I was in New Delhi last month when news broke that the Bank of Japan had intervened to reverse the appreciation of the yen. Fifteen years ago, in 1995, the yen also reached a peak, which also coincided with the cut in interest rates to zero, thus creating the yen carry trade.
The conference in New Delhi was about G20 co-operation, but it was clear that everyone was more concerned about global imbalances and exchange rates. The big debate was whether the global imbalances are cyclical or caused by structural problems. If the reasons are structural, then adjusting the exchange rate will not help too much to correct imbalances.
The best evidence of this is the yen experience. The yen appreciated substantially against the US dollar, but did not correct the US-Japan trade deficit. Indeed, the Japanese current account surplus did not decline substantially despite the appreciation of the yen, because Japanese production was shifted to the rest of East Asia. The US-Japan argument over the yen in the 1980s and 1990s has become the US-China debate on the renminbi today.
Zero interest rate policies have caused huge distortions in the economy. On this, the Japanese experience is very illuminating.
When interest rates are zero, the central bank loses the instrument to control the exchange rate, which explains why the yen-dollar rate was highly volatile, fluctuating between 80 and 159 over the last 20 years. From 159 in 1990, it rose to 80 in 1995, then fell to 143 in July 1998 and then appreciated back to 82 last month.
During this period of zero-interest-rate policy, a whole generation of the most frugal, hardworking housewives, typically called Mrs Watanabe, became currency-margin traders. They borrow yen at zero interest rate and speculate in high-interest currencies like the Australian dollar or South African rand. The hedge funds and commercial banks make a lot of money fuelling such speculation, not unlike sharks eating sardines.
