Bank of Japan derivatives purchases threaten already low equity ratio

The proposal to expand the Bank of Japan's (BoJ) asset purchase programme to include derivatives may prove challenging for the bank's balance sheet as it faces a historically low equity ratio.

The BoJ's nominee governor, Haruhiko Kuroda, said the bank may buy derivatives to pursue its inflation target of 2% in the next two years. The unconventional policy stance appears to support the goals of the Liberal Democratic Party (LDP) government, which also wants a depreciating yen to prop up the country's exports.

Yuichiro Nagai, Tokyo-based economist at Barclays, warns that adding derivatives to the central bank's balance sheet may prove detrimental to its credibility. "The equity ratio of the Bank of Japan is at historical lows of approximately 7% as of the first half of 2012, a level not seen since the early 1980s," he says.

The BoJ already purchases exchange-traded funds (ETFs) and Japanese real estate investment trusts (JReits) in a bid to diversify its asset base. According to Kazuhiko Ogata, chief economist at Crédit Agricole in Tokyo, the central bank may go further and take a cue from the US Federal Reserve by purchasing structured products as well.

"The current problem is that the size of the ETF market in Japan is about ¥3 trillion ($31 billion) and JReits are about ¥3–4 trillion. The central bank can only purchase a part of them and therefore they may have a need to diversify through the purchase of derivatives or mortgage-backed securities," he says.

Ogata says Kuroda's statement that the central bank is looking to purchase derivatives is the right one given the BoJ's inflation target.

"Kuroda's statement supports what he has been arguing on wanting to purchase more risky assets. They want to expand the range of such risky assets and derivatives may be one of those," he says.

Nagai says the bank should route its derivatives and risk asset purchases through a separate entity following the model adopted by the Bank of England for its asset purchase programme. The Bank of England Asset Purchase Facility Fund (BEAPFF) acts as its subsidiary and pays for asset purchases through borrowings from the central bank, which appear on the Bank of England's balance sheet as an asset.

"To buy risk assets, there would be a need to remove these from the central bank's balance sheet," Nagai says. "The market risks are borne by the separate entity and any losses are indemnified by the government. Without such a measure, it would be difficult for the Bank of Japan to buy risk assets in unlimited amounts."