Central bank independence in Japan – not what you would expect*

*The author was Visiting Scholar, Bank of Japan, Institute for Monetary and Economic Studies (IMES), Tokyo (1994), and Visiting Scholar, Economic Planning Agency, Tokyo (1995).

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Currently, partly in reaction to earlier threats by Japan’s premier Shinzo Abe to curtail the independence of the Bank of Japan (BOJ), a big fuss is made in the news and in public debates about an increased “politicisation of exchange rates”and a potential “devaluation competition”: To observers’ bewilderment, talk about a currency war dominated discussions at Davos and elsewhere.  Policymakers and central bankers are expressing their growing concerns. One example is Jens Weidmann, president of the Bundesbank, who said in a speech in Frankfurt:

„Schon jetzt lassen sich bedenkliche Übergriffe beobachten, zum Beispiel in Ungarn oder in Japan, wo sich die neue Regierung massiv in die Angelegenheiten der Notenbank einmischt, mit Nachdruck eine (noch) aggressivere Geldpolitik fordert und mit dem Ende der Notenbankautonomie droht.“

“Already alarming violations can be observed, for example in Hungary or Japan, where the new government is interfering massively in the business of the central bank with pressure for a more aggressive monetary policy and threatening an end to central bank autonomy.” (Cited by Reuters)

The argument is insofar misleading as central bank independence in Japan differs from central bank independence in the euro area. If the Japanese government wishes to influence the Japanese currency, for instance, it is perfectly able to do so without touching the legal rights of the Bank of Japan.

In Japan and worldwide, central bank independence is a recent phenomenon. As Neil Irwin of the Washington Post wrote:

“The Bank of England gained legal independence in 1997; the central banks of France, Italy and many other Western European nations that aren’t Germany weren’t truly independent as late as the 1990s, when there began a push to create the ECB. The Federal Reserve gained independence in the 1951 Treasury-Fed accord, but sure didn’t act like it in the 1970s, when the Nixon administration used all manner of tools to encourage easy money policies out of the central bank (and resulting high inflation). It was Fed chief Paul Volcker’s willful leadership, serving in the Carter and Reagan administrations, that brought independence to the Fed in practice, if not in law.”

The Bank of Japan became “independent” with the 1997 revision of the Bank of Japan Act. Monetary policy is set by a nine-person policy board. Government officials are able to attend the meetings and submit proposals, but have no voting rights.

The duties of the Policy Board include:

–       setting the discount and loan rates;

–       setting out the reserve requirement for banks;

–       conducting open market operations;

–       making loans to financial institutions as needed;

–       initiating transactions with other central banks, and buying and selling foreign exchange in the forex market (currency interventions).

At first glance the reform seemed great progress. Traditionally, the degree of formal dependence of the Bank of Japan had been very low as various studies documented (Reszat 1997, Chapter 9). As one scholar wrote:

“The Bank of Japan is closely tied to the Ministry of Finance in ways that would normally appear to give the Bank little independence … In fact, one of the most commonly used measures of central bank independence, that of Cukierman, Webb, and Neyapti(1992), ranks only Norway below Japan among industrialized countries.” (Walsh 1997)

A Bank of Japan study by Fujiki 1996 also referring to this CWN index sketched how the index was constructed taking into account four groups of criteria:

–       variables related to the appointment and tenure of the chief executive;

–       to policy initiatives of the central bank in the decision making process;

–       the policy objectives of the central bank and

–       the conditions attached to central bank credit to the government.

When the reform was implemented, critics regarded it only as a modest reduction in the  power of the Ministry of Finance as the Bank of Japan is legally free to set interest rates (which was more or less a confirmation of the prevailing practice) but still has to cooperate closely with the Ministry. Article 4 of the Bank of Japan Act says:

“The Bank of Japan shall, taking into account the fact that currency and monetary control is a component of overall economic policy, always maintain close contact with the government and exchange views sufficiently, so that its currency and monetary control and the basic stance of the government’s economic policy shall be mutually compatible.”

Furthermore, the Bank of Japan is still lacking the autonomy to influence the yen exchange rate: Whenever it is intervening in the foreign exchange market it is acting on behalf of the Ministry of Finance. The Bank of Japan explains:

“When the yen becomes unstable in the foreign exchange market, the Japanese government (Finance Minister) may instruct the Bank of Japan, its agent, to conduct foreign exchange intervention by buying or selling yen against foreign currencies as needed.    

When the Bank intervenes, it uses government funds, and specifically those in the Foreign Exchange Fund Special Account (FEFSA). [N.b. Manfred J.M. Neumann once studied the nature and composition of this account in detail.] … The government’s foreign-currency assets held in the FEFSA, together with other foreign-currency assets held by the Bank, make up Japan’s foreign exchange reserves, the balance of which at the end of each month is released by the government (MOF).”

How does the cooperation between BOJ and MOF take place in practice? Again, the Bank of Japan explains:

When the government (Finance Minister) deems it necessary to intervene in the foreign exchange market …, the government (MOF) instructs the Bank to intervene. The Bank provides the government (MOF) with the latest market information relevant for making decisions on intervention. Based on this information, the government (MOF) gives the Bank specific instructions for the intervention. The Bank then conducts operations by concluding, through its dealers, foreign exchange trade agreements with major participants in the interbank market, such as financial institutions and foreign exchange brokers. If intervention is required during nighttime hours in Japan, the Bank usually entrusts the operation to the central bank of the region with the most active trading in its foreign exchange market at that time of the day.”

That’s it. If the Japanese government wishes to incite a currency war, the “independence” of the Bank of Japan is no hindrance. The Bank does not have – and never had – the freedom to decide to intervene directly in the market. Furthermore, given Article 4 of the Bank of Japan Act, its scope of action is generally more limited than that of its European counterparts. There can be no doubt that with the 1997 revision of the Bank of Japan Act and a gradual alignment with practices elsewhere the dependence of the Bank has been reduced considerably. Yet still, Japanese monetary policy must be regarded as the outcome of a bargaining process between the Ministry and the Bank. Shinzo Abe’s threat might well have impressed outside observers more than its addressees.