Ministry charts 'backdoor' policy

By David DeRosa

NEW CANAAN, Connecticut (Bloomberg): Japan's Ministry of Finance is floating the idea of borrowing as much as 8 trillion yen (US$76 billion) from Japan's private banks to bridge the gap between tax collections and expenditures, according to the New York Times on Jan. 28.

It would be unusual for the ministry to go to the banks for cash. Historically, it has funded itself through the issuance of Japanese government bonds (JGBs), and by loans from other parts of the government. Now, the ministry wants to get money from banks and it may even be prepared to pay a premium to do so over what it would cost to get the money from the bond market.

To some observers, this looks like the beginning of the end for Japan. The government is going deeper and deeper into the hole. Prime Minister Keizo Obuchi's government sticks to the idea that Japan's malaise can be solved with massive government spending.

Meanwhile, tax revenues lag behind. Current estimates are that Japan's government debt now exceeds its gross domestic product. By comparison, Europe's Maastricht Treaty sets an absolute debt ceiling of no more than 70 percent of GDP for participating euro- countries.

Moreover, according to the Times' story, the ministry plans to borrow money from the banks in the form of one-year loans. That is scary. If Japan were ever hit with a real crisis, as Thailand was in 1997, then the ministry might be unable to roll over its loans.

Normally, the ministry counts on the Government's Trust Fund Bureau (TFB) to soak up large portions of its budgetary shortfall. But owing to some new legislation, the TFB will soon be constrained in its ability to expand the size of its portfolio. Hence, the ministry is scouring the country, trying to locate new sources of capital.

So on the surface this is a red flag that signals Japan's dire financial straits. In part that is true. But something else, something really subtle, may be going on here. The ministry finally may have found a way to make an end-run around the Bank of Japan with respect to monetary policy.

The central bank is charged with making Japan's monetary policy. It is supposed to be a completely independent central bank, yet the ministry believes the BOJ is pursuing the wrong policy and has been quite vocal in saying just that.

The BOJ has responded with angry assertions of its independence. It is convinced its zero interest-rate policy will be enough to bring Japan out of its slump. Yet by broad-based measures, the Japanese money supply has been expanding at anemic levels.

The broad-based monetary aggregates, such as M2+CDs (currency plus bank deposits plus certificates of deposits), are now growing at a year-over-year crawl of 2.6 percent. Last year this aggregate was expanding at 6 percent and even that rate of growth is insufficient.

The ministry has been quite vocal in demanding the BOJ initiate a quantitative easing of the money supply. Masaru Hayami, the Bank of Japan's governor, has refused, even now with new evidence that consumer demand in Japan is faltering. Hayami says supplying additional liquidity to the banking system is useless because banks are not going to expand their lending.

Hayami is partially correct. There are idle balances in the banking system. But that doesn't mean that bank shouldn't supply even more money to the economy. The new money will still be in the private economy. Ironically, Hayami doesn't realize that money is money, whether or not it is loaned out to the public.

Japan's monetary stagnation is the result of two factors. First, the BOJ is guilty of not supplying a fast enough growth of the monetary base to the banking system. The monetary base is composed of currency plus bank reserves held at the bank. Secondly, banks aren't lending enough money to keep liquidity circulating through the economy.

But now the ministry can do something about it. If it begins to borrow heavily from the banks, then the process of expansion of the money supply may begin as the banks come back to life and begin to lend again.

In other words, the ministry is about to go into the money supply business.

The writer is president of DeRosa Research and Trading and manages an investment fund. He is also an adjunct finance professor at Yale School of Management. His opinions don't necessarily represent those of Bloomberg News.