Japan: Free Money? No, Thanks

A plan to pump up the economy via cheap credit has flopped

In a normal financial system, the central bank uses a time-tested technique to keep the right amount of money flowing to the economy. It regularly offers banks cash in the form of short-term loans called repurchase agreements. The banks take the cash, tendering debt securities as collateral, then recycle the funds into loans. The cheaper the money, the better they like it. The system operates seamlessly just about everywhere.

But not in Japan, not anymore. The country is in a deep slump, but its financial system is now so sclerotic that the 30-plus banks, brokerages, and money-market dealers that the Bank of Japan deals with don't want extra cash--even with interest rates near 0%, the BOJ's current overnight call rate. "The ultimate problem is that banks have plenty of funds, and their loan growth has been declining," says HSBC Securities Inc. economist Peter Morgan.

Japan's paradox--that such a rich economy can't grow--isn't new. But until now, few realized the extent of the system's paralysis. The economy keeps deteriorating even while new Prime Minister Junichiro Koizumi cements political backing for his recovery plan.

In the first three weeks of May alone, the central bank failed at least 15 times to hit its $41 billion daily target for banking system reserves during money-market operations, which include outright buying of bonds, short-term treasury bills, and commercial paper as well as repos. The more reserves banks have, the more they can lend. But the banks refuse to tender the securities for the BOJ's cash, making it impossible for the BOJ to build up the system's cash reserves. On May 21, the BOJ sought to swap $2.44 billion for treasury bills and long-term bonds, but only got $513 million worth.

The BOJ has had trouble giving banks cash before in the last three years. What's different now is that it has an official reserve target. When it misses, the problem is obvious. BOJ Governor Masaru Hayami set the target in March when he cut rates back to zero and pledged to halt\ deflation by pumping up the money supply. That meant a robust step-up in repo activity and bond purchases. With credit so cheap, Japanese would start buying again, putting a floor under prices; company profits would start to recover, and companies would invest.

But the banks can't make money from cash. Short-term money-market instruments yield virtually zero. What about lending the cash to companies? Too risky, given the sickly economy. The banks do best by holding onto their government bonds, which, at a yield of 1.25% for the benchmark 10-year issue, are quite valuable.

RADICAL PLAN. So what does the BOJ do now? With prices still falling, it can't drop its pledge to boost liquidity, so Hayami must figure out what the banks will part with in exchange for cash. That means loosening the BOJ's rules on what instruments it will accept. Until May 18, the BOJ took only short-term treasury bills, 10- and 20-year bonds, and commercial paper. Then, Hayami's staff said the banks would also take bonds with maturities from two to six years, which yield less and are harder to sell. The BOJ might even pay a premium. One BOJ source says this may do the trick.

Some say the BOJ needs to get radical about deflation. The banks' remaining good loans are getting riskier by the day as the value of collateral falls. Nikko Salomon Smith Barney Ltd. economist Jeffrey Young thinks Japan's bad debt is now $819 billion, not the official $500 billion estimate. And restructuring will put more cheap assets on the market. "It will probably take several years of double-digit growth in the monetary base [1.4% now] to achieve a minimum economic performance" of 1.3% or so, Young says.

The BOJ could seek authorization to buy bonds from the government. But it would be baldly printing money for government IOUs--which could cause a bond-market crash. Besides, Hayami doesn't want the cash to go to the government. Another idea with high-level Finance Ministry support: get the BOJ to buy stock and real estate directly. Extreme? Yes. But it will take extreme remedies to cure Japan's very sick economy.

By Brian Bremner in Tokyo

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