Bank of Japan – Understanding BoJ Policy

Along with the European Central Bank (ECB), and the United States Federal Reserve, the Bank of Japan is one of the most important central banks in the world. Due to its long-time role as the source of the cheapest funding available to financial actors, it has been at the origin of stock and forex market trends for about a decade, and its interest rate policy is one of the fundamental building blocks of the carry trade with wide-reaching implications for the global economy.

Japan is one of the richest nations in the world, with a per capita income of around $34000 on a purchasing parity basis, and a GDP of $4.354 trillion. Japan is also one of the largest exporters in the world, with close to $700 in export volume in 2007. The Japanese economy runs a large trade surplus with the rest of the world. On the other hand, the domestic Japanese economy has been growing at a very sluggish pace, if at all, since the collapse of a massive stock market and real estate bubble at the end of the 1980s, and as such, public deficit is maintained at approximately 170% of GDP, a very high level even among developing nations, after many government efforts at boosting economic activity through public spending.. As the central bank of such a large, if somewhat sluggish, and inefficient economy, the Bank of Japan plays an extremely important role in the global financial markets.

In this text we’ll examine the history of the BoJ, its role in global financial markets, its structure, and the way it formulates its interest rate policies. We will also take a brief look at the various research papers and reports released by the institution, and discuss how they can be utilized for the formulation of fundamental strategies.

Background

Before the Meiji Restoration which brought the social and economic concepts of Western civilization to Japan, each of the feudal courts had their own institutions and issued their own currencies. As part of the reforms initiated in the Meiji Era, the yen was introduced as the new national currency by the New Currency Act in 1871, and then, in 1882, the Bank of Japan was established.

The bank issued its first banknotes in 1885, and in 1897 joined the gold standard. During the first half of the 20th century, the Bank of Japan was run in close cooperation with the government, and was tasked with running monetary policy in alignment with Japan’s wartime goals, especially during the Second World War. In response, the occupational authority of the time suspended the actions of the bank for a while, issuing currency and directing the economic affairs of the nation until the Bank of Japan was revived under a more independent system as the main authority responsible for economic stability.

The Bank of Japan experienced a series of very important reforms in 1970s, in response to the oil shock, and the collapse of pegs around the world. The reforms reestablished the yen as a currency with a floating exchange regime, and placed the Bank of Japan as the main authority performing interventions. The Policy board was established as the highest decision making body of the bank in 1949, alongside other reforms initiated by the occupation forces.

In line with a worldwide move towards more independency for central banks (the Bank of England acquired operational independence at about the same time), the Bank of Japan was granted independency in policies and decisions as part of the thorough 1997 revision of the 1942 Bank of Japan Act.

Still, in line with the general style of government in Japan, the Bank of Japan itself is hardly an independent institution in the manner that most Western central banks are. Although the central bank elects its own chief (unlike the situation in the U.S. and the E.U.) the government’s wishes and expectations play an important role in deciding who is the eventual winner in the process. In addition, the regular operations of the bank are also run in close cooperation with the government. Indeed, although the bank is independent, the Bank of Japan Act requires it to act in harmony with the government towards the goal of realizing national goals.

The Bank of Japan has been criticized for lacking decisiveness in the aftermath of the bursting of the 90s asset bubble. The bank raised rates several times in an environment of contracting credit and severe financial turmoil which is often argued to have worsened Japan’s difficulties by analysts and economists, including Ben Bernanke. In order to counter the effects of the ensuing depression, the Bank of Japan has been maintaining a zero interest rate policy since 1998, and while the rate has been raised slightly before the 2007-2009 financial crisis, it is still maintained at a level very close to zero.

The Policy Board

The Policy Board is the equivalent of the Governing Council of the ECB, the Board of Governors of the U.S. Federal Reserve, and the Monetary Policy Committee of the Bank of England. The board has nine members, including the Bank of Japan Governor, his two deputies, along with six board members. The chairperson (governor) is elected by board members among themselves. Decisions are taken by a majority vote.

The duties of the board include:

a.setting the discount and loan rates (the main, basic loan&discount rate)
b.Setting out the reserve requirement for banks
c.Conducting open market operations
d.Making loans to financial institutions as needed
e.Initiating transactions with other central banks, and buying and selling foreign exchange in the forex market (currency interventions)

Monetary Policy

According to Article 2 of the Bank of Japan Act, the aim of monetary policy is “achieving price stability, thereby contributing to the sound development of the national economy.”

Towards that purpose, the central bank determines the basic discount rate which is the equivalent of the U.K. bank rate, and the discount rate of the Federal Reserve in the United States. This rate establishes an upper limit on the uncollateralized overnight call rate, since banks can always turn to the central bank at this rate in case that they are unable to acquire cheaper funding in the interbank market. The basic discount rate was called the official discount rate before 2006.

Both the Bank of Japan Act, and the Bank’s official statements claim that the Bank of Japan is focusing on price stability as its main objective, however, as a major exporter, Japan has always attached great importance to exchange rate management, and while the yen is a floating currency, the authorities do not shrink from intervening in the forex market to steer the market in the desired direction.

Open Market Operations

The Bank of Japan conducts open market operations for ensuring market stability and keeping the overnight call rate close to its basic discount rate communicated at successive meetings. In order to absorb liquidity from the market, the bank either sells Japanese government Securities (JGS), or bills (JGBs) outright, or conducts various repurchasing agreement transactions on them. Similarly, to increase the amount of liquidity, the Bank can buy JGBs or JGS. Buy arranging these transactions, and making direct loans to major financial institutions the BoJ maintains the overnight rate close to its declared target.

The overnight uncollateralized call market is the main market for banks that need to increase their current account balances(in other words, the funds they hold as reserves) with the central bank. It is called the call rate because banks would traditionally make phone calls to each other to obtain funds, and it is still the preferred method for many institutions. The transactions between banks for the maintenance of the current account balance usually have a short maturity term, and are uncollateralized. Changes in the current account balance of banks can result from anything from deposit withdrawals by individuals, to payments and receipts from other firms and the government. Although banks can borrow the central bank itself, this is often costlier, and borrowing in the interbank market at a rate lower than the overnight call rate is the usual way for ensuring that banks are able to meet their obligations to their counterparties under normal circumstances.

Since 1998, the Bank of Japan also operates a commercial paper purchase facility to ensure the availability of liquidity and smooth operation in this market.

Anatomy of BoJ Foreign Exchange Interventions

The Ministry of Finance is the authority tasked with conducting currency interventions in Japan, and it performs this task in cooperation with the Bank of Japan. Most of the time, the Bank of Japan conducts foreign exchange operations during Tokyo market hours (between 7 pm, and 3 am New York time), however if the initial intervention does not produce the intended goals, or if further interventions are deemed necessary to better communicate the Bank of Japan’s determination, the Bank will conduct intervention through the intermediation of European Central Bank in the early hours of the morning, in a mechanism termed “entrustment intervention”. Although the request is communicated by the BoJ, both the final decision to intervene and the details of the intervention are determined by the Ministry of Finance. The funds used in the intervention process are sourced from the Foreign Exchange Special Account.

In the rare cases where foreign central banks desire to conduct interventions in Japan, the Bank of Japan will conduct the intervention on their behalf in a process called “reverse-entrustment intervention.

The technical details of the intervention are planned and implemented by the Bank of Japan Forex division, and the Planning and Coordination Division of the International Department.

The BoJ Forex Division is the analytical department of the bank in all issues related to foreign exchange markets. The Division constantly monitors developments in international markets, through public channels, as well as private communication and proprietary tools. The Forex Division then passes all the gained information to the relevant departments of the Ministry of Finance and the Policy Board of the Bank of Japan.

In the cases where movements in the foreign exchange market are contrary to the interests of Japan (or as the bank states, FX movements are too volatile), the Ministry of Finance and the Bank contact each other over a hot line, where the central banks provides relevant information to the ministry. Thereafter, the separate forex divisions of the Ministry of Finance and the Bank of Japan conduct negotiations on the time, size, goals, and effectiveness of the intervention, and reach an agreement which is then communicated to the Bank’s dealers. The intervention is thereafter executed through the various stages of bureaucracy and international markets.

Funds used for intervention are obtained from the Foreign Exchange Fund Special Account consisting of forex , and yen funds If the yen is to be sold, the necessary amount is raised by the sale of Financial Bills. If a foreign currency is to be sold, reserves held at the Foreign Exchange Fund Special Account (FEFSA) are used. Funds held in the FEFSA have been accumulated partly through yen selling operations conducted in the past for the purpose of protecting Japan’s exporters. These funds are held in foreign government bonds, are utilized when intervention is necessary.

Importance for Forex Traders

As the central bank of a major industrial nation, the Bank of Japan has a crucial role in maintaining the stability of the forex market, and international markets in general. It is also the key component of many trading strategies in the forex market where interest rate differentials are crucial. The carry trade, for instance, would be a less popular strategy if the interest rates of the BoJ were at ahigher level. While most young traders are unused to Japanese rates being anything but some fraction of one percent, before the Japanese Depression, the official discount rate could be as high as 9 percent, and commonly it was above five percent.

Thus, low rates of the Bank of Japan have always been an important part of the modern financial world. The Bank of Japan maintains them for the purpose of preventing even deeper deflation and possible economic contraction in Japan.

Apart from the low rates, the BoJ is also significant for its intervention policies, and its frequent sales of the yen for the purpose of propping up Japanese exporters who are often the main source of dynamism for the Japanese economy in the absence of any domestic vigor. Japanese interventions were much more common in the earlier part of this decade. But perhaps in an effort to give American attempts to force the Chinese to float the yuan greater credibility, the Japanese have toned down their interventions considerably in recent years.

Conclusion

The Bank of Japan is like a sleeping elephant for forex traders. It is big, bulky and powerful, with massive amounts of reserves backing its decisions, but its room for maneuver is constrained by domestic and external factors. In the past it could cause a carry trade crash by raising rates, yet domestic sluggishness, and brief periods of deflation prevented it from doing so. It could also help the Japanese economy get out of its stupor by selling the yen and helping out exporters, but political reasons prevent it from being very active in this field as well. As of 2009, there is little sign that any of these factors will undergo great changes in the medium term. The Bank of Japan has great potential for causing major changes, but little interest in doing so.

Chris Lee

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