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Is quantitative easing putting the Bank of Japan's solvency at risk?

The BOJ's return on assets was only 0.31% in fiscal 2014.

TOKYO -- The Bank of Japan has been slurping up huge quantities of Japanese government bonds through quantitative easing. Is the central bank making a profit from these JGB purchases, or is it losing money? The success of the easing policy depends greatly on how deep the BOJ's pockets are.

     The BOJ has been buying bonds with money deposited by banks on which the central bank pays little interest. The spread between the central bank's funding costs and its investment returns translates to a profit for the BOJ, 75% of which is returned to the government. In fiscal 2014, which ended in March, the BOJ had a net profit, or retained earnings, of 1.009 trillion yen ($8.14 billion at current rate), and transferred 756.7 billion yen to government coffers.

Yield nothing

Generating a profit of 1 trillion yen sounds like a great success, but given the vast sums of money involved, what counts is the profit margin. The BOJ's holdings of long-term Japanese government bonds rose by 80 trillion yen a year, and its total assets expanded to 324 trillion yen at the end of fiscal 2014. The bank's return on assets, that is, net profit divided by total assets, stood at 0.31%.

Bank of Japan Gov. Haruhiko Kuroda

     How does that compare with the U.S. Federal Reserve's ROA? At the end of 2014, the Federal Reserve had total assets equivalent to 540 trillion yen and a net profit of 12.15 trillion yen, at an exchange rate of 120 yen to the dollar. That translates to an ROA of 2.25%. The big gap in performance at the two central banks is largely due to differences in the yields of the securities they hold.

     The yield on long-term government bonds held by the BOJ was 0.556% in fiscal 2014. By contrast, the yields on fixed-rate government bonds and mortgage-backed securities held by the Federal Reserve were 3.26% and 3.53%, respectively, in 2014.

     This yawning gap was created by differences in long-term interest rates in Japan and the U.S., and when the two countries began their quantitative easing programs. The yield on 10-year JGBs had already fallen below 1% by April 2013, when BOJ Gov. Haruhiko Kuroda initiated quantitative easing. The Federal Reserve began buying long-term government bonds when the yield on 10-year Treasurys was hovering at 4%, following the collapse of Lehman Brothers in September 2008.

     The return the Federal Reserve is earning must make the BOJ green with envy. With an ROA of more than 2%, the Fed builds its net worth year by year while continuing to carry out quantitative easing, a feat the BOJ could never pull off.

Stay low

The BOJ's holdings of JGBs have continued to grow. At the end of March 2015, fixed-rate bonds held by the BOJ totaled 210 trillion yen, up 140% from the end of March 2013, which was shortly before Kuroda began quantitative easing. The weighted average maturity of the BOJ's holdings also rose from 3.81 years to 6.57 years, nearly three years longer than before.

     If the interest rate goes up by 1 percentage point, unrealized losses on bonds held by the BOJ will rise proportionally. According to one estimate, the bank's unrealized losses jumped from 3.3 trillion yen at the end of March 2013 to 13.8 trillion yen at the end of March 2015.

     Even if the bank suffers unrealized losses on its bondholdings, it does not have to include those losses on its financial statements, so long as it holds the bonds to maturity. Still, the BOJ's capital base -- capital accounts plus provisions -- was 7.17 trillion yen as of March 2015. If the bank's unrealized losses were to exceed its capital base by a large margin, critics of Kuroda's quantitative easing would no doubt jump at the opportunity to question the BOJ's financial health.

     The problem will become even more serious when the bank ends quantitative easing. To begin tightening, the BOJ needs to raise the interest rate it pays for bank deposits held with the central bank to prevent the deposits from flowing into the market. Meanwhile, the BOJ will find it hard to sell off its pile of bonds. In this situation, the BOJ's interest payments to banks are likely to exceed its interest income from its bondholdings. Eventually the BOJ's capital base could turn negative, and the bank might need an injection of taxpayer money to stay afloat.

     This is a favorite argument of those opposed to quantitative easing. It is true that the BOJ has a tough road ahead, but the skeptics' apocalyptic view of monetary policy is troubling as well.

     The question that needs to be addressed is whether a particular rise in interest rates is a good or bad sign. If it is a "good increase" that factors the government's reaching its 2% inflation target and economic recovery, the markets will see quantitative easing as a success and react calmly. If it turns out to be a "bad increase" that takes place with no sign of the economy picking up, the BOJ's monetary policy will be called into question.

     With the BOJ's assets now equal to 64.7% of Japan's gross domestic product, compared with 25.5% for the Federal Reserve, the credibility of the central bank is, more than ever, tied to the Japanese government's fiscal discipline and the soundness of its bonds.

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