The End of Independence: Japan’s Shift to Fiscal Dominance

Neil Dwane | 17/10/2016
nd-japan-editorial

Summary

Japan’s imposition of yield-curve controls marks the moment that monetary policy finally became subservient to government policy. Neil Dwane says “fiscal dominance” is a dangerous successor to financial repression – not just for investors, but for entire economies.

Key takeaways

  • The BOJ’s recent decision to implement yield-curve control opens a new chapter for central-bank monetary policies
  • After QE and NIRP failed to reinvigorate economic growth and inflation, the BOJ is stepping up its efforts by explicitly financing government policies
  • As Japan legislates for pay increases and the BOJ underwrites the expenditures, expect a weaker yen and rising inflation in Japan; this will exacerbate trade tensions and challenge bond investors globally
  • As yields rise and fiscal dominance spreads, the great wealth stored in overvalued bond markets today will erode, and bond markets around the world could reprice lower
  • After peak liquidity, investors may need to position for both higher volatility in currency and bond markets as well as potential losses in fixed-asset portfolios

With its new policy of yield-curve control, the Bank of Japan (BOJ) has begun supplanting financial repression with “fiscal dominance”. Japanese monetary policy will now be subservient to government policy, which will use domestic fiscal measures such as wage controls to create the necessary levels of inflation that have up to now been hard to manufacture.

By choosing yield-curve control instead of what the market expected – helicopter money and infrastructure stimulus – Japan has all but ended the pretence of central-bank independence. If the practice of financing fiscal policy with monetary policy is successful, it will create inflation that erodes capital savings in many bond markets, it will endanger the purchasing power of retirement savings, and it will threaten global trade by raising international tensions as currencies become more volatile again.

If Japan’s new initiative is successful, it will create inflation that erodes capital savings, endangers the purchasing power of retirement savings and threatens global trade

Will the world follow Japan’s lead?

At our recent Investment Forum, AllianzGI’s investment experts extensively discussed whether Europe was confronting the same demographic and economic challenges as Japan did in the 1990s – and making some of the same mistakes. We also discussed the folly of negative interest-rate policies (NIRP) and the confusion they caused; NIRP has not only crushed banking profitability in Japan and Europe and undermined consumer confidence, but it has ironically caused savings levels to rise.

With central banks now dominating many bond markets – the BOJ, for instance, owns approximately 40 per cent of all Japanese government bonds – investors have been corralled into higher-risk and longer-duration bonds, and into bond-like equities with lower volatility. This situation may persist for some time, as there is no sign that any major central banks will be raising rates anytime soon – with the only prospect of monetary policy divergence coming in the form of a rate hike by the US Federal Reserve.

However, the BOJ’s recent changes to monetary policy are worthy of serious reflection: They are a tacit admission that NIRP is not working, and they are proof of Japan’s acceptance that a new policy response is required to avoid a crushing classic recession. Japan’s actions come after six years of central banks justifying their actions as a means of generating the economic growth and inflation needed to resolve the global economy’s excessive levels of debt – which happens to be the essence of our financial repression thesis.

The BOJ’s changes are a tacit admission that NIRP is not working, and proof that Japan knows it needs a new policy response to avoid a crushing recession

Yet yield-curve control moves central-bank policy in a momentous new direction. The BOJ is promising to keep bond yields at their currently low levels – 10-year Japanese government bonds yield zero per cent – while increasing the supply of yen into Japan’s economy until inflation meets or beats the BOJ’s 2 per cent target. This sounds like continued financial repression but in reality it is much, much more. It will allow the Japanese government to fight the labour constraints of its ageing and shrinking population by implementing a "wages policy" that will mandate income and pay increases until inflation rises sufficiently. (Of course, it is notable that even when the yen was much weaker, Japan’s policies failed to create inflation – so pressing are the forces of demographic deflation in Japan.)

The BOJ has raised the stakes in a dangerous game

Far beyond being merely a successor to financial repression, fiscal dominance is in fact more dangerous than its predecessor policy because the BOJ has not actually promised to cap Japanese bond yields; instead, it may in fact allow yields to rise as inflation returns, imposing potential capital losses on bond holders as well. If that happens, fiscal dominance would not only lessen the purchasing power of bonds through inflation but also create drawdowns of capital for an ageing and cautious population of savers.

Far beyond being merely a successor to financial repression, fiscal dominance is in fact more dangerous

Moreover, a weaker yen could reward Japanese exporters just at a time when the political cycle is moving against globalization, possibly toward protectionism. This could sow the seeds of trade wars and retaliation, all of which would further lessen global economic growth and confidence.

With much debate at the Fed’s recent Jackson Hole meeting about the policy responses needed to soften the inevitable US recession, the BOJ has substantially raised the stakes: It will be monetizing its government's financial needs at the expense of the yen. The Fed has admitted that it normally eases interest rates by approximately 5 per cent during a recession, which it cannot do now. As such, it may resort to another significant bout of quantitative easing (QE). For its part, the European Central Bank (ECB) has already begun to reach the limits of its own monetary programs, and it may be forced to taper regardless of its willingness to lessen its support for the economy. Indeed, central banks globally now recognize that the longer QE lasts, the more it distorts markets and economies, and the harder it is to cease.

Ironically, it is still possible for the Fed to implement fiscal dominance as it has in the past, but it will be impossible for the ECB to do so, since that would require even bigger Target 2 balances; at their current level, the ECB is already transferring enormous quantities of funds from strong European members to weaker ones.

Why fiscal dominance matters

Clearly, we are migrating from a world of financial repression – where interest rates are held below stubbornly low inflation rates – to fiscal dominance, where the monetary policy of central banks becomes subservient to the solvency and fiscal requirements of their governments. This is a significant shift for many reasons:

  • If more governments adopt this stance, they will be able to influence inflation with fiscal policy. This would complete the re-politicization of central banks and draw them back into the arms of the governments from whence they were created.
  • Fiscal dominance also pushes central banks further down the road they had been travelling down for years, after their failure to exercise oversight and economic control resulted in two equity market crashes and one enormous financial crisis in 20 years.
  • Fiscal dominance means that Japan’s government will generate enough inflation to ease the distress that has been affecting Japan for the last 25 years. However, as the yen devalues (importing inflation), the BOJ will find itself unable to control interest rates, bond yields and the level of its currency at the same time.

Investment implications

  • As Japan heads down this path, the yen and Japanese government bonds will likely come under pressure. A weaker yen would likely help Japanese exporters, but the overall trend against globalization and free trade may ultimately work against them.
  • Although fiscal dominance is so far limited to Japan, it could have profound implications for investors elsewhere if other governments follow Japan’s lead and ensure that their bonds no longer protect the purchasing power of savers.
  • Whether economies stick with financial repression or tilt toward fiscal dominance, this negative environment may persist for decades. As such, global economic growth will remain slow and low, and investors’ returns will be driven by their appetite for accepting volatility and risk.
  • It continues to be important for investors to pursue alpha with active management, since beta returns are set to be low and volatile, which could undermine cheap index investments. And given the ongoing environment of volatility, investors should continue taking a close look at the risk-mitigation and diversification benefits that alternatives provide.

Although fiscal dominance is so far limited to Japan, it could have profound implications for investors elsewhere if other governments follow Japan’s lead



About fiscal dominance: A central bank’s blank check for its government

When a government forces its central bank to buy its debt, which the bank does by “printing” more currency, it creates a rare situation known as “fiscal dominance”. A government usually takes this extreme step to finance higher spending levels – perhaps with the express goal of manufacturing inflation. The biggest downside of fiscal dominance is that central banks lose their independence and meet their governments’ spending needs rather than their countries’ economic needs, and their currencies generally suffer greatly. Japan has experimented with fiscal dominance before, in the 1930s, as have Argentina, Brazil, Italy and Zimbabwe. All have found it difficult to escape.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission (SEC); Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; and Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan. | AGI-2016-10-18-16631

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Neil Dwane

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Global Strategist
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.

6 Buzzworthy Books for the Investors on Your List

Neil Dwane | 20/12/2016
Tea and blanket

Summary

This year, our Global Strategist’s carefully curated holiday reading list centers around China, geopolitics and disruption – three powerful forces that could reshape the world as we know it for generations to come.

Before you begin putting your feet up to enjoy the holiday festivities, you may want to grab a few titles from my new reading list, which gathers interesting perspectives on key political, economic and investment themes. China’s re-emergence and rebalancing challenges will be a significant force in 2017; so will shifting political and geopolitical narratives, and the transformative power of disruption and technological innovation. I hope you find something on this list that will entertain, enlighten and provoke your “grey matter” while you enjoy time with your families! Best wishes for 2017.

On China

Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise, by Carl Walter
This book is a refresher on how important big banks are to China’s economic policy – and why Beijing’s recent intervention in the “shadow banking” world is part of a plan to meaningfully refocus these unregulated activities back into its economy. The larger goal for China over the next decade is to “rebalance” – moving away from exports toward consumption and services – as it becomes a global player in finance, trade and geopolitics. Will it work, and will China really surpass the US as the world's premier global economy?

The China Price: The True Cost of Chinese Competitive Advantage, by Alexandra Harney
China's “factory economy” frequently beats the competition by short-changing its workers and the environment, but China’s new leaders seem intent on redressing some of the consequences of the country’s amazing economic progress. Yet at a time when trade protectionism is growing, China is also facing high costs: It must focus on its environment, which has been greatly diminished by the nation’s explosive growth, and it must address its ageing population’s challenges while still offering opportunities to its millennials.

On geopolitics and finance

All the Presidents’ Bankers: The Hidden Alliances that Drive American Power, by Nomi Prins
Who will really rule America in the Trump era? Wall Street and the White House have a long history of interdependence that can’t be dismissed merely as money driving politics – or greed driving bankers. For years, they worked together to champion the expansion of America abroad while focusing on the greater good at home. But eventually, the desire for profits trumped allegiance to public service and presidents lost control over the economy – as we saw in the Great Financial Crisis of 2007-2008. Will the changing political tide shift the establishment’s alliances, or will these hidden partnerships continue shaping the nation?

Winter Is Coming: Why Vladimir Putin and the Enemies of the Free World Must Be Stopped, by Garry Kasparov
This book is still holding a place on my list of must-reads for a range of reasons, not least because 2017 marks the 100-year anniversary of the Russian Revolution, a major geopolitical event that still resonates a century later. At risk of drawing too close a comparison between the rise of the Bolsheviks and the state of today’s political affairs, the world is clearly seeing a pronounced rise of populism and nationalism. Brexit and Trump have just set foot on the world stage, with LePen and others waiting in the wings. Meanwhile, President Vladimir Putin stokes nationalism in his own country as he carefully plots his next move. In this book, Kasparov outlines how the West has acquiesced in the ascent of President Putin and his cronies, giving Russia’s leader the ability to grow into an ever more powerful threat to local, regional and global affairs.

On disruption

Smarter Than Us: The Rise of Machine Intelligence, by Stuart Armstrong
As an investment theme, disruption is one of the most dynamic forces at play today, presenting an existential danger for some industries while opening up game-changing opportunities for others. Just consider the disruptive auto technologies that will continue to boom globally as the industry embraces artificial intelligence – and then consider what might happen if AI becomes smarter than people. This book investigates the immense potential, both positive and destructive, that this new technology holds, and the ethical challenges today’s scientists and researchers are confronting. Is humanity up to the challenge, and how can we as investors build portfolios that sustainably benefit from AI technology and disruption?

Our Final Invention: Artificial Intelligence and the End of the Human Era, by James Barrat
In just a few years, artificial intelligence could surpass human intelligence – the technological Holy Grail for many governments, corporations and scientists around the world. But what happens next? Could we be forced to compete with a cunning rival that has a fierce survival drive? This book delves into the dangers of pursuing advanced AI, asking whether we can coexist with beings that possess intelligence that dwarfs our own – and even whether “they” will allow us to. Perhaps Hollywood’s dystopian movies may prove right after all.

What’s next on my list

  • The Age of Em: Work, Love and Life when Robots Rule the Earth, by Robin Hanson, on more AI and brain emulation.
  • The Cultural Revolution: A People's History, 1962―1976, by Frank Dikotter, on Chairman Mao’s next big idea.
  • A Declaration of Independents: How We Can Break the Two-Party Stranglehold and Restore the American Dream, by Greg Orman, on the future of Washington’s gridlock and US politics.
  • Wilful Blindness: Why We Ignore the Obvious at Our Peril, by Margaret Hefferman, on why humanity finds it so easy to overlook patent truths.

Your thoughts?

If you’ve enjoyed any of these books, or if you have a special recommendation for me, drop me a line at NeilDwanesView@allianzgi.com.



In case you missed it: Explore earlier reading lists

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security.

The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted.

This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations.

This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association]; Allianz Global Investors Korea Ltd., licensed by the Korea Financial Services Commission; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

© 2016 Allianz Global Investors. All rights reserved.

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Expert-Image

Neil Dwane

linkedIn
Global Strategist
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.

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