Necessity is the mother of invention, even when it comes to quantitative easing.
After exhausting other, more traditional forms of asset purchase, the Bank of Japan is kicking off its investments in several custom-made exchange-traded funds, or ETFs, that screen specifically for companies that increase workers’ wages and carry out the most capital expenditure. The new custom-made ETFs track the following indexes: the MSCI Japan Human and Physical Investment Index, the JPX/S&P Capex & Human Capital Index, and the Nomura Enterprise Value Allocation Index.
The decision to create new ETFs has caused some finger-wagging from market watchers and lawmakers, who worry that the BOJ’s unusually creative approach to asset purchases will end in tears. One former vice finance minister warned that the Japanese central bank may find it tough to exit its new positions.
Maybe. But in their desperation to try something — anything — to jump-start their economy, BOJ officials have made an interesting tweak to the concept of QE. By at least attempting to eliminate some its worst side-effects (corporate cash hoarding, wage stagnation, income equality), they’re trying an approach that contrasts with that pioneered by the Federal Reserve. The US central bank bought $3.5 trillion worth of bonds during successive rounds of QE between 2008 and 2014. This lowered bond yields and chased investors into riskier assets such as S&P 500 stocks. Most of these companies took advantage of the artificially-low rates not to expand their business and raise wages, but to return money to their shareholders via buybacks and dividends. As stockholders are typically the wealthiest Americans, this has the unfortunate residual effect of exacerbating income equality.
It appears the Bank of Japan has learned from this and is trying to send a strong message to Japanese companies to spend their money on people and capital instead of financial engineering. It isn’t an exact science, however, as one of the new ETFs has a 72 per cent overlap with the Nikkei 225 Index, in terms of weighting. Still, instead of dropping money from a helicopter, the BOJ is trying to crop-dust specific areas.
The other element of this strategy that has raised eyebrows is the fact that the BOJ now owns 59 per cent of the ETF market without an exit strategy. But they aren’t alone. It is not a stretch to say the Fed also owns a large chunk of the US ETF market as well — albeit indirectly — and with no exit strategy either. The Fed’s indirect ownership of stocks (and ipso facto ETFs), can be seen in the below chart of the S&P 500 Index and the Fed’s balance sheet. Consider what would happen if policy makers opted to sell their arsenal of bonds; it would drive up yields, and ETFs that track stocks would likely plummet and see outflows.
In other words, any concern over exit strategy shouldn’t necessarily be isolated to Japan.
Further, assuming the BOJ does actually want to exit its new ETFs, it wouldn’t cause a problem for existing ETF shareholders — even for ETFs that don’t trade a lot — thanks to how ETF shares are created and destroyed. It’s not as though the BOJ would place a market order to sell billions of ETFs in one shot. They would use the so-called “creation and redemption” process at the heart of the majority of ETFs, which means they would skip the exchange and hand the ETF shares to the issuer via an authorized participant, who would then give them back the equivalent of stocks in the ETF’s basket.
Those baskets of stocks would then be sold in the open market, where there is more exchange volume. So, yes — selling by the BOJ would push down stocks and the price of the ETF, as would any big seller, or group of sellers. But nothing extra bad would necessarily happen to ETF investors.
In this context, using the versatile ETF structure to target fresh monetary stimulus towards companies that are doing the most hiring and capital spending makes a good deal of sense. Whether Japan’s novel QE style will work in boosting its economy and its stubbornly low inflation rate is a whole other question, however.