Is the Bank of Japan Barreling toward a Bailout?

Its spending spree could make the unthinkable a reality

How bad are things in Japan? So bad there's serious apprehension that the Bank of Japan might need a government bailout. Sure, central banks normally can't run out of money, because they own their currency's printing presses. But the BOJ is a special case. To enable the bank to play its role as lender of last resort for both Japan's central government and its rickety commercial-banking system, BOJ Governor Masaru Hayami's Policy Board reluctantly launched an enormous spending spree that could someday burn a very big hole in the bank's balance sheet.

Since 1997, the central bank's outright purchases--as opposed to repurchase agreements--of Japanese government bonds have exploded, to a cumulative total of $471 billion. To keep the money markets flush with cash, the bank now devours some $10 billion in bonds a month on the secondary market. At that rate, it'll absorb about 40% of all new Japanese government bond issuance in 2003. On top of that, it announced plans last year to buy as much as $17 billion worth of stocks from commercial banks, which need to sell off their corporate shares to raise cash.

Now the central bank is under intense pressure from the ruling Liberal Democratic Party and its allies in the Finance Ministry to buy more stocks, plus corporate bonds, and even real estate. Insiders worry about the huge growth in the bank's potential liabilities. Policy Board member Shin Nakahara insists: "There should be a limit to the bank's discretionary purchase of such risky assets."

The bank has already crossed a dangerous line. It has to maintain capital adequacy ratios just like other financial institutions. For the fiscal half-year period ended last September, it didn't: Because Japanese pulled so much yen out of the banking system, the ratio fell below its minimum target of 8%, to 7.6%, for the first time in 12 years.

Hayami, 77, successfully resisted pressure to hit the accelerator on the bank's bond purchases at a two-day central bank meeting beginning on Jan. 21. But his term expires in March, and things could get really radical then. Prime Minister Junichiro Koizumi could tap a maverick--someone who'll make an aggressive effort to counter Japan's spiral of deflation by buying up everything in sight. Morgan Stanley analyst Takehiro Sato says that under such an "anything goes" monetary policy, the central bank could seek to relieve the debt burden of banks and corporations by adding more stocks, corporate bonds, and real estate to its portfolio. The idea would be not only to halt deflation but generate inflationary expectations that would give companies pricing power and prompt consumers to start spending again.

Concerned staffers see a grave situation if the central bank takes on risky assets and they plunge in value. Already, they point out, the bank's holdings--including government securities, gold, cash, overseas currencies, and foreign bonds--add up to $1.05 trillion. That's 60% more than the assets of the U.S. Federal Reserve.

Optimists point out that prices for the benchmark 10-year Japanese government bond have been holding steady thanks to healthy demand. In any event, says Nikko Salomon Smith Barney economist Jeffrey D. Young, a weak balance sheet is the last thing the timid souls at the central bank should be worrying about. "Remember, their mandate is price stability," he says. That means keeping prices from cratering, even if the bank has to lift the rule limiting its total bond portfolio to the value of bank notes in circulation, about $600 billion.

Skeptics counter that more massive central bank bond purchases could set the stage for a bubble that would drive prices skyward--until investors, worried that the bank had lost all discipline, panic and hit the sell button, sending prices crashing. One official notes that just a 10% fall in the value of the central bank's bond portfolio would wipe out close to $42 billion in reserve capital.

If things really spin out of control, the central bank at some point might have to turn to the government, which holds a 55% stake, for a capital infusion. That would be humiliating for a rich country such as Japan. More important, such a bailout could forever undercut the bank's independence. Watch out, Mr. Koizumi: A central bank's credibility is one asset that's irreplaceable.

By Brian Bremner in Tokyo

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