A post last week suggested that the Bank of Japan’s monetary blitz would boost the M3 broad money supply by less than 3% in 2013. Further analysis supports this conclusion.

Central bank bond purchases have a direct impact on broad money only if securities are purchased from domestic non-banks – their bank deposits swell as the transaction is settled.

When the central bank buys from the banking system, the banks swap securities on their balance sheet for reserves at the central bank. The money supply is unchanged unless the rise in reserves leads banks to increase lending or undertake other money-creating activities. Any impact, in other words, is indirect.

Buying from overseas investors also has no first-round impact since their bank deposits are excluded from the money supply.

A significant direct boost from the current programme, therefore, depends on BoJ purchases substituting for buying by non-banks. The distribution of holdings and recent behaviour, however, suggest that banks and foreigners will accommodate increased BoJ demand.

The table below is a simplified presentation of data from the BoJ’s flow of funds accounts, showing flows and stocks of government securities by sector. Note, first, that domestic non-banks accounted for 42% of the stock of securities held outside the BoJ at the end of 2012* (right-hand column). The share of the banking sector – comprising Japan Post, domestic banks and other private intermediaries – was higher, at 48%.

These shares imply that, if the BoJ buys from sectors in proportion to their existing holdings, the ¥51 trillion of purchases planned for 2013 will give a direct monetary boost of ¥21 trillion (i.e. 42% of ¥51 trillion). ¥21 trillion is equivalent to 1.9% of the M3 money stock.

Now consider changes in sectoral flows between 2010 and 2012. BoJ buying increased significantly between the two years, from ¥5 trillion to ¥24 trillion. Yet purchases by domestic non-banks fell only marginally, from ¥17 trillion to ¥15 trillion. The BoJ’s increased buying was more than offset by a slump in banking system demand (i.e. including Japan Post), from  ¥26 trillion in 2010 to -¥4 trillion last year.

One explanation for the negative correlation between BoJ and banking system transactions is that banks vary their government securities holdings to offset changes in central bank reserves. BoJ buying boosts bank reserves even when purchases are from non-banks or foreigners. If banks target stable overall liquidity, defined as reserves plus government securities, a rise in their BoJ deposits will automatically trigger a rundown of securities holdings.

A negative correlation between reserves and banking system transactions in government securities is also evident in the UK in recent years and is the basis for the view here that QE pass-through may have been as low as 20% rather than the 60% claimed by the Bank of England – see previous post.

As shown in the table, the BoJ is targeting government securities purchases of ¥51 trillion and ¥50 trillion respectively in 2013 and 2014 but current BoJ deposits are projected to rise by even more, i.e. ¥60 trillion and ¥68 trillion. This huge reserves boost is likely to trigger heavy bank sales of securities. The illustrative forecast in the table shows sales rising from ¥4 trillion in 2012 to ¥27 trillion per annum – smaller than the swing between 2010 and 2012 despite a much larger increase in reserves expansion. With overseas holdings and overall issuance assumed, conservatively, to be stable, this would allow domestic non-bank buying to continue at its recent pace.

On plausible assumptions, in other words, the direct monetary boost from the BoJ’s actions could prove miniscule. A significant overall effect depends on banks and foreigners deploying cash received from the BoJ to increase lending to or buy assets from the rest of the economy. The hope is that, by changing expectations, the policy shift will induce such behaviour but Japan’s prior QE experiment as well as recent US and UK experience argue for caution.

Japan’s economic outlook has improved but this trend was in place before last week’s “shock and awe”, which may have only a marginal further impact and has been pushed through at the cost of the BoJ’s independence, increasing the risk of its future use as a source of permanent monetary deficit financing.

*This compares with a share of domestic non-banks in UK gilt holdings of 61% at end-2008 before QE started in March 2009.