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. http://www.forexfraud.com
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