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Wednesday, December 16, 2020
Implications of the BOJ's Intervention in Securities Markets
ANBOUND

In recent years, low interest rates, quantitative easing(QE), and fiscal stimulus since the COVID-19 pandemic have all been, to some extent, examples of the policy preference of major countries for modern monetary theory (MMT). Considering that the conventional fiscal and monetary theories are basically unable to effectively deal with the current government debt problem, MMT provides an alternative theory to maintain debt, which is its core advantage that has gained wide attention in recent years. However, the conventional MMT theory lacks both the systematic theory of "generating money" and the practical theory of "collecting money", and there is only the theory of "raising tax rates". In reality, due to the high cost and insufficient flexibility of tax system adjustment, the so-called "flexible tax adjustment" policy proposal is difficult to be realized. In this context, the recent emergence of the Bank of Japan as the largest shareholder in the Japanese stock market may provide new insight into MMT theory in the future.

To be specific, the conventional MMT theory does not provide a practical approach when it comes to the operation of money transfers. Despite the subversive nature of the theory, in practice (or hypothetically), national policy authorities still rely on the basic chain of "government -- bank -- other departments" to regulate the money supply through macro policies. On the other hand, this mode of indirectly regulating the money supply is gradually showing its drawbacks. For instance, the disparity in yields, risks, and other attributes between industries and sectors has led to the government being unable to successfully deliver the desired support to the respective industry or sector in many cases. The severe bubble in the stock markets brought about by global monetary loosening since the pandemic is one of the strong evidences. This is in fact the main reason why opponents of MMT are not convinced by the theory.

In the face of the failure of old policies, governments are considering new policy tools. But as we have repeatedly emphasized, the theory and practice of MMT are at an "experimental stage", with few governments even admitting they are adopting MMT. In this case, the high traceability of digital currency and its restraint on the power of the central bank might be a practical direction of MMT in the future, though the idea certainly needs more scrutiny.

On the other hand, the Bank of Japan's recent operations in capital markets may offer some new insights, i.e., the central bank's direct access to the capital markets and its "targeted support" through micro-level economic behavior. This is a kind of "government-sector" approach to monetary regulation, which considers the government to skip financial institutions, invest money directly in the respective sectors and recover the excess supply of money through dividend and profit-making behavior in the market. Specifically, since 2010, the Bank of Japan's equity purchase program has been buying risky assets including corporate bonds, equity ETFs and REITS in order to steer long-term interest rates and lower the risk premiums, while ensuring that "zero interest rates will be maintained until price targets are achieved". In terms of equity selection, the Bank of Japan initially chose to purchase ETFs that tracked the Tokyo Stock Price Index (TOPIX) or the Nikkei 225 index, and has since broadened the portfolio's tracking range. Although the bank engaged in trust business is still appointed as trustee, it should be pointed out that in the whole process, the bank will no longer choose who to disburse the funds to, but only acts as an intermediary. This ensures that the process of money supply does not revert to the old approach of "government - banks - other sectors". As a result, the ETF purchase program has indeed had the effect of controlling risk appetite and boosting asset prices. Although it has still not been effective in advancing the inflation target in this way, according to a number of studies, inflation figures would only get more severe without the measure.

The question, then, is whether this model of central bank's direct access to capital markets (let's call it version 1.5) is feasible? How is it different from the "macro policy adjustment (version 1.0)" model originally proposed?

First of all, the main problems of the conventional "macro policy adjustment" model can be roughly summarized into the following categories:

  1. The classification of "public sector" vs "private sector" is too general. Only when the money supply flows into specific industries can it boost economic productivity and reduce the financial risks brought by inflation to a certain extent. It is difficult to achieve with the conventional model, as capital is always profit-seeking and the highly profitable industries are often not the target industries for MMT.
  2. Tax regulation is not feasible in reality, and it tends to suffer from a certain lagging due to the logical nature of its macro policies. On top of that, the 1.5 version of the MMT model effectively allows the central bank to be both a rule-maker and a player, and in an ideal world, it might solve many problems.
  3. To a certain extent, "targeted support" can be realized. Due to the "shareholder status" of the central bank, the central bank also has a clearer grasp of the use of funds by enterprises.

In addition, the direct access of the central bank to the stock market can boost the valuation of the stock market and provide a relatively stable income expectation for stock investors, which can further attract foreign capital. In addition, retail investors can also, to a certain extent, increase their expected income and thus promote consumption.

On the other side of the "recycling" currency issue, this approach differs from the rigid tax system, as the share of shares purchased by the Bank of Japan gradually increases, and the precise recycling of the currency by participating in corporate operations and adjusting the ratio of annual dividends sounds, at least, more realistic than the "flexible adjustment of tax rates".

In addition, it appears that the central bank, rather than the treasury department, has chosen to implement this measure, is largely due to a huge debt burden that will be difficult to resolve in the short term. Sharing part of the fiscal responsibility by the central bank is a "flexible adjustment" model based on objective conditions. As the world faces a debt crisis, considering that this model will not further increase the financial debt pressure, it has a certain reference value.

The problem, however, is that this is a "thought experiment" in an ideal situation, and the reality is that it would be undoubtedly much more complex in practice. It is worth noting that the central bank's role will also change in this new model based on the MMT framework. The central bank will become both a rule-maker and a player, which is highly susceptible to rent-seeking and corruption. In reality, it is somewhat unrealistic to expect the central bank to play both roles at the same time. Moreover, it could be seen as a new "planned economy", where the academic debate on the advantages and disadvantages of planned economy versus the market is already well established. In this model, the institutional constraints that prevent the new mixed mode from transforming into a planned economy have actually been broken. This likewise will give rise to a variety of problems.

Taken together, the phenomenon of "direct central bank participation in the capital market" undoubtedly deserves continuous observation. We do not know whether the Bank of Japan's economists are really deliberately forging a new path, but it seems that a vague outline of both opportunities and challenges has been observed.

Looking back to China, we can see that even though China still has relatively sufficient room for interest rate adjustment, there is also a problem of out of control of incremental funds, as evidenced by the diversion of credit discount funds into real estate investment in Shenzhen and other places at the beginning of this year. In the face of this "out-of-order reinvestment" problem, it has to be put on the agenda to cultivate a more efficient investment path to boost effective demand. The stock market, with its low capital barrier and abundant liquidity, is a good financial market alternative to the property market, which has a high capital barrier, and prone to severe bubble and severe shortage of liquidity. At the same time, the government's direct purchase of shares will at least bring stable expectations of capital inflows into the stock market, and for the Chinese stock market, which is currently characterized by a "capital market" and a "policy market", such a clear policy direction and stable expectations will further enhance the attractiveness to domestic and foreign investors, providing continued support to the capital market and thus stabilizing the economy. In addition, in the face of the huge government debt problems, it is difficult for the treasury department to completely ignore the debt burden and continue to raise debt before the national policy system is fully implemented in an MMT framework. Thus, while having the central bank intervening in the stock market may mean a reduction in the traditional sense of central bank independence, whether it is important to uphold the strong independence of the central bank under the new system, or to maintain economic stability at a lower cost, may require further scrutiny.

Final analysis conclusion:

Faced with the obvious "disorderly reinvestment" problem, China needs to foster a more efficient investment path to boost effective demand. Given the huge local debt burden, it is about time for the central bank to step in to provide stable funding expectations in the securities market.

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