Reply #23: Japan's giant sucking sound

[54anickel]

http://atimes.com/atimes/Japan/HD18Dh01.html

On March 9, the central Bank of Japan (BOJ) signaled that the era of free money, known as "quantitative easing", would soon begin to wind down. This change has spurred broad international commentary focused mainly on the timing of Japan's return to normal interest-rate-directed monetary policy and the broad implications of this return for both Japan's economy and the global economy.

Much more significant, the end of quantitative easing will pull an enormous amount of liquidity from Asian and US stocks and bonds, prompting widespread asset price depreciation and yen revaluation.

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The $300 billion question: Where did the liquidity go?
The cash available to Japan's financial institutions, via their reserve accounts with the BOJ, was not limited to just the nominal increase in liquidity in these accounts from 50 trillion yen to more than 300 trillion yen. Rather, this excess liquidity was made continuously available to the financial system, like an inexhaustible fountain, for nearly three years.

Though this open monetary tap provided more than enough liquidity to increase the supply of domestic credit, demand for domestic credit remained very weak. Total credit in Japan contracted, in nominal terms, by 4% in 2003 and 3% in 2004. Domestic credit stopped contracting in 2005, when total credit growth was flat, before finally beginning to grow in February and March of this year - the first such growth since 1998.

The flood of cash into Japan's financial system didn't go anywhere in 2003 and 2004. Financial institutions used this cash to bolster their own balance sheets - a process that greatly improved the creditworthiness of Japan's banks. This sharply reduced counterparty risk for foreign banks, which began earnestly to tap into Japan's never-ending supply of liquidity. Using a Japanese bank as a counterparty, foreign banks borrowed huge amounts of yen at very low interest rates in 2005. This yen was swapped for foreign currencies and invested in other Asian countries as well as in the United States.

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