Japan's debacle...
(the "Rogue Wave" - Market Tsunami is still out there. Will it be Argentina, or Japan; or another Terrorist act ?)
prudentbear.com
International Perspective - by Marshall Auerback
JAPAN: A YEN DEVALUATION IS RISKY, BUT THE ALTERNATIVES ARE FAR WORSE
November 27, 2001
It’s very tough to be a policy maker in Japan these days given the flurry of contradictory advice that keeps flooding the country from abroad. The international expressions of anxiety (and concomitant suggestions) are mounting in proportion to the worsening global economic backdrop: despite massive monetary ease, America’s economy shows little sign of recovery yet, notwithstanding Paul O’Neill’s recent protestations to the contrary; the much-heralded bounce-back in US consumption last month merely reflects tomorrow’s purchases being cannibalized by today’s massive price discounting and zero-interest loans. Similarly, the German government has confirmed that its GDP shrank in the third quarter of the year. The biggest economy in the European Union is now no longer growing, and the short-term outlook looks set to worsen further.
At this time of gathering global economic distress, policy makers are looking to Japan more in desperation than hope. The pessimism appears justified in that the plight of the world's second largest economy and largest creditor has worsened yet again over the past few quarters. The Japanese economy has fallen back into recession, with domestic prices not just falling but doing so at an accelerating rate. Since 1993, the deflator for gross domestic product has fallen by 6 per cent. But in the first 6 months of this year, it fell by 2.2 per cent. Irving Fisher’s theory of debt deflation is alive and well in Japan 2001.
Discussions of a liquidity trap in Japan are nothing new, but the tone more recently has definitely taken on a new sense of urgency. For example, just last week the Financial Times mooted the possibility of the Bank of Japan initiating large scale purchases of foreign bonds, a policy that would be tantamount to embracing a devaluation of the yen, provided the central bank is prepared to create money to purchase foreign exchange. Instead of hysterically warning about the dangers posed by a falling yen, the FT analysis rightly focused on the most germane issue, namely, the continuing problem of stagnating domestic demand in Japan itself. In a recent editorial, the paper suggested that however desirable "reform" and liberal market deregulation might be under normal circumstances, the overriding priority at this juncture must be to break the cycle of deflation: "Structural reform and dealing with the overhang of non-performing loans are important tasks for the medium term. But the overwhelming priority is to halt the gathering momentum of deflation. The failure of the Bank of Japan to achieve this, in apparent violation of its obligation to secure price stability, is simply a calamity. No other word for what is happening will do."
Although one always has to view the chances of anything positive emerging from Japan these days somewhat sceptically (given the history of undelivered promises over the past decade), there are some tentative signs that Japan’s leading monetary authorities are finally prepared to contemplate more radical measures for their beleaguered economy. Most encouraging is that the discussions are focusing on open-ended purchases of government bonds, of other domestic assets and, most radically of all, foreign assets such as US bonds. All would take debt monetization to a new level, as well as invariably creating the conditions for a much weaker yen, if carried out in earnest.
We must stress that the hidebound governor of the BOJ, Masaru Hayami, has not signed off yet on any of these proposals; but they are being actively debated within the Bank’s Monetary Policy Committee. This policy is not without its own risks, as it throws open the possibility of an accelerated flight out of the yen, turning a gradual devaluation into a Third World style run on the currency, potentially destabilizing the other economies of Asia in the process. But maintenance of the status quo is a far riskier option; a sick and ailing Japan against a global backdrop of weakening economic activity heightens the possibility of an international financial meltdown, as MIT economist Rudi Dornbusch recently observed:
"Instead of being bottled up in Japan, the economic shock will spread like a tidal wave, just as the New York collapse of 1929 did. Policy responses to such economic shocks may be better nowadays than they were during the Great Depression -- for example, we know not to embark on a trade war should the yen crash -- but no one knows how long and painful the process of correction will be."
Why do we take the current trial balloons signalling devaluation more seriously given previous disappointments? Chiefly because in the past, any policy that implied yen devaluation was immediately shot down by US government officials, notably former US Treasury Secretaries Robert Rubin and Lawrence Summers, both of whom repeatedly warned during their respective tenures that Japan must not try to export its way out of recession. Such "advice" came despite the fact that the pursuit of a weaker yen was ostensibly consistent with America’s strong dollar policy which, as these very same gentlemen were fond of constantly asserting, was "always in the interests of the United States". Not only has the American rhetoric been harsh in the past, but the signals being sent have generally been very confusing and, indeed, contradictory. For example, the U.S. Treasury used to be fond of telling Japan that their path to economic growth was in ever expanding fiscal deficits. At the same time, the U.S. Treasury has (until September 11th in any case) tended to assert that American economic growth has in large part been achieved by getting its own house in order – i.e. through ever contracting fiscal deficits.
So which is it? At the very least, one might suspect that (in the words of President Bush’s chief economic advisor, Lawrence Lindsey): "Treasury officials are not expounding some universal economic truth, but rather are applying, ad hoc, a relationship between two variables based on political necessity, not economic logic".
Perhaps this time political necessity and economic logic are finally running on parallel tracks toward an agreed destination. According to a recent account in the FT, US administration officials have indicated privately that they had been asked about the latest trial balloon relating to a potential devaluation of the yen and did not shoot the proposal down as in the past. As an aside, it is interesting that Tokyo still feels the need to consult with the US government on a policy designed to restore faltering economic growth in Japan, the so-called "reform politics" of Prime Minister Koizumi notwithstanding. Whether devaluing their currency in the 1980s, or asserting a "strong dollar" policy during most of the 1990s, Washington’s economic policy makers generally showed themselves to be supremely indifferent to the global economic consequences of their actions. Argentina, for example, is the most recent manifestation of a country unhappily caught in the crossfire between the competing interests of America’s manufacturers and financiers in respect of the debate over the strong dollar policy, yet we do not recall any advance consultations with the Argentineans or, indeed, the Mexicans, prior to the onset of Rubin’s strong dollar policy.
Perhaps there should not have been any advanced consultation, particularly if the respective policy choices were seen as essential to America’s long-term global economic prosperity (although we have our doubts that such noble long-term aspirations ever animated the Rubin Treasury). Most Americans would deem it absurd that another country should have an implicit veto on their conduct of domestic economic policy. Why, then, should Washington have the final say in the monetary affairs of the Japanese? In any case, the most recent set of trade figures from Japan in October showed another sharp (-40% y-o-y) drop in the trade balance, with exports falling 18 per cent in dollar terms, and imports 15 per cent y-o-y, consequently rendering it increasingly difficult to argue the case against a devaluation of the yen.
An imprimatur from Washington, or Japan’s Asian allies, should not be a quid pro quo to carry out a policy of aggressive expansion of domestic demand, even if a weak yen is a direct consequence of such reflation. It is important for Tokyo to recognize that the advice conferred by one party will almost invariably be contradicted by another, given the potential conflict of interests and the self-serving nature of the various policy recommendations. Even with the US tacitly conceding the need for a weaker yen, the Chinese have again revived the old threat of a devaluation of the Chinese renminbi.
True, China’s growth, notably its external sector, has shown recent signs of deceleration in line with a faltering global economy. We would argue that this has less to do with the renminbi’s overvaluation, and more to do with decelerating global demand. Even today, China has a large trade surplus and, in particular, continues to run huge bilateral trade surpluses with Japan, a highly advantageous position that the country understandably wishes to safeguard. But given China’s huge foreign exchange reserves, and underdeveloped domestic infrastructure, the country is surely in a better position than most to accommodate increased imports from Japan or the US and pursue more aggressively a policy designed to stimulate domestic consumption.
Even if the Chinese current account surplus does deteriorate as a consequence of such a policy, the continued existence of capital controls does minimize the potential risks posed by short-term destabilizing Western portfolio flows and short-term debt, as the relative resiliency of the country’s economy in 1998 clearly demonstrated. True, today China is in the midst of a nasty trade dispute with the Japanese. By the same token, however, one should hardly expect the Chinese government to offer a completely disinterested analysis in respect of what a fall in the Japanese currency might mean to them and the region as a whole. Consequently, a threatened devaluation of the renminbi in response to a weaker yen should be taken with a grain of salt.
This conventional wisdom of the dangers posed by a rapidly depreciating yen has also been challenged by Japan’s vice minister of finance for international affairs, Haruhiko Kuroda. To begin with, Kuroda makes a key point that we have been emphasizing for months: namely, that the source of Japan’s current economic weakness must be addressed, so as to avert generalized weakness in the region as a whole. A restoration of Japanese growth, even at the cost of a depreciating currency, is a necessary precondition to restoring growth and economic stability throughout Asia:
"The crux of the problem of the Japanese economy, many argue, is non-performing loans in the banking system. Although banks have adequately provisioned for bad assets and written off some of their bad assets, new NPLs have emerged. As a result, the total size of the NPLs has not declined. This gives the impression that banks haven’t dealt with the problem. However, the emergence of new NPLs can’t be stopped until the economy starts to recover vigorously and until land and stock prices start to rise (or at least not decline further). The vicious cycle of asset deflation and weakening economy has to be stopped." (Our emphasis)
Kuroda gets to the essence of the problem. For a highly indebted economy there are in fact two states: one characterized by the dynamics of debt deflation and one not. When the income flows of debtors become depressed, however, the over-indebted economy begins a phase of debt deflation. At this stage, many otherwise laudable and conventional policies must be deferred; everything must be done to return the economy to a state of equilibrium from which an expansion can proceed and restructuring can then take place. With recovery comes the higher cash flows needed to validate high debt. In extreme cases, there must be enough accompanying inflation to create negative real interest rates and thereby erode the crushing real burden of that debt.
This is also a message that has been recently echoed by the chief economics commentator of the FT, Martin Wolf:
"Assume that the [Japanese] economy is set to grow at 1.5 per cent a year, while the price level falls at 2 per cent a year. Assume also that the primary fiscal deficit (the deficit before interest payments) continues at just over 4 per cent of GDP and the interest rate paid by the government falls from its current average level of 3 per cent to 2 per cent in 2003 before rising back to 3 per cent in 2005 and then 4 per cent in 2010. Under these assumptions, the ratio of net debt to GDP (excluding social security) hits 150 per cent by 2007 and 250 per cent by 2015. The ratio of gross debt to GDP hits 185 per cent in 2007 and 310 per cent in 2015."
This is clearly untenable over the medium and long term. Consequently, the overwhelming priority of Japan’s monetary and financial officials must be to halt the gathering momentum of deflation.
True, there are risks posed by Japan openly embracing a commitment to a depreciated exchange rate, as economist Rudi Dornbusch has recently noted:
"Japan's finances will remain stable only as long as Japanese households support the status quo by rolling over their holdings of government debt or by buying even more in the mistaken belief that such bonds remain plausible investments. Having seen their investments in stocks be destroyed by the collapse of the bubble 10 years ago, it is not surprising that individual Japanese hang on to their government's liabilities as a last remaining hope.
This is dangerous. One day there will be a creditors' strike. Investors will take flight into foreign assets as in any delinquent emerging market, and this will send the yen into a tailspin. When a currency crashes in this way, debt crashes and confidence falls, dragging consumption down with it. Overnight, Japan could descend into a new Great Depression."
Without seeking to ignore the real risks highlighted by Dornbusch, we feel that his analysis misses an even greater danger: the immense costs that could arise were Japan continue to do nothing to address the problem of deflation. Japan’s current finances are perilous precisely because it is an economy already burdened with vast post-bubble debt and a heavy burden of non-performing loans, which are themselves the consequence of years of policy inaction by the Bank of Japan. These debts must be inflated away rapidly; the status quo is no longer an option.
It is also worthwhile noting that in contrast to the current situation in the US (where 40 per cent of the Treasury market is held by overseas’ investors), the composition of Japan’s debts is virtually all yen-denominated and primarily domestically held. This condition virtually eliminates the risks posed were a large proportion of the country’s debt dollar-denominated, with substantial overseas’ holder potentially bolting at the first sign of trouble (thereby hugely raising the cost of the debt as the yen depreciated). This was a condition that afflicted both Korea and Indonesia in 1998.
Indeed, one could make the additional case that a policy by the Bank of Japan to buy foreign assets would have the further attraction of diversifying the central bank’s asset portfolio which, at present, is largely dominated by Japanese government bonds. If the BOJ were to succeed in combating deflation, the price of these JGBs would invariably fall, but the value of the overseas bonds would rise, thereby alleviating part of the damage to the banks’ reserves that would arise in the event of a precipitous fall in the yen. It is certainly much easier to initiate this process when pre-existing levels of foreign debt and foreign ownership of debt are fairly limited.
By contrast, maintenance of the status quo would mean an ever-widening spiral of mass bankruptcy, financial contraction and deepening recession. In such circumstances, not only would the huge public sector deficit that so worries Dornbusch continue to rise inexorably, but the very prospect of the creditors’ strike to which he alludes would increase markedly.
True there is the risk that a gradual yen decline may turn into a rout, but this would simply accelerate the inevitable inflation and thereby reduce the real cost of the debt overhang more rapidly. And given the high degree of leverage in Japanese corporate balance sheets, higher inflation will rapidly increase the net worth of Japanese corporations, as its destroys debt. As for the argument that such inflation would unfairly destroy the country’s vast pool of domestic savings, or destroy the value of the principal asset now held by the country’s commercial banks (i.e. JGBs), we would respond that such savings are in reality overstated, given that most are deposited in banks that are likely bankrupt already.
The corollary also applies: the "assets" of Japan’s banks are dwarfed by their still considerably understated liabilities. A recent study by Analytica Japan’s Stephen Church puts the total of NPLs held by the private sector -- city banks, regionals, coops, insurers, etc. -- at 44 percent of gross domestic product. Church then adds the rarely noted loans extended by the public sector, chiefly the Finance Ministry's Trust Fund Bureau. This enlarges the NPL universe to almost 70 percent of GDP. Reading Church’s compelling analysis, it is hard to shy away from the conclusion that nationalization is almost inevitable, given the relentless compounding of gross debt to GDP brought about by the intensification of debt deflation dynamics.
By the same token, most of Asia will also collapse, as Dornbusch suggests, if Japan continues to stick with the status quo. It would be naïve to argue that there would be absolutely no spillover effects at all in emerging Asia, notably countries such as Korea, Taiwan, and Singapore in the event of a substantial fall in the yen. After all, these economies are already being buffeted by external IT growth shocks from the US and a generalized risk aversion to investment in the emerging markets region as a whole, chiefly as a consequence of Argentina’s current travails. So some competitive devaluation fallout is to be expected.
But given emerging Asia’s high foreign exchange reserves, huge household savings, current account surpluses, and minimal reliance on short-term external debt (since 1998), the region is arguably better placed to absorb these shocks today than observers like Dornbusch imply. In addition, these are still emerging economies, in desperate need of the FDI that the Japanese could bring, were the latter allowed to run a larger current account surplus. Consequently, we do not share the view that yen depreciation inevitably marks the first step toward renewed financial crisis in Asia as a whole. On the contrary, we think investors should welcome yen depreciation as it would likely represent the first concrete sign that Tokyo was finally coming to grips with its prolonged problem of deflation, the elimination of which would do much to restore the region’s growth prospect, with Japan the new economic locus.
We do not wish to understate the dangers of the path that Japan’s monetary authorities appear to be contemplating. There are invariably risks associated with any measures taken by the country’s monetary authorities today; such is the cumulative cost of years of misguided policy. But we think the greatest risks posed not only to Japan, but also to the global economy as a whole, is continued policy inertia and assertions by the hapless BOJ governor that he has done all that he can do. In the long term, ending the deflation by a more aggressive and unorthodox monetary policy is certainly not all Japan needs to do. But it is a precondition for all the rest: the problem of the NPLs in the banking system, the inefficiencies of the country’s distribution system, the restructuring of the country’s public finances, etc. Today the country’s policy makers understandably suffer from a lack of confidence, given the economy’s apparent inability to respond to any measure taken thus far. But the time for dithering and half-hearted stop-go reflation is over, particularly given the perilous state of a global economy that still shows no sign of imminent recovery. Japan must stop soliciting approval from the gaijin and get on with the job of rescuing their economy before the nightmare scenario laid out by Rudi Dornbusch does in fact become reality. |
