In recent months, the Nikkei stock average recorded its highest levels in 30 years. The remarkable stock performance contrasts with the fragile economic conditions caused by the second state of emergency declaration in Tokyo and nine other prefectures amid the highest number of infections and deaths since the outbreak of the COVID-19 pandemic. The yen’s persistent appreciation since the middle of last year is also hurting Japanese firms’ foreign profits valued in yen.
Japan’s stock prices quickly rebounded after plummeting last March as the pandemic took hold. The major driver is higher U.S. stock prices — driven by excessive liquidity arising from massive monetary easing generated by the U.S. Federal Reserve. The impressive sales performance of large U.S. tech companies and the hope that the start of emergency vaccinations will accelerate the pace of a global economic recovery are also contributing to the stock hike.
In addition, the Bank of Japan’s policies have greatly contributed to Japan’s stock prices. The bank has expanded the maximum purchase amount of stock exchange-traded funds (ETFs) to ¥12 trillion annually in the face of the COVID-19 pandemic, from the annual pace of about ¥6 trillion. As a result, the central bank has become the largest shareholder in the Japanese stock market, causing market distortions.
In a normal stock market, diverse investors perform transactions and discover appropriate stock prices while obtaining opportunities to promote sound asset formation. The market also provides efficient financing for companies. The stock price should reflect the present value of the future profit of the company.
A company that loses the ability to sustainably earn profits should be removed from the stock market. In its place, start-up companies will emerge, grow and eventually be listed. This dynamism among firms is essential for the stock market to function well. The corporate governance code introduced in Japan in 2015 and its revision aim at reforming corporate management practices by increasing the number of independent nonexecutive directors and encouraging management to make greater efforts to increase the earning capacity of Japanese companies through enhanced monitoring.
Long-term oriented institutional investors (such as pension funds and insurance firms) and asset managers are increasingly engaging in constructive dialogue with companies and exercise their voting rights as shareholders to help increase medium to long-term corporate value. Such value must be achieved in a sustainable manner from environmental, social and corporate governance (ESG) perspectives.
In particular, companies urgently need to transform their business models in line with the Paris Agreement of limiting global warming to below 2 or close to 1.5 degrees Celsius, compared to pre-industrial levels. Such ESG investment will be supported further in 2022, as the Tokyo Stock Exchange will reorganize the existing market segment and introduce a new Prime Market comprising companies that meet the tougher criteria, including corporate governance standards — which might include an increase in the number of independent nonexecutive board members to more than one third.
An expansion of ESG investment and a sustainable finance market is essential for Japan’s economy. Given that the Bank of Japan is likely to hold stocks for an extended period and hardly exercises responsible investment from the ESG perspective, it is clear that its massive stock ETF purchases end up reducing the number of floating stocks that are potentially available to investors. Overvalued prices regardless of ESG performance of each listed company risk delaying corporate restructuring and the corporate metabolism needed in well-functioning stock markets.
The central bank has announced an assessment of its monetary policy will be conducted this March, but it will do so without changing existing monetary easing framework. It is widely understood that the Bank of Japan worries about the current annual pace of ETF purchases due to its excessively large influence in the stock market and adverse impact on its balance sheet. The bank may wish to reduce it to well below ¥6 trillion, perhaps closer to ¥2 trillion to ¥4 trillion. This enables a continuation of the purchase program a little longer.
The central bank should terminate such purchases completely, especially when stock prices are as overvalued as they are now.
Yet, many stock market participants count on the bank’s commitment to intervening in the market so that the downside risk remains limited. It will be interesting to see if the BOJ changes the purchasing guidelines this March without giving the impression of monetary tightening or a step toward normalization.
What is clear is that the probability of unwinding the stock ETF purchases through reducing the holdings of stocks is increasingly becoming infinitely close to zero.
Sayuri Shirai is a professor at Keio University and a former Policy Board member of the Bank of Japan.
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