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BoJ’s bazooka increasingly felt around Asia

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The Bank of Japan's (BoJ) unprecedented monetary stimulus is increasingly being felt around Asia, with the central bank's liquidity set to provide an important buffer against the Federal Reserve's impending tightening, says HSBC.

"With inflation [in Japan] still far from target, we expect the BoJ to keep financial conditions extraordinarily loose for some time. Asia will increasingly feel the impact of Japanese capital," Izumi Devalier, economist at HSBC wrote in a report.

In April 2013, the central bank launched an aggressive easing program to pull the world's third largest economy out of two decades of deflation and sluggish growth. It has since been injecting $60-80 billion per month into the financial system via purchases of Japanese government bonds (JGBs) and risk assets.

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The availability of cheap Japanese funding will rise in importance as the Fed takes monetary policy in the opposite direction of the BoJ, Devalier said.

The U.S. central bank has steadily scaled back its monthly asset purchases over the course of the year to $35 billion per month, down from a peak of $85 billion in 2013. It is expected to begin raising interest rates as early as the second quarter of next year.

"That evokes concerns of a sudden drought of liquidity in Asia, where aggressive easing by the Fed has increased the availability of dollar funding, encouraging portfolio flows from overseas investors," Devalier said.

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"Fortunately, many Asian countries have beefed up their defenses over the past few quarters, rebuilding their FX reserves and adopting a cautious monetary stance, where necessary. The liquidity provided by the Bank of Japan will provide an additional buffer against the next wave of Fed tightening," she added.

Martin Schulz, senior economist at Fujitsu Research Institute, agreed and noted that "the Japan story is a positive story for Asia. The BoJ won't be tightening for at least two years – this will be a source of liquidity for Asia."

Evidence of spillovers

Japanese commercial bank lending to Asia has soared to an all-time high of $450 billion, up from $364 billion at the end of 2012, as banks turn to overseas markets for better returns.

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"Flushed with cash, Japanese banks have become much more active around Asia, particularly in ASEAN. Since interest rates are higher in neighboring Asian countries, this arbitrage works very well for the lenders," Schulz said. The BoJ's bond purchases have seen banks' excess reserves balloon to 12 percent of their assets. This is forecast to reach 16 percent by the end of 2014.

Furthermore, Japanese foreign direct investment into neighboring countries has risen steadily. Last year, the country's outward direct investment in Asia reached a record high $38.7 billion, a seven-fold increase from 2000.

Asia's share of Japanese direct investment stock is now as high as the U.S. and exceeds that of the European Union, according to HSBC.

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By sector, manufacturing is a primary recipient of Japan's direct investment flows, although there are signs investment into the non-manufacturing sector is starting to accelerate. Countries like Vietnam, India and Indonesia have seen a significant pick up in service-oriented FDI from Japan, the bank said.

"This suggests that, along with the traditional manufacturing industries like automobiles, Japanese companies have started to increase their presence in the service sector as well. Firms are increasingly viewing Asia not just as a production base but a vibrant, consumer market," Devalier said.