The Bank of Japan (BOJ) is a top 10 shareholder in 90% of stocks listed on the Nikkei 225. This startling statistic came from public research published in an April 2016 Bloomberg article by Yuji Nakamura, Anna Kitanaka and Nao Sano. The three Japanese market analysts also point out that the BOJ owns 55% of Japanese exchange-traded funds (ETFs), or more than every other investor in the world combined.

In fact, the BOJ owns more of Japan's equity market than BlackRock Inc. (NYSE: BLK) and Vanguard Group. This could be considered a nationalization of the Japanese stock market, except that the BOJ technically earned independence from the Japanese government in 1998. Modeled after the U.S. Federal Reserve system, the BOJ is a public-private chartered organization with a state-protected monopoly over the money supply.

"This is clearly distorting the sanity of the stock market," said Shingo Ide, chief strategist for the Toyko-based NLI Research Institute. Stock prices are supposed to reflect the underlying value of a company. To be priced correctly, equities should reflect earnings and other fundamental characteristics, not the whims of central bankers. Any unexpected policy moves could send the market haywire.

Security Purchases as Monetary Policy

On April 5, 2013, BOJ Governor Haruhiko Kuroda announced an ambitious bond and stock purchase program. The BOJ planned to buy between 60 and 70 trillion yen worth of securities with the hope of doubling Japan's monetary base.

As Nakamura, Kitanaka and Sano point out, the BOJ is not the first or only government agency to buy stocks of private companies. The U.S. Treasury Department and the Hong Kong government previously purchased distressed assets to prop up valuations and capitalize major companies after the Great Recession. The Japanese case is only different because of its unprecedented magnitude and relatively open-ended commitment.

It also leaves Japanese investors in a precarious situation because the BOJ is now the dominant presence in the Nikkei. Unlike other investors, the BOJ is not looking to earn dividends or capital gains. Instead, it only cares about preventing deflation.

Specifically, this is the culmination of the BOJ's desperate and experimental attempts to revive 2% inflation in Japan's economy. The 2% inflation target is a major policy goal for Prime Minister Shinzo Abe, though efforts have mostly fallen flat. Mainstream macroeconomic policy, which consists mainly of large government deficits and very low interest rates, has failed to revive growth in Japan for more than 25 years.

The Tokyo Whale

Now the BOJ is a major shareholder in at least 200 of the 225 companies within the Nikkei. The central bank is gobbling up so many stocks that Nakamura, Kitanaka and Sano dubbed it the Tokyo Whale, as "whale" is a common name for big money players in the stock market.

The Tokyo Whale is expected to grow larger. Just a week before the Bloomberg article was published, analysts from Goldman Sachs predicted BOJ purchases of ETFs to climb to 7 trillion yen from 3.3 trillion yen per year. Reuters published an article entitled "BOJ Warming to Idea of Buying More Stock Funds: Sources" during the same week and predicted similar activity.

There Is Probably an Asset Bubble

Through these policies, the BOJ risks creating a very big asset bubble. Market analysts would say the Nikkei is detached from the fundamentals, much like the American technology sector in the late 1990s or the Japanese real estate market in the late 1980s. More air may enter the bubble if the BOJ ramps up securities purchases.

The BOJ may already find itself in an uncomfortable position. Even a relatively small sell-off could scare outside investors away from Japan, crushing valuations for Japanese firms. Worse yet, it means international currency markets aren't sure how to price the yen correctly. If the BOJ sells most or all of its private security assets, a huge amount of yen could leave circulation. If the BOJ keeps on printing and buying, eventually nobody may want to hold yen for fear of deflation.

This is a tightrope act, and it is not clear whether the BOJ can make it to the other side. All the while, there should be less pressure to improve corporate governance among Japanese firms. After all, managers and directors can always run to the BOJ for more money.

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