BOJ Reserve Payments Threaten to Break Bank in QE Exit Scenarios

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The Bank of Japan is flagging a source of losses as it plots an exit from bond-buying stimulus: a surge in the interest it pays banks for their reserves.

Deputy Governor Kikuo Iwata said last week that there is potential for those payments to exceed income on the central bank’s bond holdings as it exits from quantitative easing. If the interest rate on reserves is raised to 2 percent from 0.1 percent, matching the BOJ inflation target, the cost could swell to as much as 8 trillion yen ($64 billion) annually by the end of 2017, according to Barclays Plc. That could swallow the bank’s capital base and require a taxpayer bailout, it said.

The BOJ is the biggest holder of Japanese government bonds with about 26.5 percent of outstanding debt, making selling the notes extremely difficult without unsettling the market. Higher payments on reserves it holds for commercial lenders, which ballooned along with money in circulation, are another risk should the bank achieve its inflation goal and end stimulus.

“The BOJ is going to need to start debating tapering as something completely separate from the question of achieving 2 percent inflation,” said Kyohei Morita, the chief economist in Tokyo at Barclays Plc. “There’s a possibility we’ll see quite a political controversy if taxpayer money is needed to cover any BOJ losses.”

Continued Easing

Stagnation in consumer prices this year has reignited doubts about the BOJ’s ability to foster stable 2 percent inflation by the end of its target period in September 2016, raising the possibility of protracted stimulus or a further expansion of asset purchases. The next policy move is more likely to be an expansion of asset purchases than a tapering, which would be “unthinkable” at this stage, Masahiro Kawai, a professor at the University of Tokyo and one of 10 private-sector advisers to the central bank, said in an interview Tuesday.

Even at the current pace of increasing the monetary base by 80 trillion yen a year, excess reserves would double to 400 trillion yen by the end of 2017, Barclays estimated in an Aug. 7 note to clients.

Iwata told parliament on Aug. 4 that there were risks that interest on excess reserves could exceed yields on the BOJ’s bond holdings -- which reached a record 275 trillion yen as of March 31 -- at the time it ends stimulus. He also said the market value of its exchange-traded funds and real-estate investment trusts could fall below book value. He reiterated that it was too early to discuss an exit.

Financial Stability

“There’s a limit to how much the BOJ can expand its balance sheet, considering that it’s responsible for stability in the financial system in addition to prices,” said Kazuto Doi, Tokyo-based fund manager at Western Asset Management, which oversaw $452.5 billion as of the end of June. “There’s no good exit policy from this unprecedented stimulus.”

The BOJ’s holdings of outstanding JGBs will swell above 54 percent by March 2019, assuming the government boosts total debt by 30 trillion yen a year, according to Western Asset estimates.

An increase in the interest rate on excess reserves would be least disruptive to debt markets, so it’s “generally regarded as the most market-friendly exit strategy,” Barclays said. The deposit rate would need to rise to 2 percent in order to prevent the inflation-adjusted rate from being negative, assuming policy makers achieve their target at the time of exit.

Risks Turmoil

Selling bonds as a way out of stimulus risks much bigger dislocations, the London-based lender said. The central bank’s massive purchases have already sapped liquidity and aggravated market swings, helping drive the 10-year JGB yield to a record-low 0.195 percent this year.

The yield will double to 0.75 percent by the end of next year, analysts predict, from 0.375 percent at 10:30 a.m. Wednesday in Tokyo.

BOJ Governor Haruhiko Kuroda told parliament in May that the central bank’s earnings will face downward pressure during an exit of stimulus, though the bank won’t report valuation losses on its debt holdings even if long-term yields rise, because of the accounting methods it uses.

“The longer the BOJ takes to exit stimulus, the more gigantic its eventual losses will be, even if it builds up capital,” said Noriatsu Tanji, a senior bond strategist at Mizuho Securities Co. in Tokyo.

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