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Japan's Central Bank goes shopping for
shares
Heydon Traub, Boston Business
Journal, November 15, 2002
In the United States, it is commonly accepted practice for companies to buy
back their shares in the market, often in lieu of dividends. In Japan, this
rarely happens. But there is a variation on this, which has been recently
announced by the Bank of Japan (BOJ). The Central Bank itself plans to
purchase shares from the troubled commercial banking sector.
Both the United States and Japan's rules prevent their central banks from
purchasing shares. However, due to the ongoing crisis with Japan's economy,
the Central Bank plans to seek approval from the Ministry of Finance to buy
shares that commercial banks would like to sell.
What are the investment implications of this surprise move by the Central
Bank? The initial reaction of most investors was that stock prices should
move up, and in fact, they did. The plan was announced just before the close
of trading in Japan on Sept. 18. Although the market was down for the day,
the announcement reversed an ugly day as the Nikkei moved up about 2 percent
intraday in response. The following day, the market moved up another 2
percent, but has since fallen back about 9 percent below where it was just
before the announcement. This reflects the market's disappointment with the
details and lack of fast follow-through.
Looking forward, the implications of this move are far from clear. There is
little precedent of central banks intervening in a country's stock market.
The most notable occurrence was when the Hong Kong Monetary Authority (HKMA)
jumped unannounced into the market during the 1998 Asian crisis and bought
up stocks for three days. It did seem to stop the free-fall, and by the end
of the next year the market had more than doubled. It has not fallen back to
the crisis levels, despite the stock market declines the past few years. The
HKMA has gradually sold off its shares via the creation of an
exchange-traded fund (ETF) called the Tracker Fund. By most standards, the
intervention was a success.
However, there are significant differences in the case of Japan. First, they
are likely to wind up owning nonliquid or problem stocks that would be
difficult to sell. This is because the banks will likely have the option to
sell the Bank of Japan what they want. The large, liquid names can just as
easily be sold in the market. This means selling these stocks may eventually
be difficult for the bank.
Second, this move does not address the root of Japan's problems. The key
factors most experts agree need to be resolved are the disposition of the
banks' nonperforming loans (NPLs), i.e. cleaning up their balance sheet and
reversing the deflation in the economy.
The latter can be addressed by rapidly increasing the money supply, and the
government has recently presented an anti-deflation plan. Regarding the
nonperforming loans, it seems the government's money would be better used if
it were to buy the NPLs from the banks. This would finally restore a healthy
banking system, something missing for about 12 years, and free up capital
for banks to begin meaningful corporate lending again.
One key caveat here, though: Nonperforming loans are estimated to be 60
trillion to 120 trillion yen (roughly $502 billion to $1 trillion U.S.) with
the government's estimate at the low end of this range. Thus, NPL purchases
would require massive amounts of capital, compared with what would be needed
for the share purchases.
Although the share repurchase is not ideal, there are several positives. At
least part of the government (Bank of Japan, for instance) finally seems to
be acknowledging the severity of the bank's problems and is looking to do
something about it after years of inaction. In fact, the announcement seems
to be more of a political move by the BOJ to force action and needed
cooperation from other government entities to solve the bigger NPL issue. In
addition, the planned holding period is 10 years, so this will not be a
short-term fix where shares have to be sold soon.
Despite the reservations above, we think that the Bank of Japan's plan will
be moderately positive for Japanese equities. In addition, the market's
prolonged decline of almost 80 percent from its peak in 1989, along with an
earnings recovery this year, has brought the market's price-earnings ratio
based on expected earnings down to "just" 24. That may still sound high, but
there are two points making Japan's stock market better priced than the
United States, even though the equivalent p/e measure for the United States
is just 18.
First, the quality of earnings is better in Japan. They report one set of
books based on their taxes. Thus, they have an incentive to minimize
reported taxes as opposed to the inflated operating earnings we see reported
in the United States.
Unlike the United States, in Japan, for the most part, you don't see
companies exclude large losses they have written off, and there is minimal
use of options granted to employees. Second, interest rates are
extraordinarily low, even compared with the United States. Short-term rates
are zero and long-term government bond yields are about 1 percent. Thus, the
dividend yield on the stock market is equal or higher than what investors
can get in the fixed-income market. This creates incentive for local
Japanese investors finally to buy stocks.
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