Can Japan direct downward march of yen without triggering a currency war?
Andrew Sheng says competitive devaluation could begin if the central bank can’t moderate the fall
When Shinzo Abe became prime minister of Japan late last year, he promised to deliver change. Shortly after, he announced a 10.3 trillion yen (HK$877 billion) stimulus package to end deflation and pressured the Bank of Japan to adopt a 2 per cent inflation target. As a result, the Nikkei stock market index has steadily risen and the yen has fallen to 91.76 per dollar, the weakest since June 2010.
Such action has already provoked muttering about another currency war, invoked by Russian, German and South Korean officials.
Are we moving from a trade war to a currency war? Not yet.
Firstly, the global imbalance is already ameliorating, with the Japanese current account surplus declining sharply due to rising oil import costs.
Second, every reserve currency central bank (the European Central Bank, US Federal Reserve, Bank of England and Bank of Japan) claims it has inflation in its target, rather than the exchange rate. In other words, currency rates are a consequence of monetary policy, not a target. And we know that if everyone devalues at the same time, there is no advantage to one country.
To be fair, the Japanese economy has been in retreat since the bubble burst in 1990. The government has tried almost every tool in the book, and its fiscal prime-pumping has pushed gross debt to over 230 per cent of GDP, even as the population is ageing fast.
The good news is that, unlike the European deficit countries, Japan is a net lender to the rest of the world. So, a weaker yen could reflate the economy if exports are stimulated and will also increase the yen value of Japan's net foreign exchange assets.
Since Japanese exports comprise a lot of imports, especially oil and gas, it is not clear how much the tradeable sector will improve. Nevertheless, tourists will flood to Japan to take advantage of high-quality food and service, so the non-tradeable services may revive with better employment.
The real question in terms of spillover is less in the trade account than in the capital account. The substantial devaluation of the yen is an invitation to the revival of the yen carry trade, which was what made the speculation in currency and stock market trade in the rest of Asia so profitable in 1997/98. So far, markets in Southeast Asia are all hitting near-record highs, but it is not clear how much of this is due to the carry trade or simply the broader effects of the third round of the Fed's "quantitative easing" and the improvement in US stock markets.
The real questions are what instrument the Bank of Japan can use to control the level of the yen and what happens next if the inflation target is achieved.
Central banks can control the exchange rate using the quantitative tool, the price tool or moral suasion. The market knows the Bank of Japan cannot use the interest rate tool, because higher rates would hurt all borrowers, especially the huge government debt burden.
This means that guiding the exchange rate would require central bank intervention in the foreign exchange market. The Bank of Japan has intervened in the past few years by buying dollars. So to prevent the yen depreciating too fast, the reverse would have to occur. The question is how much of it would be required to keep the yen rate stable. Intervention is credible when central banks work together to intervene, as happened in July 1998.
There are clearly psychological barriers. The first is 100 yen to the US dollar. As all foreign exchange traders know, once a psychological barrier is breached, there is likely to be an overshoot with momentum pushing the price to another barrier, in this case 110 or 120. It took four years to move from 136 yen to the dollar, in April 1991, to 85 yen in April 1995, where it stayed for four months before it began to depreciate again, taking two years to fall to 147 in July 1998, before intervention took it upwards again.
From July 1998 to January 2002, the currency fluctuated between 100 and 133, but after the Lehman Brothers failure in September 2008, the yen was seen as a haven currency and steadily appreciated to a record level of 76 by December 2011, despite periodic intervention.
The triple trick Abe has to pull off, beyond the terms of monetary and fiscal policy, includes structural reforms. Japan's structural problem is that the strong export sector that has kept the economy afloat in spite of an inefficient non-tradeable sector is beginning to sag under the combination of a strong currency and allowing competitors in the car and electronics sectors to eat into the Japanese market share. On top of this, the ageing population is affecting overall productivity.
If growth revives with inflation to 2 per cent, without a rise in interest rates, the inflation would eat away the debt overhang, and the trick is done.
Critics of Abe's initiatives claim it has all been tried before, with little success. The coming months will be a test of nerves. If the yen goes beyond 120, then some tough decisions will have to be made on whether competitive devaluations would begin.
Andrew Sheng is president of the Fung Global Institute