(Jan 30): The Bank of Japan (BOJ) made a significant step towards shrinking its massive balance sheet last week, while market watchers were fixated on the biggest interest rate increase from the central bank in 18 years. 

The BOJ decided on Friday to offer no new lending from July under its fund-provisioning programme to stimulate bank lending. The programme’s outstanding loans stood at ¥77 trillion (US$496 billion, or RM2.17 trillion) as of Jan 20, accounting for around 10.4% of the central bank’s overall balance sheet, according to BOJ data.

The phasing out of the loan programme underscores BOJ governor Kazuo Ueda’s determination to slowly but steadily proceed with the normalisation of policy after more than a decade of radical monetary easing. 

All the outstanding loans are now set to expire in early 2028. January also marks the final month for the purchase of commercial paper and corporate bonds, a move first flagged last March. That’s another 6.5 trillion yen that will disappear from the balance sheet by January 2028. 

Together with last year’s decision to cut the purchase of government bonds, the central bank has now secured ways to trim its enormous balance sheet by more than 15%, as it proceeds with quantitative tightening. 

“Although it got little attention, ending the funding programme is a big decision,” Kentaro Koyama, chief Japan economist at Deutsche Securities, said in a Bloomberg survey this week.  

The need to undergo quantitative tightening is not unique to the BOJ. Many of the bank’s global peers have already been trimming balance sheets that became bloated during the pandemic, as priorities changed from supporting the economy to battling inflation. But the relative scale of the BOJ’s holdings, at 126% against the size of the economy, towers above that of the Federal Reserve or the European Central Bank (ECB) at closer to 30% of gross domestic product (GDP).

Still, the Fed’s experience points to potential risks ahead for the BOJ, as it tries to reduce its balance sheet without spooking markets. 

The Fed started tightening in 2022, but in June last year, policymakers were forced to slow the pace of unwinding, amid growing concerns over the asset runoff roiling short-term funding markets. 

After the stand-pat decision on Wednesday, Fed chair Jerome Powell reiterated the Fed’s readiness to adjust the details of its balance sheet reduction approach if needed, to ensure the smooth transition of monetary policy in light of economic and financial developments.

Powell has sliced about 24% off the Fed’s balance sheet since it hit its peak in April 2022, according to Bloomberg data. 

Koyama, a former BOJ official, says the scrapping of the loan programme will reduce demand for government bonds used as collateral, a factor that might push up yields. The move will nudge the banking sector to search for alternative stable funding sources, and may also exert upward pressure on short-term interest rates due to a decrease in the monetary base, he wrote in a report.

All outstanding loans from the lending programme are expected to be wiped off the BOJ’s books by March 2028. The central bank’s balance sheet stood at ¥740 trillion, according to the latest data.

In the BOJ’s portfolio, long-term government bonds account for about 79%, while the share of exchange-traded funds (ETFs) calculated at book value is 5%, according to central bank data. 

The BOJ’s first major quantitative tightening step took place in July, when it decided to slash bond buying by ¥400 billion every quarter. The bank estimated the move would shrink its bond holdings by about 7% or 8% through the first three month of 2026.  

The lending programme dates back to October 2012, when former BOJ governor Masaaki Shirakawa opted to provide long-term funds to banks. At the time, Shirakawa stressed it was an “unlimited” programme, moving shortly after the ECB’s decision to buy an unlimited amount of government bonds during the European debt crisis. 

Back then, the BOJ initiative was viewed by many investors as an effort to escape criticism that it wasn’t embarking on more ambitious monetary stimulus. 

After multiple tweaks in the programme over the years, the duration of the loan offering was cut to one year from four years last March, when the central bank decided to call time on the massive monetary easing programme introduced by Shirakawa’s successor, Haruhiko Kuroda. 

Uploaded by Isabelle Francis