The contrasting money-market operations of the BoJ, where it is unclear whether the bank does or does not seek to increase provision of liquidity, may attract greater criticism in the markets. depending on how the economy and markets develop from here. Here we consider a rough overview of the economy and market in light of these circumstances.

Overview of the Economy and Market

We envisage the downturn climaxing in the current October-December and January-March quarters. Economic data continue to get worse in January-March. Production plans in manufacturing industry are down about 5%Q in October-December, with output declining at a rate that matches the aftermath of the IT bubble. On the micro side, there is no let-up in news of production cuts, especially for automobiles and IT goods, and job losses. GDP for October-December and the December Tankan continue to show similar deterioration, with the former running close to minus 3% annualized, and the latter headline showing a double-digit drop. Corporate earnings declined about 20% in 1H (for listed firms), almost matching our bearish outlook, but we expect steeper falls in 2H for a drop of 30% over the entire year.

The problem is guidance for next fiscal year. Companies could well set extremely cautious targets, extrapolating from the sharp decline in 2H profits into next year, and analysts would presumably come out with guarded forecasts ahead of this. We expect this type of news to continue in March and April next year.

Shortfall in corporate earnings outlooks for F3/10 would be a new drag on the stock market, and could well lead to further buying of the yen in the currency markets. The MoF is currently holding off from market intervention in response to the unwinding of the yen carry trade, but depending on the pace of the yen’s advance would not refrain indefinitely from intervention to push down the yen. As a result, with the BoJ not mopping up the funds supplied to the market by MoF’s yen-selling intervention (which is thus unsterilized), the BoJ would find itself passively overseeing a massive supply of funding.

We see room in this process for two 15bp rate cuts, one in January-March and one in April-June. Depending on how constrained corporate financing is, unconventional measures similar to those used by the Fed could be taken. The governor has already directed the bank’s administrators to study and report back on steps to ease corporate financing by the next MPM. (The statement following the November MPM (November 21) included this direction from the governor: “The Bank will carry out purchases of CP under repurchase agreements more flexibly to facilitate corporate financing. Also, in this regard, the Chairman (governor) has instructed Bank staff to swiftly examine and report at the MPM possible changes in the treatment of corporate debt as collateral, as well as possible ways to enhance flexibility in funds-supplying operations collateralized by corporate debt.”)  It is premature to think that all means have been exhausted, and there is a conceivable menu of policy options.

Risks

There appears to be some belief that aggressive provision of liquidity by central banks, including Japan’s, can contribute to a recovery in asset prices that have fallen sharply. Yet, expansion of central bank balance sheets is complementary to private sector balance sheet shrinkage, and no more than that. For example, the Fed’s balance sheet has ballooned to about US$2.2 trillion (+40%Y) in the week of November 19. The BoJ, while not on the same scale, has also seen a hefty increase of about JPY118 trillion (+12%Y) as of November 10. However, this is a counterpart to the contraction of credit in the private sector. In other words, in response to deleveraging in the private sector, the complementary supply of liquidity by central banks has not necessarily meant an increase in the absolute amount of currency supplied. Indeed, in Japan’s case, the money supply (M1) in October shrank at a faster rate (-1.1%Y) than in September (-0.5%), despite the increased supply of funds, and the apparent effects of private-sector deleveraging are also showing up in macro data. (Conversely, M1 in the US has increased sharply. See David Greenlaw’s US Economics: Revenge of the Ms, November 18, 2008 for details.) 

The BoJ also has swap agreements in place with the Fed, and responds to dollar funding needs of financial institutions that do business in Japan. However, clearly there is no question of provision of dollar funds by the BoJ spilling over into dollar funding for the financial and non-financial private sector. Both Japanese banks and foreign banks operating in Japan need to raise money in dollars to fund their dollar-denominated assets (lending overseas, etc.), but since such funding is currently tight, the BoJ and by extension the Fed, which should complement funding transactions between private sector counterparties, are supplying funds.

The situation above resembles how funds did not feed into the real economy during quantitative easing, however much the BoJ supplied, because the balance sheet problems of the financial institutions had impaired the mechanism of credit intermediation. Japan’s experience shows clearly what needs to be fixed.

Important Disclosure Information at the end of this Forum

Global
Aggressive Policy Actions Will Avert Both Depression and Deflation
November 26, 2008

By Richard Berner | New York

In recent weeks, a policy vacuum in Washington and terrible economic news had increased the ‘tail’ risks of prolonged recession and deflation.  Not surprisingly, comparisons between the current crisis and the Great Depression or Japan’s Lost Decade multiplied. 

In our view, comparisons with those disasters are greatly exaggerated.  To be sure, serious risks still point to a weaker economy, a longer downturn and the threat of deflation.  And today’s sins of omission have been similar to the 1930s and the Lost Decade: Policy has yet to break the adverse feedback loop from the deleveraging of lenders’ balance sheets to the economy that is at the heart of  this credit-crunch-induced recession.  More importantly, however, those two earlier calamities also involved egregious sins of commission or at least delay.  Tightening monetary and fiscal policy turned a serious recession into the Great Depression, and protectionism made it worse.  Japanese authorities eventually embraced the right policies, including cleaning up bank balance sheets, but it took a decade to adopt them. 

In contrast, we believe that the Obama Administration will implement aggressive policy actions that reflect the lessons of those two events.  As we see it, three lessons for policymakers from the Depression and Japan stand out: First, aggressively use macro policies to buy time for other needed policies to be implemented and to take effect.  Second, employ policies to stabilize the financial system and attack the roots of the credit crunch.  Finally, adopt measures to reduce the imbalances, especially in housing, that triggered the downturn.  Let’s examine them in turn.

First, macro policies must be forceful and appropriate to cushion the blow from the adverse feedback loops depressing markets and the economy and to avert deflation.  How forceful?  Consider that the free fall in global equity prices and the decline in home prices will have slashed household net worth by $11 trillion or nearly 20% over the course of 2008.  Even if asset prices somehow stabilize by year-end, this unprecedented plunge in household wealth may prompt consumers to cut spending by a cumulative four percentage points next year and in coming years.  Tighter lending standards for businesses, residential and commercial real estate, state and local governments and a weakening global economy seem likely to depress demand by roughly another 2 percentage points of GDP over the coming year.  While the sharp slide in gasoline and other energy quotes will add back $250 billion or more (2-2.5%) to discretionary incomes, that still leaves a hole of roughly 3-4% of GDP ($425-575 billion) to fill.  If no lame-duck plan is enacted (other than extending unemployment insurance benefits), then the incoming Obama Administration is right to consider a very substantial menu of fiscal stimulus including immediate, medium-term and longer-term elements (for details, see “The Obama Policy Mix”, Global Economic Forum, November 10, 2008).

Likewise, the “output gap” between actual and potential real GDP seems likely to rise to 5-6% of real production of goods and services – a level consistent in the past with declines in inflation of more than 2 percentage points.  Given that underlying or “core” inflation measured by the CPI is now running just over 2%, the risks of deflation in that context are rising.  Further aggressive steps for monetary policy to avert such an outcome are appropriate, but with the Federal funds rate at 1%, many perceive that the Fed is running out of ammunition. 

In our view, nothing could be further from the truth.  The Fed has already begun an aggressive plan of quantitative easing (QE) that has doubled the size of its balance sheet in two months.  The problem, of course, is that banks are hoarding the resulting expansion of reserves.  As a result, QE has had little impact on expansion of bank balance sheets or on the economy; in effect, the money multiplier (the ratio of monetary aggregates or bank liabilities to bank reserves) has collapsed (for details, see Revenge of the Ms, November 18, 2008). 

But the Fed is not pushing on a string.  Three additional policy options are available to realize the full potency of QE, ease financial conditions, and help revive securitization markets.  First, the Fed can buy longer-term government securities or private sector securities such as mortgages.  That would bring down longer-term yields and more importantly the wider risk spreads that are symptomatic of dysfunctional securitization markets and that have made financial conditions ever more restrictive.  Second, the Fed can commit to keep the funds rate rates low.  The FOMC used such a strategy in 2003-4, but then the commitment was unconditional or merely a function of the calendar; rates were kept low for “a considerable period”.  A more refined strategy would make any such promise conditional on inflation performance.  Such a pledge, like Japan’s in 2002-3, would prevent inflation expectations from falling below the point where deflation could become a self-fulfilling prophecy.  Finally, the Fed can monetize the coming fiscal stimulus, keeping rates low despite significant actions that would boost the demand for credit and otherwise push rates up.  These three options are actually all familiar to the FOMC, as they were discussed at length as early as the January 2002 FOMC meeting (see Board Staff Presentation on the Implications of the Zero Bound on Nominal Interest Rates, January 29, 2002).  It appears that the Fed’s expansion of the December 16 FOMC meeting to two days rather than one is designed to weigh such a strategy and tactics.

While these aggressive macro policies are necessary to prevent a downward economic spiral, they are unlikely to be sufficient, because they do not get to the sources of the credit crunch; namely sliding asset values, erosion of capital at leveraged lenders, deleveraging of their balance sheets, and the economic imbalance between supply and demand in housing. 

Indeed, we think three other sets of policies are needed to stop the rot and promote the basis for eventual recovery.  First, officials should prosecute full implementation of steps to stabilize the financial system: 1) backstop liabilities and counterparty risk, 2) continue to increase funding, and 3) clean up balance sheets (for detailed recommendations see A Plan to Stabilize the Financial System, October 10, and Assessing the Plan to Stabilize the Financial System, October 15). The final rules in the FDIC’s Temporary Loan Guarantee program should begin to promote new issues of senior debt that will strengthen financial institutions’ balance sheets.  The willingness to expand and possibly extend the Fed’s several lending and funding facilities and FX swap lines should continue to foster ample market liquidity.  For example, officials are apparently considering a new ABS funding facility that would help to jump start the moribund ABS market for consumer loans. 

Most important, using available funds to inject capital in exchange for preferred shares, and creating a mechanism – a “good-bank-bad bank” structure – to ring-fence some troubled assets would buy time to assess NPLs, promote appropriate writedowns, and encourage significant further consolidation in financial services.  In turn, cleaning up balance sheets, as was ultimately done in Sweden in their 1992 banking crisis, in Japan, and in the US savings and loan crisis, will help slow the deleveraging process and ultimately is the only way to end the credit crunch.  To quote my colleague Robert Feldman in drawing conclusions from the Japanese crisis: “Capital injections are a necessary but not sufficient condition to restore confidence in bank equity prices.  Confidence needs to be restored in the value of the assets before stocks undergo a sustainable increase.  This can only be achieved by removing bad assets from the balance sheets, without recourse.”  I couldn't agree more.  It is encouraging that the Fed and the Treasury are using such a structure – not just to help ailing Citigroup, but also to reduce systemic risk (see Betsy Graseck, Citigroup: Fed Action a Strong Positive; Less Loss and Dilution Risk, November 24, 2008).

The second needed set of policies includes aggressive implementation of steps to mitigate mortgage foreclosures.  The rising tide of foreclosures adds to the inventory of vacant homes and to the real estate owned on lenders’ balance sheets, puts downward pressure on home prices, and creates significant economic hardship for the individuals, the lenders, and the communities involved.  There are many obstacles.  Not all foreclosures should or can be avoided; the goal is to reduce preventable foreclosures.  Forbearance in some cases may simply delay default and encourage irresponsible behavior.  The government can’t influence all mortgages, and making loan workouts work will cost some money.  There is a risk that any remedy to fix a temporary crisis will become permanent.  Given those obstacles, there are no good choices, but the least bad ones would be targeted, varied, and would share losses among borrowers, lenders and the taxpayer.  The FDIC proposal, modeled after the protocol used for IndyMac Bank, shares the losses 50-50% between the lender and the agency in the event that modified loans re-default; the plan for Citigroup requires use of this plan.  These measures will complement steps to clean up balance sheets and help troubled homeowners. 

Finally, officials should seek policies to reduce the supply-demand imbalance in housing.  Here there is debate over the most effective policy options.  New tax subsidies, as proposed by Alan Meltzer, would increase housing demand, but they risk becoming permanent.  And in the context of a serious credit crunch, they may not be sufficient to push up housing demand.  It’s worth noting that the benefits for housing demand from lower mortgage interest rates and increased credit availability from steps 1 & 2 above should also help.  In other words, these three steps should be implemented in concert as part of a complete package.

For investors, there is no mistaking the fact that barring economic calamity, sufficiently bad news is now in the price.  Indeed the vicious circle of economic weakness and policy uncertainty has continued to depress markets that already discount a serious debt-deflation spiral.  For example, my colleague Greg Peters points out that investment-grade cash corporate bonds are priced for a 52% default rate over the duration of the instrument, compared with 4.7% in the worst 5 years of history from the early 1990s.  And my colleague Abhijit Chakrabortti notes that the S&P 500 dividend yield at 4% is 150 basis points above its long-term average. 

But they also note that sequencing matters: Policy steps to improve funding and credit markets must precede any rally in risky assets such as equities.  Aggressive, coherent policy steps to address that feedback loop have been taken over the weekend and are welcome in that respect.  That the incoming Obama Administration is mooting a multi-year, $500 billion fiscal plan testifies to their resolve to prevent dire economic outcomes.  Investors should look next to stability in funding and then credit markets, and then finally to riskier assets, as they begin to anticipate better economic news.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.