COVER STORY • Mid-Term Prospects for the Global Economy — Where Is It Heading in the Midst of Structural Change & Geopolitical Crisis? • 7

T

he Current State of Japanese
Public Finance & Its Relationshipwith the Bank of Japan

By Kazumasa Oguro

Japanese Finance Further AggravatedOne of the strategies of Abenomics was to balance fiscal
restructuring and economic revitalization by increasing tax revenues
through economic growth. But national tax revenues for fiscal 2016
were down by 2.1 trillion yen compared to the estimated tax revenues
in the initial budget, down 0.8 trillion yen compared to the year before,
and marked a decrease for the first time in seven years. This may be
one piece of evidence that the Japanese economy is heading towards
an economic downturn.
Under such circumstances, the Cabinet Office announced recently(July 18, 2017) the revised version of the “Estimates on Mid- to LongTerm Economy and Finance”. According to the preliminary
calculations, even if Japan were able to achieve a high growth scenario(economic revitalization scenario) with a real GDP growth rate ofaround 2% by the early 2020s, and if the scheduled hike in the
consumption tax rate for October 2019 were implemented, thecombined national and local Primary Balance (PB) for fiscal 2020 will
fall to a deficit of 8.2 trillion yen and a PB surplus which thegovernment is aiming to achieve by 2020 cannot be realized.
Moreover, if the mission for increased government revenues throughthe consumption tax hike were to be changed and the budget for childcare support and free education expanded, it is clear that achieving a
PB in fiscal 2020 will become even more difficult.
To begin with, in the mid- to long-term preliminary calculations, the“Total Factors in Productivity (TFP)”, which the high growth “economic
revitalization scenario” assumes, is an optimistic and unrealistic
scenario. Despite the TFP for fiscal 2016 being 0.6%, the scenario
assumes an increase to 2.2% by the early 2020s, but this is anaverage TFP figure from the period between 1983 and 1993 when theJapanese economy fell into deflation, and roughly similar to the TFP
figure during the “Bubble” period. This is the major reason behind theeconomic revitalization scenario where the real GDP growth rate rises
to around 2% by the early 2020s despite the average real GDP growthrate being 0.8% from fiscal 2002 to 2015.
Japan must abandon this unrealistic scenario and face “the reality of
public finance”. In the mid- to long-term preliminary calculations forthe cautionary scenario of Real GDP Growth Rate at 0.7% (Nominal
Growth Rate of around 1.2%), the fiscal deficit (percentage of GDP) for
fiscal 2025 is forecasted to be around 4%, but if the tax increase ispostponed, the deficit is certain to expand to around 5%. In this case,
we can also see that the final outstanding balance (percentage of GDP)of government bonds etc. will exceed 400% if Domar’s Theorem is

Author Kazumasa Oguro

implemented. As social security costs surge and the financial deficit
persists with the decreasing birth rate and aging population, thefinancial situation for Japan looks extremely tough with government
debt being twice the size of GDP, and it is forecasted that this will
become even more grave.

Relationship Between the Bank of Japan & Government
from an Integrated Balance Sheet Perspective
As the term “Financial Democracy” describes, finance is “the mirror
which reflects politics” and whether or not we regain financial
discipline will depend on the choices Japanese citizens make, but oursense of crisis about the sustainability of finances is weak.
One of the large factors behind this is the Bank of Japan (BOJ)
keeping national bond yields at an extremely low standard, havingbought massive amounts of government bonds through a “different
dimension” monetary policy. As a result, yields on Japanese
government bonds have remained around 1% (weighted average yield
on issued government bonds), and interest payments for the roughly 1
quadrillion yen government debt have been curbed to around 10
trillion yen.
Under such circumstances, there have been claims that “if theBOJ buys up all of the government bonds, fiscal restructuring willend with no fiscal burdens on the Japanese people”, but theimportant message from economics is that “there is no freelunch”, and this claim is false. Even if the BOJ bought up all of thegovernment bonds, it does not imply that a financial reconstruction iscomplete. It is of utmost importance to have a deep understanding of
this fact as a premise, when discussing the relationship between
finances and the BOJ, and why is explained below in steps.
The first reason is that monetary policy is an “equivalentexchange” of assets and what supports BOJ buying of government
bonds is mainly our bank deposits. In order to understand themeaning of this, let us consider a simple scenario.
In actual economics, many different households, businesses, andmonetary institutions such as banks exist, but let us assume thatbesides the government sectors and BOJ, there is only one privatebank. We also assume that the balance sheets for the government
sector, BOJ, and the private bank look like Chart 1. (Note: For
simplicity, we ignore other assets and equity capital of the BOJ except
for government bonds, equity capital and others of private banks.)“Cash” on the liability side of the BOJ balance sheet indicates thebalance of BOJ notes circulating in the market, and “Reserves”
Japan SPOTLIGHT • January / February 201829

COVER STORY 7

CHART 1

Balance sheet for each sector before
buying operation of government bonds
Government sector

AssetsGovernment
Deposits

Bank of Japan

AssetsLiabilities
50

Government
Bonds

800

Government
Bonds

Liabilities
400

Cash

CHART 2

Balance sheet for each sector after
buying operation of government bonds
Government sector

Assets100

Government
Deposits

50

Reserves

200

Government
Deposits

Bank of Japan

AssetsLiabilities
50

Government
Bonds

800

Government
Bonds

Private Banks
Assets250

Government
Bonds
Lending

Deposits

500

Cash

100

Government
Deposits

50

Reserves

350

Private Banks

Liabilities

Reserves

Liabilities

Assets1600

Liabilities

Reserves

350

400

Government
Bonds

300

950

Lending

950

Deposits

1600

Source: Compiled by the author

Source: Compiled by the author

indicates the deposits the central bank is entrusted with by the privatebanks.
Now, let us implement a monetary policy of a bond-buying
operation where the BOJ buys 100 bonds from the private bank. This
policy is a measure “to equivalently exchange bonds and reserves”,
and as such the BOJ must increase the current deposits of the privatebank by 100 in compensation for the bond purchase. In other words,on the BOJ balance sheet, bonds on the asset side increase by 100,and reserves on the liability side increase while the balance sheet ofthe private bank sees an increase in reserves on the asset side by 100,
but a decrease by 100 in bonds. As a result, the balance sheets for thegovernment sector, the BOJ and the private bank look as follows:
The highlighted sections in yellow and green indicate the changes
from Chart 1, but what does Chart 2 mean? Let us first look at thebalance sheet for the private bank. The asset side of this balance sheet
has reserves of 350, bonds of 300, and lending of 950, and the total of
1,600 is supported by the deposit of 1,600 on the liability side. In otherwords, a portion of the deposits (350) on the liability side is supporting
the reserves of 350. Let us now look at the BOJ’s balance sheet. Thisbalance sheet has cash of 100 (= BOJ notes circulating in the market),government deposits of 50, reserves of 350 on the liability side, andthe total 500 is supporting the government bonds of 500 on the asset
side. In other words, reserves of 350 on the liability side aresupporting a portion of government bonds of 350 on the asset side.
As a result, the composition looks to be, a portion of the depositon the liabilities side of the balance sheet for the private bank(350), through 350 of reserves on the asset side, indirectly
supporting a portion of the government bonds (350) on the asset
side of the balance sheet of the BOJ. It is important to note that
“Bonds” which make up the majority of the asset side of the BOJ
balance sheet is “BOJ loans against the Ministry of Finance”, and“Reserves” that make up the majority of liability is “private bank loans
to the BOJ” (debt from the BOJ perspective). Thus, generally, BOJowned government bonds and reserves cannot be offset from a bond/debt relationship. But, for example, in Chart 2, if a portion of BOJowned government bonds (350) and reserves (350) were offset from afinancial reconstruction perspective, that is the same as thegovernment sector imposing a 100% tax policy on the 350 reserves,and the end result is a partial loss (350) of our deposits with theprivate bank.
By the way, it is also important to note the fact that capital which
covers outstanding government bonds is basically deposits, andthat monetary policy does not increase the capital stock. This fact
can be easily understood from the integrated balance sheet of the BOJ
and the private bank. First, if we integrate the BOJ balance sheet andprivate bank balance sheet in Chart 2, then offset the reserves on boththe asset and liability side, it produces Chart 3 as below. This
integrated balance sheet indicates that 100 cash on the liability side (=BOJ notes circulating in the market), government deposits of 50 and
our deposits of 1,600 are supporting the outstanding government
bonds of 800 that the government issued and 950 lending tobusinesses and others.
In addition, if the balance sheets of the BOJ and private banks were
integrated and reserves on both the asset side and the liability side
were offset, the exact same balance sheet as in Chart 3 can beobtained. This fact indicates that capital which covers outstanding
government bonds is basically deposits and that monetary policies do
not increase the capital.
The second reason is, as interest rates normalize, if the BOJ
interest on “excess reserves” at the BOJ from private banks is tobe restrained rather than brought up to an adequate level incomparison to the market rate, then from the perspective of an

30 Japan SPOTLIGHT • January / February 2018

CHART 3

Case study of integrated balance sheetof the BOJ & private banks
Government sector

AssetsGovernment
Deposits

Bank of Japan + Private Banks
AssetsLiabilities
50

Government
Bonds

800

Liabilities

Government
Bonds

800

Cash

Lending

950

Government
Deposits
Deposits

Source: Compiled by the author

100
50
1600

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CHART 4

Case study of integrated balance sheetof the government sector & BOJ(1)
Government sector + Bank of Japan
AssetsLiabilities

Private Banks
Assets100

Reserves

250

Government
Bonds

400

Government
Bonds

400

Reserves

250

Lending

950(2)
Government sector + Bank of Japan
AssetsLiabilities

Cash

Liabilities

Deposits

1600

Private Banks
AssetsLiabilities

Cash

100

Reserves

350

Government
Bonds

300

Government
Bonds

300

Reserves

350

Lending

950

Deposits

1600

Source: Compiled by the author

integrated government of the government sector and BOJ, it is infact the same as imposing deposit taxation. In addition, if the BOJ
interest on “excess reserves” were to be raised to an adequatelevel, from an integrated government perspective, “excess
reserves” is virtually roughly the same as issuing government
bonds (issuing short-term government bonds). The context of thiswill be explained in stages below.
To deepen our understanding on this matter, let us consider the
integrated government balance sheet for the government sector andthe BOJ for each of the cases in Chart 1 and Chart 2. By offsetting
government deposits and government bonds on both the asset side
and liability side of the balance sheet of the integrated government(government sector + BOJ), Chart 4 for each scenario can be obtained.
Of the facts that can be read off Chart 4, there are two mostimportant perspectives. The first perspective is that in both thescenarios of Chart 4, (1) and (2), the total 650 of “Bonds” and“Reserves” on the liability side of the balance sheet of the integrated
government (government sector + BOJ) coincides with the total of the“Bonds” and “Reserves” on the asset side of the balance sheet of theprivate bank, and what supports this asset is our “Deposits of 1,600”
on the liability side of the balance sheet of the private bank.
The other perspective is that of “Cash”, “Bonds” and “Reserves” on
the liability side of the balance sheet for the integrated government, theinterest cost on cash is “zero”, the interest cost on government bonds
is “long-term yield (e.g. 10-year government bond yield)”, and theinterest cost for reserves is “BOJ interest”.
In a situation where the nominal interest rate is more or less zerounder deflation, both interest costs on government bonds (= long-term
interest rate) and interest costs on reserves (= BOJ interest) is more orless zero, and therefore the debt cost for the integrated government(government sector + BOJ) for scenario (1) and (2) in Chart 4 isroughly equal.
On the other hand, if interest costs (= long-term interest rate) andreserve interest costs (= BOJ interest) differ greatly, debt costs for the
integrated government (government sector + BOJ) will also differ
greatly. For example, if BOJ interest can be maintained at a much lower

level compared to the long-term interest rate, the debt costs for the
integrated government (government sector + BOJ) will be lower for
scenario (2) than scenario (1) in Chart 4, and debt costs can be
reduced.
What then occurs if long-term interest is kept at a much lower
level than the BOJ interest even after interest rates havenormalized? In looking at the integrated government (government
sector + BOJ), that is the same as imposing tax on deposits. On theother hand, if interest rates normalize and if the BOJ interest isbrought up, BOJ interest on excess reserves will be at the samelevel as “short-term interest” such as yield on short-term bonds
and call-rates. From the perspective of the integrated government(government sector + BOJ), “excess reserves” in effect is the sameas issuing government bonds (issuance of short-term government
bonds).
In other words, the claim that “if the BOJ buys up all of thegovernment bonds, financial restructuring is complete withoutburdening Japanese citizens” is a lie, and to secure the sustainabilityof finance, there is a need to pursue financial reconstruction in a solidmanner.

Risk of Losses at the End of Monetary Policy
As the BOJ buys up a huge volume of government bonds as partof the monetary policy, there is also an inherent risk that thecurrent BOJ is carrying, and one of the major issues is the risk oflosses which comes at the end of monetary policy after Japan
comes out of deflation. In its Monetary Policy Meeting which washeld in late July 2017, the BOJ extended the completion period for the
2% price target by a year from “around fiscal 2018” to “around fiscal
2019”, but this is the sixth price target extension since April 2015.
Thus, overcoming deflation seems very difficult, and it is quitepossible that it would still be some time away, but there is anincreasing concern that if the price target of 2% is achieved, the BOJ
will become insolvent with “a negative spread”.
Whether the BOJ will actually become insolvent with “a negative
spread” will depend on the speed at which it proceeds with interest
rate hikes once Japan overcomes deflation. Therefore, let us do a
simple “brain exercise” as below.
As Chart 5 shows, interest rates on managed assets at the BOJ havebeen continuously falling and the most recent interest rate on
combined managed assets is around 0.3% (0.381% for long-term
government bonds). As of Oct. 6, 2017, the balance sheet has around
500 trillion yen in assets of which around 440 trillion yen is ingovernment bonds. Even if interest rates normalized after overcoming
deflation and market interest rates are pressured to slowly rise,
coupons (yield) on government bonds, which is a type of bond, arefixed, and therefore yield on managed assets at the BOJ will not rise in
the short term.
On the other hand, if a price target of 2% can be achieved byovercoming deflation, the BOJ needs to raise interest rates in order torestrain further rises in prices. Under such circumstances, the BOJ has
two main methods to do that.
The first method is to sell government bonds that the BOJ owns toguide a rise in interest rates. If government bonds are sold off, the BOJ
Japan SPOTLIGHT • January / February 201831

COVER STORY 7

CHART 5

Yield on main managed assets at the BOJ
(%)
6
Loans

5

Receivable under resale agreement
Short-term Government Bonds
Long-term Government Bonds

4

CP etc.
Corporate Bonds

3
2

0.381

1
0

2007

2008

2009

2010

2011

2012

2013

2014

2015 2016(Fiscal Year)

Source: Bank of Japan

can receive payments on excess reserves as compensation fromprivate banks and other institutions, and while the BOJ balance sheet
will shrink in size, it can sell government bonds when there is
downward pressure on government bond prices with rising interest
rates, and the BOJ may have to accrue capital losses. Japanesefinance, which also carries an enormous debt of 1 quadrillion yen, also
faces the risk of sharp increases in debt payments as interest rates
rise.
The second method is for the BOJ to raise its interest on excess
reserves and guide a rise in interest rates. The BOJ interest on excess
reserves is at the same rate as the “short-term interest rates” such as
yields on short-term government bonds and call rates, and therefore if
the BOJ interest rate is raised, there will be upward pressure on shortterm interest rates.
In this case also, the BOJ may stand to experience capital losses,
but as mentioned previously, it has adopted the “amortized cost
method” (method of accounting equal amounts of losses every year
until amortization of the government bond) for its accounting
standard, hence there is no need to accrue capital losses if the BOJ
holds on to government bonds until maturity.
Losses will arise when the BOJ experiences negative spread. In
other words, if the BOJ interest on excess reserves which make up the
majority of its debt exceeds the yield on government bonds whichmake up the majority of the managed assets of the BOJ, the losses for
the BOJ will manifest.
For example, let us consider the case where the BOJ asset is 400
trillion yen in government bonds with a yield of 0.4%, the BOJ debt
cost is at 0.1% including BOJ interest with 100 trillion yen of issuedbank notes, and excess reserves of 300 trillion yen. In this scenario,
the BOJ is able to receive interest on managed assets of 1.6 trillion yen(= 400 trillion yen x 0.4%), at the same time paying 0.3 trillion yen (=300 trillion yen x 0.1%) as debt costs, and make a net profit of 1.3
trillion yen. After corporate taxes and other taxes, 95% of the final
profit must be paid to the National Treasury as a general rule and thisthen becomes part of the revenue for the national budget.
32 Japan SPOTLIGHT • January / February 2018

However, what about the case where the BOJ interest rate is raised
to constrain inflation? If the inflation rate is within the range ofnegative 0.5% to 1%, the BOJ interest rate is set to be 0.1%, andtherefore for the real interest rate to be at the same rate as inflation of
2% to 3%, it is natural to assume that the BOJ interest rate needs tocome up to the 1.1% to 3.6% range.
In this case, the yield on government bonds will remain around the
0.4% level for a while and therefore while interest income frommanaged assets will remain around 1.6 trillion yen, debt costs will
expand to 3.3 trillion to 10.8 trillion yen (= 300 trillion yen x 1.1% to3.6%), and under negative spread the losses of the BOJ will manifest
in the range of 1.7 trillion yen to 9.2 trillion yen. If this sort of loss
continued for a few years, the BOJ would become insolvent.
According to Dr. Peter Stella (“Do Central Banks Need Capital?”, IMF
Working Paper, July 1997, and “Central Bank Financial Strength,
Transparency, and Policy Credibility”, IMF Working Paper, August
2002) and others, there have been many cases where central banks
have gone into insolvency. For example, the Venezuela Central Bank
(1980s to 1990s), Jamaica Bank (1980s to mid-1990s), and the oldPhilippine Central Bank became insolvent when central banks were nolonger able to achieve the goal of price stability, leading to highinflation.
On the other hand, there are cases like the Czech Central Bank whichbecame temporarily insolvent (1990s to 2015) but the problem did not
persist. Thus, even if the BOJ temporarily becomes insolvent, it cannot
be concluded that it will become a critical issue. In addition, dealing
with insolvency would mean an increase in the burden on its people,
thus gearing up interventions by financial authorities and politicians on
the size of compensation for losses and methods, thereby raising thepossibility that while conditions will be levied which may necessarily
be consistent with the price stability goal which the central bank aims
to achieve, there is room to consider the fiscal authorities taking oncompensation for losses and resolving the insolvency of the central
bank.
Either way, if we consider the government and BOJ being a unit,
the perspective that even if the BOJ owned government bonds, theintegrated debt cost basically does not change, is more important.
Interest rates are currently around zero and therefore debt costs havenot manifested, but once Japan overcomes deflation, cash andreserves on the liability side of the BOJ balance sheet will become
impossible to maintain unless prices go up by several times over, andthe BOJ needs to either decrease its government bond holdings todownsize the balance sheet, or raise its interest rate on reserves tomaintain the current scale of the balance sheet.
When that occurs, the circumstance in which a fiscal deficit can befinanced at no cost is completely over, and massive debt costs will
once again manifest. This creates the need for thorough considerationof the risks of different dimension monetary easing and future costs
when thinking about the exit from an expansionary monetary policy
and its limitations.

Kazumasa Oguro is a professor of the Faculty of Economics at Hosei
University and consulting fellow at the Research Institute of Economy, Trade &Industry at METI.