Was that it? Markets’ reaction to the Bank of Japan’s unscheduled monetary policy moves last week in response to the coronavirus outbreak was a swift and highly negative dismissal of the actions taken as inadequate to the challenge posed.
But while the BoJ’s actions were a modest surprise in their timing, the bank’s choice of measures — to increase asset purchases to try to calm markets, and to provide funding for banks to support struggling businesses — was all too predictable, given that already negative policy rates left it limited room for manoeuvre. Equally predictable was the adverse market reaction; the BoJ was not alone in seeing markets shrug off even the most massive interventions.
Now, with the BoJ’s arsenal of monetary policy weapons much depleted, the big question is simple: what next? The reality is that whatever central banks now do, global markets will not regain solid ground until investors can see plausible scenarios for recovery and a path out of the Covid-19 pandemic and its economic fallout. This leaves Japan’s central bank searching for answers.
Still, the BoJ’s action to increase asset-purchasing operations was a necessary step to mitigate market disruption. For many years, financial markets in Japan, especially stock markets, have been spoiled by active central bank intervention aimed at dampening volatility. Without the latest measures, financial conditions would have worsened.
More importantly, a renewed appreciation in the yen has been avoided in this risk-off period. Although the yen/dollar rate is not a direct policy target, it has been the most important parameter for the BoJ’s policy decision for decades. In recent years, big central banks have seen their ability to influence FX rates fade. The impact of monetary policy in the US and Europe is also diminishing as interest rates approach the zero-interest rate bound. Still, the BoJ had to act to avoid perceptions that it was lagging behind other central banks, which could have caused the yen to strengthen.
Meanwhile, the measures taken by big central banks to boost US dollar liquidity globally should offer an effective safety net, backstopping the global financial system. The facilities, which are based on global swap arrangements among the six big central banks, were important in containing market disruption during the global financial crisis.
Dollar funding has been the Achilles heel of Japan’s economy as businesses, facing limited growth prospects at home, have expanded globally. I had worried that the increasingly inward-looking Trump administration might prevent the Fed from meeting its global responsibilities to provide sufficient amounts of the global reserve currency to the rest of the world. But given the desperate worldwide economic situation, the US has no choice but to continue to take global leadership for the time being.
Regarding corporate funding, Japan still needs to do more for small and medium-sized enterprises, especially in regional economies. Coronavirus is hitting these businesses hard, particularly those related to social consumption in crowded areas — recreation and culture, hospitality, transport, clothing and furniture. These sectors have large shares in regional economies that are already stagnating, and make up a significant proportion of Japan’s SMEs.
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The effectiveness of the BoJ’s new Funding for Lending Scheme depends on how actively and generously banks extend loans to troubled firms. Although the BoJ scheme will lessen borrowing costs and ease concerns over liquidity, banks cannot escape the credit risks. They will need to judge precisely whether firms can become viable again after the shock.
This is going to be a particularly challenging task for regional banks. Although special measures to encourage banks to lend to local businesses expired in 2013, regional banks have tried to support vulnerable firms with generous lending. But profitable lending opportunities have been limited. Secular stagnation in regional economies and adverse demographics have hurt the profitability of many SMEs and prospects for recovery are dim. Distinguishing viable businesses from zombie companies will require delicate judgment.
Until recently, Japan’s Financial Services Agency had been pressing regional banks to stop extending loans to zombies. The outbreak of Covid-19 has forced an about turn. Authorities are now pushing banks to support firms with temporary funding problems. Faced with this mixed message, regional banks are likely to extend loans to firms liberally, which will bring some short-term relief to the economy, but could cripple the banks’ profitability over the next couple of years.
The BoJ continues to say it will not hesitate to ease further, but has little ammunition left beyond continued asset purchases. Its latest decision has underscored the difficulty of cutting policy rates further below zero, which would damage the health of regional banks — the very institutions that are needed to support troubled firms. In 2016, the BoJ also learned that negative rates damage public sentiment, which is clearly something to avoid in a time of crisis. But this is 2020, and its options are running out.
Shigeto Nagai is chief Japan economist at Oxford Economics and a former director-general at the Bank of Japan
