Is the world about to fall victim to a currency war?
When Shinzo Abe became Japanese prime minister on Boxing Day last year, he promised to deliver change. Very shortly, he announced a 10.3 trillion yen (US$116 billion, or 2.2 per cent of GDP) 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 jumped 28.3 per cent from mid-November to current levels, and the yen weakened by 20.1 per cent from 75.7 to the dollar to 90.9, its lowest level in over two years.Such action has already provoked rumours about another currency war, invoked by Russian, German and South Korean officials.
Are we moving from a trade war to a currency war?
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, the US Fed, the Bank of England and Bank of Japan) claim that they only target inflation, rather than target exchange rates. In other words, currency rates are a consequence of the monetary policy, not a target of it. And we all know that if everyone devalues at the same time, there is no advantage for any single country. Since the world moved off the gold standard in 1971, everyone is aware that competitive devaluation ends up with no winners.
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 their fiscal prime-pumping has pushed gross debt to over 230 per cent of GDP, even as the population has aged very fast.
The good news is that unlike the European deficit countries, Japan is a net lender to the rest of the world to the tune of $3.45 trillion. 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 services, so the non-tradeable services might revive with better employment.
The real question in terms of spillover is less in the trade account but rather in the capital account. A devaluation of the yen from around 77 to 90 is an invitation for the revival of the yen carry trade, which was exactly what made the speculation in currency and stock market trade in the rest of Asia, financed by borrowing a devaluing yen during the Asian financial crisis, so profitable in 1997-98. So far, the 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 quantitative easing (QE3) and the improvement in US stock markets.
The real questions are, what is the instrument that the Bank of Japan can use to control the level of the yen and what happens if the inflation target is really achieved, for Japan as well as the rest of the world?
Central banks have three instruments for controlling the exchange rate - the price tool, the quantitative tool and moral persuasion. The market knows that the Bank of Japan cannot use the interest rate tool, because higher interest rates would hurt all borrowers, especially the huge government debt burden.
This means that guiding the exchange rate in any direction would require central bank intervention in the foreign exchange market. The Bank of Japan has intervened in the last few years to resist the yen appreciating too much by buying dollars. So to prevent the yen depreciating too fast, the reverse operation would have to occur. The question is how much is required to do this to keep the yen rate stable. Intervention is credible when the leading central banks work together to intervene, as happened in July 1998.
There are clearly several psychological barriers. The first is 100 yen to the dollar. As all foreign-exchange traders know, once a price breaks a psychological barrier, there is likely to be an overshoot with market momentum pushing the price to another barrier, in this case 110 or 120. It took four years to move from 136 to the dollar in April 1991, to 185 in April 1995, where it stayed for four months before it began to depreciate again, taking two years to depreciate to 147 in July 1998, before intervention took it again towards upward revaluation.
Between July 1998 and January 2002, the currency fluctuated in a wide range from 100 to 133, but after the Lehman 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 that Abe has to pull off is not just in monetary and fiscal policy, but in real structural reforms. The 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 strong currency and allowing competitors in the auto and electronics sectors to eat into Japanese market share. On top of this, the ageing population is also affecting overall productivity, with the population declining by 200,000 in 2011 and 2012 respectively. If growth revives, with some inflation, to 2 per cent, without having to raise interest rates, the inflation eats away the debt overhang, and the trick is pulled off.
Critics of Abe's initiatives claim that it has all been tried before, with little record of success. There is little doubt that a weak Japanese economy cannot be good for both the Asian and the global economy. The coming months will be a test of nerves. If the yen goes beyond 120, then some really tough decisions will have to be made whether competitive devaluations will begin.
Watch that line.
Andrew Sheng is president of the Fung Global Institute (www.fungglobalinstitute.org).