Moneycontrol
May 28, 2013 03:59 PM IST | Source: CNBC-TV18

FIIs got too upbeat on Japan; QE act of desperation: Nomura

QE to me is an act of desperation, all the interest rates are brought down to zero. However it is not producing results because people are not borrowing money, says Richard Koo, chief economist, Nomura.


In an interview to CNBC-TV18 Richard Koo, chief economist, Nomura shared is outlook on global markets, Japanese economy and key global currencies - euro and yen.


Must read: See Q4 GDP at 4.5%; 25bps CRR cut by RBI in June: Nomura


Below is the verbatim transcript of his interview on CNBC-TV18


Q: How are you reading all the volatility that we have seen in the equity, in the bond market in Japan and what is the call there?


A: In Japan, when Abenomics was put on the table, especially the Bank of Japan easing, all people got excited, especially foreign investors.


Japanese institutional investors who knew what is happening in Japan were more cautious, but the foreign investors went really crazy about it, push the yen lower, push the stock market higher and that got the whole excitement moving.


However, this idea of Bank of Japan leading the Japanese economy with inflation targets and so forth, have number of problems, Japanese institutional investors are aware of it. But now the market is beginning to pay more attention to those problems and that is if you push the inflation up higher then the borrowers get excited, and the lenders get excited too but in the opposite direction.


After three months of this excitement about the Bank of Japan, now the lenders are beginning to say that if the inflation is really coming, we have to charge higher interest rates. That resulted in Japanese government bond yields going higher and that in turn pushed the Japanese stock market lower.


So, now they have to sort out what to do with the bond market as opposed to the stock market before moving on to the next step.


Q: So the key question is what happens with all this easy liquidities from Japan? In your note you mentioned that withdrawal is going to be the key. First time around when Japan actually withdrew the quantitative easing (QE), it was smooth. This time around would you expect some volatility?


A: The first QE by Bank of Japan, which was started in 2001 and ended in 2006, was all concentrated at the short-end of the market and the interest rate at the short-end was zero to begin with. So at zero interest rates, you add liquidity or you subtract liquidity it is still zero. When the removal was announced bond market responded negatively for few weeks, but it returned to the original level because everything was at the short-end.


This time around in US, UK and Japan everything is at the long-end. Once you play with the yield curve at the long-end and when something happens, then you have to remove this liquidity, the central bank has to sell - they have to sell the long bonds and when the long bonds have to be sold into the market naturally bond yields will have to go up.


That is the challenge all of these economies are facing at the moment that how are they able to come out of the QE when so much of the easing took place at the long-end of the market.


Q: What is your expectation of when we could see the Fed tapering the QE3 and what could be the implications because one of your headers in your note says QE easy to starts scary to end?


A: QE to me is an act of desperation, all the interest rates are brought down to zero, nothing happens - so they say okay let us start putting in money through the QE. However it is not producing results because people in United States (US), UK and large parts of Europe are not borrowing money. They are not borrowing money because they were involved in a bubble.


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They borrowed lots of money during the bubble days, leveraged themselves up - the bubble burst, huge asset prices collapsed, liabilities remained and they are stuck with a huge debt overhang.


When you have a debt overhang that means you are technically bankrupt, so you have to repair your balance sheets first. All of these private sectors in the US, UK and in Japan until recently were paying down debt even with zero interest rates.


If people are paying down debt with zero interest rates, naturally money multiply is negative at the margin, money supply cannot grow and that’s why all these QE produced very little result upto now.


Once the private sector balance sheets are repaired and these people start borrowing money again, then the massive liquidity in there will have to be withdrawn because if that liquidity stayed in the market and people started borrowing, the money supply can grow exponentially.


There is enough reserves in the banking system in US for example, to increase money supply by 16 times and five times in Japan, 10 times in the UK. So those have to be removed just when people are trying to borrow. This is going to be a very difficult process because if the central bank becomes too aggressive, interest rates can go very high and the private sector who are finally beginning to borrow money would be discouraged.


Q: On the currency front, the euro has been pretty stable at around 1.29, but on yen we saw quite a bit of volatility, it went to 104, now back to 101. What is your call on both euro and the yen going forward?


A: The weakness that we saw in the Japanese yen, from about December of last year to the present – a large part of that actually is justified. It is justified in the following way - Japan is no longer a trade surplus country. Japan had been a trade surplus country for 20-30 years. So, when we talk about Japan and Japanese yen we almost automatically assume that Japan is a trade surplus country, that’s not true anymore.


Japan is a trade deficit country and not because of increase in oil imports as Japan shut down this nuclear power plants but the other part; the non-oil surplus is also shrinking. So, when the government in Japan start saying we like to do QE and bring the yen down, no one could complain G7, G20 they all remained very quiet because they recognise that Japan is actually a trade deficit country and for trade deficit country wants to bring exchange rates lower, no one can complain.


So, that part is actually based on fundamentals. Increasing stock prices as a result of better profit opportunities for Japanese companies coming from the weak yen that part is fully justified in my view.

However, there is a little bit of hype also in Japanese stock market, where companies that have nothing to do with weak yen, the prices have also gone up and there would be some adjustment to those guys going forward.

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