Q&A: BoJ's Nakaso on QE, JGB liquidity and Basel III

At ¥80 trillion ($668 billion), the annual bond-buying target for the Bank of Japan is roughly twice the country’s planned debt issuance for 2015 – raising questions about how long the programme can continue. Deputy governor Hiroshi Nakaso offers the answers to Risk.net

Hiroshi Nakaso, Bank of Japan

Market participants have two big worries about the Bank of Japan's (BoJ) bond-buying programme, launched in April 2013: what happens when it stops, and what happens if it doesn't stop?

The first is based on fears that stocks and the economy will slump without the central bank's indirect support; the second reflects concerns that quantitative easing (QE) – expanded in October 2014 to target annual purchases of Japanese government bonds (JGBs) that are twice the size of planned issuance – will hoover up so much of the available debt that the JGB market effectively stops functioning.

Against this backdrop, it might seem the BoJ cannot win. That is not how deputy governor Hiroshi Nakaso sees it. He recognises both challenges, but is confident the central bank can manage them, and emerge victorious in its two-decades-long fight against deflation.

"We intend to continue with QE until our price stability target is reached and inflation stabilises. Of course, we continue to monitor market conditions. But our objective is to achieve the 2% inflation target, and until we meet this target we will continue with QE," he says.

The BoJ's belief is that deflationary pressures are now lifting, and that inflation will hit 2% some time in the first half of the 2016 fiscal year, says Nakaso, depending on what happens to oil prices.

I think it is now important to eliminate regulatory uncertainty and create an environment where banks find it easier to plan

In the meantime, he adds, QE does not appear to pose a serious risk to the health of the JGB market. Data published by the BoJ on August 18 shows a drop in the depth and resilience of the JGB futures market since QE was expanded – the size of trades that can be executed at the best-offer price has shrunk, and the price impact of each trade has increased – but Nakaso says there are no big problems with bond liquidity.

If liquidity deteriorates, Nakaso believes a range of counter-measures will mitigate the problem, some of which are already being put into practice. As one example, opening hours for the central bank's JGB settlement system, BoJ-Net, are to be extended in February next year so it remains open into the morning of the European trading day. This could encourage foreign clearing houses to accept JGBs as collateral, expanding demand for the bonds, Nakaso says.

When QE has served its purpose, how will markets respond? Nakaso is optimistic – the roughly 80% rise in Japanese stocks since the start of 2013 reflects returning economic strength as well as QE, he argues, and should withstand a return to more conventional monetary policy.

"The higher stock prices are not only attributed to the QE policy but also to fiscal stimulus and the growth strategy. So to the extent these last two measures play a major role, along with the fundamental recovery of the corporate sector, it is very likely the Nikkei will behave accordingly, reflecting macro fundamentals as well as the performance of the corporate sector," he says.

Nakaso joined the BoJ in 1978, rising up the career ladder to become head of the financial market department in 2003 after a stint at the Bank for International Settlements in 2000. In 2010, he was named assistant governor. He was promoted to one of the two deputy governor posts in March 2013, when Haruhiko Kuroda took office as governor.

In this interview, Nakaso also shares his thoughts on the post-crisis reform of bank prudential rules – a project that has been in train for seven years and has further to run. It is important, he says, to "eliminate regulatory uncertainty and create an environment where banks find it easier to plan and execute more dynamic business strategies".

What part has QE played in the various liquidity events markets have seen over the past 12 months?

Hiroshi Nakaso: It's very hard to deny the influence coming from central banks' monetary policies, given the magnitude of central banking intervention, and the same thing can be said about international prudential regulations. I think those regulations have an impact on participants and their risk-taking activities.

We have also seen structural changes in the markets, such as the increase in high-frequency trading, a larger presence of asset management entities, and an increase in cross-border capital flows.

My temporary assessment is that there are very complicated interactions between all of these factors.

Of course, we have a natural interest in the effects of our QE policy on the functioning of the JGB market, which is the core market in Japan.

What effects have you seen?

HN: We have been monitoring the functioning of the JGB market based on data from the JGB futures market, which plays a very important role in yen rates markets. The assessment has been conducted using three criteria: trading volumes, market depth and market resilience.

First, our assessment shows trading volumes have maintained a good level and bid/offer spreads have been tight most of the time, except for a spike observed immediately after the introduction of QE in April 2013.

Now, for market depth, we looked at orders at the best-ask price in the JGB futures market. This has become thinner since the first quarter of 2014, recovering somewhat after hitting its lowest level in the first quarter of 2015.

Finally, we think market resilience can be measured in terms of the estimated impact on prices for a unit volume of transactions. These indexes suggest market resilience has somewhat declined over the period from the first quarter of 2014 to the first quarter of 2015. It has improved since then but hasn't fully recovered.

We think this data clearly indicates there are no serious problems with the liquidity and functioning of the JGB market, nor does it seem likely that liquidity has declined to the extent that it makes a continuation of our large purchase of JGBs difficult.

Having said that, this does not mean we are pleased about the JGB market. As I said, we have seen some deterioration in market depth and market resilience. So this is something we've got to monitor carefully going forward, and I would tend to look at indicators such as the frequency with which our securities lending facility operates or the relationship between general collateral and special collateral in the repo market. They tell you a lot about the market conditions.

What can the BoJ do if liquidity declines further, other than stopping or scaling back QE?

HN: There are a couple of things we can do as a central bank. First, we should focus on the improvement of market practices, and second, we should look at the improvement of market infrastructures.

With regards to market practices, several initiatives have already been launched. One has to do with the repo market. The BoJ hosts a repo market forum, which concluded in a report in May that we could take possible measures to improve market functioning by facilitating same-day settlement and also asked that we encourage so-called term repo transactions.

With regard to the improvement of market infrastructures, there has been notable progress. Our settlement system, the BoJ-Net, will be upgraded in October. Its operation hours will also be extended from 7pm to 9pm after February next year, enabling it to cover Asian and European time zones. It's partly intended to facilitate the more efficient management of JGB as collateral on a cross-border basis.

On that note, I should also mention the securities lending facility (SLF) that we run. We have already softened the conditions of our SLF to alleviate squeezes in the JGB market. But, we must obviously pay attention to moral hazard issues and avoid any excessive dependence on the SLF.

How confident are you these measures will be sufficient to solve any issues around market liquidity?

HN: I'm not sure this is going to be sufficient, but I think it is a significant step forward. The BoJ-Net settles yen funding liquidity as well as JGBs. If you focus on the JGB aspect, it could be used as margin collateral by clearing houses overseas and it could be used as collateral against the funding of foreign currencies. This would make JGBs more widely used, and that would be a significant step towards making the use of JGBs more efficient.

Some observers have been calling for central banks to serve as ‘market-makers of last resort' in a prolonged liquidity crisis. Do you like the idea?

HN: This is a kind of ongoing argument. Traditionally, ‘lenders of last resort' meant bilateral lending by the central bank to a bank facing some difficulties. I think this is now changing. What central banks did after the collapse of Lehman Brothers was to act as market-makers of last resort, which means providing the markets with ample liquidity when they saw a liquidity squeeze.

On that note, I should stress the network of bilateral swap lines between six major central banks that were launched during the crisis is an invention of the central banking community to address the liquidity stresses seen in the US dollar funding market.

So, this is an issue the central banking community has already embarked on, but to what extent to intervene remains an issue. And I think the moral hazard element is also a problem.

Takehiro Sato, who sits on the board of the BoJ, warned of diminishing returns and other drawbacks of maintaining the bank's QE programme for too long. Does that mean the bank might be preparing for an exit any time soon?

HN: No. Our monetary policy is orientated towards price stability. This means we intend to continue with QE until our price stability target is reached and inflation stabilises. Of course, we continue to monitor market conditions. But, as I said, our objective is to achieve the 2% inflation target, and as long as we don't meet this target we will continue with QE.

When do you expect to hit the target?

HN: One crucial thing in the current context is that there is a gap between what market participants believe is feasible and the BoJ's outlook on inflation. We think we can reach the price stability target of 2% around the first half of the 2016 fiscal year, depending, of course, on oil prices. But market participants in Japan don't think this is feasible.

So, should this discrepancy persist – and in light of our conversation today – an abrupt shift in market expectations could undermine market liquidity. To preclude this problem, we should instead elaborate on the mechanisms that, we think, will help to meet the price stability target.

We think the improvement and the underlying trend of inflation dynamics – which consists of comparing output gap and inflation expectation, since these two elements underlie the inflation dynamic – are improving.

We estimate the output gap to be around zero, now entering into positive territories – this means the excess supply has changed to a point where we now face excess demand.

In terms of inflation expectation, we have various measures to gauge this, such as breakeven rates – the market-based index – and survey results. More importantly, however you define inflation expectations, it has to be reflected in corporate or household behaviour, which is improving. The corporate sector would never increase wages unless it thinks inflation will continue in the years ahead.

This makes us believe we will be able to meet the price stability target, particularly as the effect of the past lower oil prices are going to dissipate. I think the inflation rate will revert to a steady increase towards the end of this year. This will bring the inflation to around 2%.

What will happen to the JGB market when QE stops?

HN: A good communication is absolutely essential. If both the BoJ and market participants see the gap persisting, that will be a cause of a liquidity shortage and it will need to be tackled. If the communication is conducted in a sufficient way, you could argue that as the economy improves, the rates will pick up. But as we buy JGBs in large amounts, the upward pressure may well be offset to some extent. I hope this will create a stable market environment in which market participants can expect a steady increase in the yield curve. That will eliminate, hopefully, the risk of liquidity evaporation.

Do you expect the Nikkei 225 to drop significantly when QE ends?

HN: One of the findings of our recent analysis on the effect of QE shows stock prices have gone higher than estimated by our macroeconomic model. So the higher stock prices are not only a result of the QE policy but also of fiscal stimulus and the growth strategy. To the extent these last two measures play a major role, along with the fundamental recovery of the corporate sector, it is very likely the Nikkei will behave accordingly, reflecting the macro fundamentals as well as the performance of the corporate sector.

In May, the BoJ said it would allocate 25% of all QE profits it earns to increased reserves. Is this because the central bank wants a bigger buffer against volatility?

HN: This 25% reserve is intended to address the issue around the fluctuation of the BoJ's profits earned on the large purchase of JGBs. Since we are buying huge amounts of JGBs, profits are growing. But over the longer run, as we eventually get into the normalisation process, we will be facing less favourable conditions in terms of profitability. So, to provide for a rainy day, we are holding more reserve than the 5% we are legally required to hold.

Turning to prudential regulation, Basel III is now almost five years old, but there are still a lot of projects in train – the trading book review, interest rate risk in the banking book, capital floors. When will the response to the financial crisis be complete?

HN: The BoJ has actively participated in the discussions around the setup of Basel III. But we have consistently maintained that, first, it is necessary to assess the impact those regulations may have on financial intermediation and the macro-economy and, second, it is also necessary to accommodate differences in the conditions of financial systems across economies.

Going forward, I think there are a couple of issues the Basel Committee would need to tackle. The first is to assess the consistency and coherence of financial regulation as a whole. If one single piece of regulation is self-consistent it does not necessarily mean it will work as a whole when all pieces of regulations are put together. In addition to that, we need to assess the impact of financial regulations on financial intermediation and the macro-economy. In light of this, I'm looking forward to the discussion of the new coherence and calibration task force launched by the Basel Committee.

It is important to finalise the rules currently in the pipeline. But once this is finalised, we need to ensure the right communication with banks and tell market participants that additional prudential regulations will not be introduced for some time. The Basel Committee's review of financial regulation in response to the crisis has lasted more than seven years, and I think it is now important to eliminate regulatory uncertainty and create an environment where banks find it easier to plan and execute more dynamic business strategies.

Some banks are already retreating from some business lines, of course, citing regulatory pressure. Have the rules gone too far in some cases?

HN: That's why I mentioned the fact that further assessments are essential. Issues including any redundancy in regulation or unintended consequences will be addressed by the task force.

Do you worry about Japanese banks stepping into the gaps left by retreating global banks?

HN: I think it's true some European and US banks were hit quite significantly by the global financial crisis and have retreated from some of the global markets, which has led to the increasing presence of Japanese banks, as they were less affected during the crisis. But I also think Japanese banks' strategy is logical given the fact that the Asia-Pacific economic region has a very high growth potential. That leads to a lot of business opportunities for Japanese banks.

I must also stress that our QE policy has encouraged Japanese banks to pursue a portfolio rebalancing and take on more risk, which includes lending in Japanese currencies but also building up portfolios of assets denominated in foreign currencies.

Against this background, it is essential for Japanese banks to ensure a higher level of soundness, to survive stressed market conditions, as well as higher management capabilities – they need the capacity to accurately grasp risks on a global basis in a timely manner and take into account the findings in their business strategy.

From this perspective, I think Japanese banks have already taken practical steps. But they still have a few issues to address. One example would be the share of assets denominated in foreign currencies compared with the volume of total assets they hold. In this regard, it's important for them to ensure funding of foreign currencies. And we recognise that building up stable funding bases in foreign currencies has become a priority for Japanese banks. On our side, we will monitor very closely banks' liquidity positions – including those denominated in foreign currencies.

Which foreign currency funding sources are Japanese banks turning to?

HN: They can rely on market funding, so dollar funding liquidity in the US interbank market, or they can issue commercial papers or bonds. Alternatively, they can use foreign exchange swaps contracts. But market-based funding is obviously sensitive to market conditions. It is fine to be somewhat dependent on market instruments but, at the same time, they must have very stable funding sources. Deposits are probably the most stable source they can get.

People have talked a lot in recent years about the threat of Japanification in Europe – meaning persistent deflation, sluggish economic growth, a long period of stagnation. Are there any lessons Europe could learn from Japan?

HN: The reasons we were entrapped in a deflationary equilibrium are two-fold. First, the banking crisis prevented banks from supporting the real economy. I think this in part explains the so-called lost decades. The second reason is the demographics. Japan faces a situation where the labour force declines at a higher pace than the entire declining population because of the retiring baby boom generation. As a result, the growth potential has come from around 4% at the end of 1990s to slightly below 0.5% now.

The BoJ has tried very hard to get out of this deflationary equilibrium with a limited outcome until we embarked on QE, which is producing encouraging results.

So, several lessons could be learnt from the Japanese experience. First, once you are trapped in a deflationary equilibrium, it will be very hard to escape. To be a bit more specific, although the inflation expectation in the euro area seems perfectly anchored, if the inflation rate remains too low for too long, inflation expectations will also come down as a result. This is a situation you should avoid.

The second point is that even though the BoJ tried many solutions, we were haunted by the perception that we were an inflation fighter but not a deflation fighter. You need to be perceived as both.

And of course, more fundamentally, you should definitely avoid a banking crisis.

Having said that, I think authorities in the euro area have done a good job so far. The banking crisis has been avoided thanks to the introduction of the Single Supervisory Mechanism, which is now operational and is making good progress. And in terms of monetary policy, the European Central Bank has embarked on a very aggressive QE policy. So they seem to have learnt the lessons and that is reflected in their responses.