It is December 2020 and the Bank of Japan is now the single biggest shareholder of Japanese stocks.
Over the span of a decade, the central bank bought hundreds
of billions of dollars in Tokyo-listed stock ETFs
as part of its monetary easing programs, sitting on a handsome $130 billion profit.
You might be forgiven for wondering if it is normal for a central bank to buy "stonks".
It has never been done before in this way. Yet as Japan threatened to enter
another era of economic stagnation and deflation,
the bank decided to go where no bank has gone before in an effort to fight the future.
In this video, I want to dive into a controversial, groundbreaking program
and the market-distorting effects that it has wrought on the world's third largest economy.
In 1985, Japan and four other countries signed the Plaza Accord.
This agreement depreciated the United States Dollar against the Japanese Yen
and the German Deutsche Mark in an effort to improve the competitiveness of American exports.
Over the next two years after its signing, the dollar lost 51% of its value against the yen.
Japan entered the Plaza Accord to avoid having its goods tariffed and locked
out of the American market. America faced domestic political pressure to do something
about its exchange rates and to reduce the trade deficit. For what it is worth,
the Japanese-American trade deficit continues to this day so it is not like the Americans
got what they wanted. But in Japan, the accord nevertheless had significant effects.
The Yen's appreciation plunged the Japanese manufacturing sector into recession. In response
to this, the Bank of Japan loosened monetary lending policies and lowered interest rates.
This cheap money was supposed to be funneled into productive efforts like
building factories and the like. Instead, it went into stock, real estate, and asset speculation.
This is when Japanese real estate and stocks reached their peak price level. When prices in
central Tokyo were such that the Tokyo Imperial Palace was valued to be worth more than all the
property in California. When Japanese bought Pebble Beach, a golf club, for $850 million.
The bubble popped hard in early 1990s when the Bank of Japan
tightened lending regulations and monetary policy.
Banks were left with over 90 trillion yen worth of terrible non-performant loans.
What came next is generally referred to as the "Lost Decade". A period of time
from 1991 to 2010 where average real growth was barely above 1%.
Japan entered a long period of economic stagnation.
We are not going to dive into all of the effects of the Lost Decade and how to get
out of it. There are more than enough theories. But in general what we should come to understand
is that the government racked up debt trying to stimulate the economy, with little effect.
In 1998, the Bank of Japan received formal independence from the government
in conducting monetary policy. In response to the economy's consistent refusal to grow,
policy got increasingly ... creative.
In the 2000s, the Bank of Japan began what is known as "quantitative easing". The bank
would directly purchase Japanese bonds of various maturities to raise bond prices and lower yields.
They targeted an interest rate of zero. The policy lasted for a few years.
The effects of this work are well studied but have not come to a general conclusion
as to whether or not it “helped”. They do seem to agree that QE lowered
lending costs and interest rates for banks, spurring them to lend more.
But the quality of the borrowers was debatable and tend to be riskier than
most. America too would do a few rounds of QE later in the decade with similar controversy.
In 2010, the Bank of Japan expanded this QE program to include corporate bonds and
longer-duration financial assets. Rates in the short term had already gone to zero and
the benefits of buying more Japanese government bonds were minimal. Thus for the first time, the
Bank of Japan began to buy corporate stocks and REITs as part of its quantitative easing program.
So what is the central bank's intention in purchasing stocks? With this new program,
the BOJ hoped to stimulate "risk-taking" amongst people and firms.
Only 10% of Japanese people at the time held stocks as compared to 36% in the US
and 18% in the Eurozone. The majority of Japanese literally just own cash and bonds. If they were to
own stocks and see the value of those stocks rise, then they can feel richer and be more
willing to spend. Their increased spending equals increased income within the Japanese economy.
On the corporate side, Japanese companies are famously conservative.
Having the central bank buy their stock would in theory make it cheaper to raise capital.
Cheaper capital theoretically would spur them on to do and invest more.
Central banks have bought stocks before, but only as a measure of financial stability.
For instance, the Bank of Japan bought stocks from failing banks twice during financial crises
in 2002 and 2009 to shore up their cash reserves and keep them from insolvency.
And the Hong Kong Monetary Authority purchased $17
billion worth of Hong Kong stocks and bonds during the 1998 Financial Crisis.
I recounted this event in my video about Hong Kong and George Soros.
Go check it out. After the crisis had passed, the HKMA
sold the stocks it bought to private investors, doubling its investment.
Those two precedents are modest compared to what was coming up next. No bank has ever bought stocks
in volume to try and stimulate the economy. The Bank of Japan was about to get weird with it.
At first, the plan capped out at about 450 billion yen worth of stock purchases and
was to end in December 2011. That is about $4.5 billion USD. Considering that the total market
capitalization of the Tokyo Stock Exchange is $5.7 trillion, that was just a drop in the bucket￼.
Through 2011 and into 2012, the BOJ increased the cap four-fold to 2.1 trillion yen or about $19
billion. Japanese government bond yields fell. But the Yen continued to appreciate in value as
compared to the US Dollar, reaching an exchange rate of 80 yen to the dollar. This is despite a
series of currency market interventions by central banks and the Ministry of Finance.
This stronger yen counterbalanced the looser monetary effects brought on by lower bond yields.
It made Japanese exports more expensive, hurting manufacturers in this export-heavy economy.
Mild deflation continued and the prospect of 2% inflation seemed a dream.
In December 2012, Shinzo Abe won election as Japan's prime minster. As part of his campaign
promises, Abe would put up $120 billion worth of emergency stimulus spending and
force the BOJ to perform unprecedented monetary moves to fight deflation and weaken the yen.
After his win, the Yen quickly deflated in value, falling from 84 yen to the dollar in December 2012
to 95 in March 2013. Stock prices began to rise in anticipation of big changes afoot.
In April 2013, Abe appointed Haruhiko Kuroda as the governor of the BOJ. Kuroda was tasked
with carrying out the monetary aspects of Abe's economic policy, nicknamed Abenomics.
Kuroda came through and announced the QQE policy - Quantitative and Qualitative
Monetary Easing policy. The goal would be to go where no bank has ever gone before:
To reduce the price of risk across all assets,
lower interest rates in the long term, and stimulate the people into buying more.
The BOJ would do this by expanding the economy's entire monetary base in the amount
of 60-70 trillion yen annually. That is $540-630 billion USD, injected into the economy each year.
Abenomics did show some promise early on. Inflation spiked from 2013 into 2014.
But the decade also saw disruptions that struck at the economy’s health.
For instance in 2014, the Japanese government raised a consumption tax from 5%
to 8% and that significantly impacted the economy. In response, the BOJ bought yet
more bonds and tripled its buying of ETFs. Abe had to delay a second tax hike to 2019.
Four years into the policy, the bank’s purchases were warping the stock market on the whole.
Such distortions forced it to more specifically target
its purchases. They diversified from the Nikkei 225, adding the Nikkei 400, the Topix,
and then ETFs tracking companies making “investments in physical and human capital”.
The intention was to reward companies making suitable investments for growth. Examples include
the Nomura Enterprise Value Allocation and the Daiwa MSCI Japan Human & Physical Investment ETF.
The companies in these ETFs are some of Japan's biggest and most
prominent companies. They include Toyota, Nintendo, Tokyo Electron, and FANUC.
Going into 2020, the BOJ had 40 trillion yen or $360 billion of stocks on their balance sheet.
The Bank's holdings accounted for over 5% of the country's entire stock market.
For one out of every two Tokyo-listed companies,
the BOJ was a top 10 shareholder. It was Fanuc's biggest shareholder.
And then came the pandemic and everything went crazy after that.
Direct stimulus from governments all over the world fueled the Nikkei 225 to new heights.
In response to the economic crisis from the virus, the BOJ raised the ETF purchases' ceiling yet
again to a theoretical limit of 12 trillion yen, or $112 billion. For what it is worth,
they fell short of that ceiling in 2020 - buying only 7.1 trillion yen or $64 billion worth.
The program has yet to formally end but it does seem to be slowing down.
The BOJ seems to be at the very least fine-tuning. With that being said,
in March 2021 the BOJ purchased nearly 300 billion yen or 2.7 billion USD worth of ETFs.
So you are probably looking for an answer to the big question:
Did it work? Did people feel richer? Did companies invest more? Did it help the economy?
The reality is that evaluating policy is complicated.
Especially one that lasted ten years across a number of business cycles.
Japan has a 100 million people and the third biggest economy in the world. It's complicated.
Let us start with the most desired effect:
Inflation. Looking at inflation from 2011 to 2019 short of the pandemic,
it looks like the economy saw more inflation than deflation during the ten year period.
Real GDP growth over the same time period is also kind of heartening. If you throw out the
pandemic years of late 2019 and 2020 then you can see that the Japanese economy grew.
And if you chart the ETF purchases against the stock return of the Nikkei 225,
it seems to be that the purchases helped grow and prop up the market's returns over the past
few years. Stock prices went up. Presumably, some Japanese stock holders got richer.
Furthermore, the 2010s saw challenging global economic conditions in the US and the Eurozone.
That as well as the aforementioned consumption tax hike in 2014 could have caused real,
permanent damage to the Japanese economy. And of course, we can’t forget about the pandemic.
One can argue that were it not for the BOJ's unprecedented monetary actions,
things could have ended up much worse. To have shown even this tiny bit of growth
throughout this tricky time period, you might see this as an absolute win.
But now we need to look at the drawbacks and
the cost of nearly a decade of your central bank going YOLO on stocks.
Is it okay that the Bank of Japan is the country’s single biggest corporate stock holder?
There are a few problems associated with this activity that we can foresee.
Actually, more than a few. I got five. Sit down because this is going to be a long one.
First has to do with corporate governance. Japanese companies are not exactly known for
taking care of their shareholders. There is a lack of transparency on how the business is being run
and shareholder money is spent. Shareholders have few ways to replace management when things are
not being run well. Management compensation is less tied to how well the stock performs.
The Bank of Japan, despite being the single biggest holder of Japanese stocks,
does not currently exercise its voter rights. On one hand, that reinforces management's power over
the company. But what if it were to decide that it wanted to? We criticize the Communist Party of
China for getting deeply involved in the workings of private companies. Would this not be similar?
Second is the problem of price discovery, a criticism more generally tied to the idea of ETFs.
As ETFs have grown more popular amongst investors,
there comes the risk of "freezing" the relative valuations of a country's biggest companies.
The ETF's basket of stocks is determined by an index, generally ranked by market size but not
always. So as more ETFs are created, more of the biggest stocks get bought - simply because
they are already big or in a specific index. This creates market distortions.
For example, Fast Retailing, the company behind Uniqlo, is over-represented on the Nikkei 225
as compared to the TOPIX with an 11% weight. The BOJ's purchases of the Nikkei 225 turned
the clothing company, which only made $18 billion USD in 2020, into a $80B giant.
Its founder Tadashi Yanai is Japan's richest man with a $40 billion fortune.
When the BOJ announced that it would phase out purchasing Nikkei 225 ETFs
for the TOPIX in March 2021, Fast Retailing lost 6% of its value.
The third problem is: What is the Bank of Japan going to do with all of its stocks? Are they going
to hold them forever? If they sell, are they going to take down the whole market with them?
The anticipation of ETF sales down the line likely dampens the effects of buying them in the first
place. Sure you might feel richer right now, but all that wealth is just on paper right now. Thus
far, the Bank has not announced anything with regards to its future plans for those ETFs.
Fourth! I talked about the very weak inflation and economic growth. What if it wasn’t because
of the stock buying? Studies of the policy up to 2019 find that Japanese publicly listed companies
neither spend more on R&D nor grew their sales because the Bank bought their stocks.
In fact, the price to earnings ratio of the index
actually declined throughout the time period despite the higher stock prices.
One can argue that the market was more out of favor entering 2019 than it was in 2011.
Shares jumped a whole lot in 2020 and 2021 but it is more likely that jump was due to
worldwide stimulus packages. Every stock, bond, crypto, whatever went up in 2020.
Public companies did sell shares into the stock market to take advantage of the favorable stock
environment. But they opted to just keep the cash on their books - saving for a rainy day.
Last but most concerning. I did a video about Taiwan's low labor wages. People yelled at me.
Well, Japan has a similar problem too. As befitting an economy that sputtered
through the last ten years, wages and incomes have stagnated. Today's Japanese
workers make less than they did 30 years ago. Monetary easing likely worsens this effect.
I wish I can talk more on this, but that is for another video. But I wanted to at least
mention it. We focus so much on companies that we forget about the people. We should not.
The Bank of Japan's actions and results should be studied because it foretells what other central
banks might do in the near future. The BOJ ran quantitative easing during the early 2000s.
The Federal Reserve and other central banks did it in 2008 during the Global Financial Crisis.
And then in May 2020, the Federal Reserve took another step towards what the Bank of Japan did.
They started buying ETFs too. But not of stocks. Of corporate bonds. Bonds relating to downgraded
companies suffering from the pandemic. It was the first time the American central bank has
ever done this. And if you ask me, corporate bonds are not that far away from stocks.
The Japanese and American economies are very different from each other. So what might work
for one country might not work for another. For Japan, this stock buying spree seems to have
had a limited effect on the country's actual economic prospects. There was something but
it did not last very long. The USA should think about that when considering its next action step.