EXCLUSIVE-BOJ to consider scaling back ETF buying, market control in March review-sources

* BOJ to look at making its ETF buying more flexible – sources

* Review will also address excess fall in super-long yields

* No consensus on how best to tweak guidance on ETF buying

* BOJ may also release estimates on impact of tools on growth

* BOJ to release findings on review at March 18-19 meeting

TOKYO, Jan 18 (Reuters) – The Bank of Japan will discuss ways to scale back a controversial programme that buys massive amounts of exchange traded funds without stoking market fears of a full-fledged retreat from ultra-loose policy, sources say.

The programme will come up in the BOJ’s March policy review, largely because of policymakers’ concerns over the ballooning size of the central bank’s stock exchange-traded funds (ETF) holdings which, at 35 trillion yen ($337 billion), account for roughly 80% of Japan’s ETF market, said five sources familiar with the BOJ’s thinking.

The BOJ will also consider loosening its grip on yield curve control (YCC) to allow super-long interest rates to rise more, as its dominance in the market keeps yields in an extremely tight range, they said.

The move highlights how years of heavy-handed intervention has left the market reliant on the BOJ, essentially making the central bank a victim of its own success in terms of controlling market moves.

“Prolonged easing has made markets rigid and complacent, so the BOJ needs to change that,” one of the sources said.

“The key is to heighten flexibility in the BOJ’s policy so it can respond to any big shock effectively,” the source said on condition of anonymity, a view echoed by four other sources.

Under YCC, the BOJ buys huge amounts of government bonds to guide short-term rates at around -0.1% and 10-year yields around zero.

It also pledges to buy ETFs at an annual pace of up to 12 trillion yen, although actual purchases have slowed well below this level in recent months as Tokyo stock prices rally.

While the measures are credited for slashing borrowing costs and underpinning stocks, they have drawn criticism for hurting financial institutions’ margins and distorting market pricing.

With the coronavirus pandemic seen forcing it to maintain its stimulus programme for years to come, the BOJ last month announced a plan to examine its policy tools to make them more “sustainable and effective.”

In findings to be announced in March, the central bank may release estimates on how effective the tools have been in boosting growth and inflation, they said.

The BOJ will also look at ways to more flexibly slow ETF buying when markets are calm, the sources said.

By tapering purchases when markets need less support, the central bank will have more ammunition left to ramp up buying and soothe market jitters in times of crises, they said.

“There are questions on whether the BOJ needs to buy so much ETFs when stock prices are booming,” another source said. “There’s room to make the BOJ’s ETF buying more flexible.”

YIELD CURVE CONTROL

The BOJ will make no major tweaks to YCC but look at ways to prevent excessive falls in super-long yields that hurt returns of pension funds and insurers, the sources said.

The challenge would be to do this without giving markets the impression the BOJ is eyeing a full-blown exit from ultra-loose policy – no easy task when a renewed state of emergency to combat COVID-19 clouds Japan’s economic outlook.

While replacing the numerical guidance on the pace of ETF buying is among options being discussed at the BOJ, some are cautious for fear of triggering a market sell-off, they said.

The last thing the BOJ wants is a communication mishap that jolts markets at a time many Japanese firms close their books at the March fiscal year-end.

Whether the BOJ can strike that delicate balance will have implications for other central banks, especially those looking to use tools like YCC to deal with the pandemic fall-out.

The U.S. Federal Reserve and the European Central Bank have reminded markets they have no immediate plan to taper purchases, and could expand stimulus if needed.

“The BOJ wants to give itself more leeway on policy and dispel market concern its policy is unsustainable,” a third source said. “But the communication strategy will be tricky.”

$1 = 103.7300 yen Reporting by Leika Kihara; additional reporting by Tetsushi Kajimoto, Takahiko Wada and Kentaro Sugiyama; Editing by Raju Gopalakrishnan