The Bank of Japan’s 14 February decision to expand its asset purchase program (APP) by ¥10 trillion to ¥65 trillion appears to represent a serious effort to loosen monetary conditions and may contribute to a further weakening of the yen over coming months.

The APP was introduced in October 2010 and stood at ¥44.5 trillion on 20 February. The aim is to reach the new ¥65 trillion ceiling by the end of 2012, suggesting a monetary boost of about ¥20 trillion over the next 10 months, equivalent to $250 billion or 4.25% of Japanese annual GDP.

Sceptics, however, argue that the BoJ is, once again, using an expansion of the headline APP target to deflect political pressure and is unlikely to follow through with a significant liquidity injection. They point out that the rise in the APP to ¥44.5 trillion since October 2010 has not been fully reflected in the size of the BoJ’s balance sheet and the monetary base (i.e. notes in circulation plus bank reserves) – BoJ assets have increased by ¥23 trillion and the base by only ¥16.5 trillion.

Less than 40% of the APP “injection”, in other words, has fed through to the monetary base. On this basis, the planned ¥20 trillion expansion by the end of 2012 may boost the base by only about ¥8 trillion.

To understand why this is probably too pessimistic, it is necessary to examine the reasons for the limited impact to date. The current ¥44.5 trillion APP total comprises “fund-supplying operations against pooled collateral” of ¥33.5 trillion and securities holdings of ¥11 trillion. Banks have used a large proportion of the funds accessed under the former facility to repay existing borrowing from the BoJ. Total BoJ loans have risen by only ¥11 trillion since October 2010, explaining the slippage between the APP and balance sheet expansion.

The even smaller impact on the monetary base reflects, in addition, an increase of ¥8 trillion in BoJ repo borrowing, which drains reserves from the banking system.

Looking ahead, the planned ¥20 trillion APP expansion by the end of 2012 is intended to be achieved mainly via a ¥19 trillion expansion of securities holdings, implying an equivalent boost to the size of the balance sheet. The BoJ’s new commitment, meanwhile, to target inflation at 1% over the medium to long term would seem to preclude sterilising this liquidity injection by increasing repo borrowing further. The APP rise, therefore, should be broadly matched by the monetary base.

The chart shows straight-line projections for BoJ assets and bank reserves assuming that 1) the planned increase in securities holdings is achieved, 2) there are no other influences on the size of the central bank’s balance sheet or the monetary base and 3) notes in circulation are stable so the rise in the base is reflected in reserves. The suggestion is that BoJ assets will expand to about ¥159 trillion by end-2012 versus a previous record of ¥150 trillion reached after the March 2011 earthquake / tsunami, with bank reserves rising by nearly three-quarters from their current level.