Stock lending weakens BoJ’s ETF buying programme, BIS paper claims

The Bank of Japan is progressively weakening the impact of its colossal fund buying programme by allowing the stocks held in its name to be lent to short sellers, research has claimed.

The Japanese central bank has bought $248bn of domestic equity exchange traded funds since 2010 as a novel element of its quantitative easing programme to tackle entrenched deflation. The value of these holdings had increased to $355bn by March 31 this year off the back of rising markets, according to the bank’s balance sheet.

The programme is designed to loosen monetary conditions in the world’s third-largest economy by reducing the country’s equity risk premium, as well as creating a wealth effect by putting more money in consumers’ pockets.

The BoJ now owns about 7 per cent of the free-float of all Japanese listed companies and 55 per cent of the entire Japanese ETF market, according to data from ETFGI, a consultancy.

This unprecedented buying spree has seemingly succeeded in pushing the Japanese stock market higher, with the blue-chip Nikkei 225 index up about 250 per cent since 2010.

However, a paper written by Koji Takahashi, an economist at the Bank for International Settlements — often referred to as the central bankers’ central bank — and two Japanese academics has claimed that the benefits of the policy are being diluted by stock lending by the ETFs they have invested in.

In their BIS working paper, “To Lend or Not to Lend: the Bank of Japan’s ETF purchase program and securities lending”, the trio state that the BoJ’s buying spree “inevitably result in increases in demand for individual stocks that constitute the ETFs, thus tightening supply-demand conditions in the stock market and possibly leading to overvaluation or liquidity shortages of individual stocks”.

If so, this might have increased the desire by hedge funds and other players to borrow stock in order to build short exposure to these now overvalued equities.

The paper contends that the BoJ’s purchases have increased the supply of lendable stocks, as the ETFs it has invested in have an incentive to make their holdings available to short sellers as a way of generating additional revenue to bolster investment returns.

This increased supply could reduce stock lending fees, making shorting even more attractive. Based on an assumption that stock lending has a downward impact on the market, this would work against the upward momentum generated by the BoJ buying the stocks in the first place.

This is exactly what the authors say they have found.

“A clear relationship between the amount of BoJ’s ETF purchases and the lendable shares is observed in the data,” the paper said.

“We empirically show that, over longer periods, the BoJ’s accumulated purchases lowered lending fees in the stock lending market and weakened the effects of the BoJ’s purchases on stock returns . . . thus diminishing the policy effect of the ETF purchase programme.”

The impact was statistically significant for what the authors call “special” stocks — the 10 per cent or so of equities that have limited availability in the stock lending market, and therefore command particularly high lending fees.  

For these stocks, the paper found that the impact of the BoJ’s buying spree was diluted by an average of 15 per cent. For some of these stocks the dilution was as high as 30 per cent.

The Bank of Japan is not believed to have discussed the stock lending issue in any depth when it devised the equity ETF purchase programme. However, it is thought to view the initiative as a success.

Indeed, although the purchases have largely stopped as consumer price inflation has risen above 3 per cent, the BoJ retains the ETFs as a tool in its arsenal.

Earlier this month it bought ¥70bn ($470mn) of ETFs, its data show, after the stock market sold off amid a spike in US Treasury yields. This was the third time the BoJ had dipped into the market this year, following two days in March when it steadied Tokyo stocks in the wake of the collapse of Silicon Valley Bank in the US. The BoJ declined to comment for this story.

The research raises the possibility that the BoJ could get more bang for its buck — pushing the Japanese market higher for every dollar it spends — by asking the managers of the ETFs it holds to not lend out its holdings, although this would be likely to reduce its returns at the margin. It could alternatively sell the ETFs and use the proceeds to buy the underlying stocks directly and not lend them out, although this might prove more controversial.

Bryan Armour, director of passive strategies research, North America at Morningstar, agreed with the authors that stock lending could push down the price of a stock.

However, even if the BoJ did stop the lending of its equity holdings, he argued that short sellers would just go elsewhere.

“There will be people out there that borrow, and if it’s not from your fund it will be from another one, so I don’t think it adds any downside pressure on your fund. It’s generally a net positive,” Armour said.

Deborah Fuhr, managing partner of ETFGI, doubted that many market participants wanted to short Tokyo stocks anyway, given their strong run.

“The Japanese market for a while has been doing really well, so do people really want to go short?” she asked. “You have shorting because people think that the market is going to go down. If the market is going up it’s less likely that people would want to put on a hedge.”