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The Yen
Fundamentals
The yen has retraced most of its gains since the US/Japan
intervention. The markets now assume that such intervention will not work
unless the "fundamentals" change. What are the fundamentals and are
they changing?
For the markets, the fundamentals relevant to any possible change in
trend in the yen/dollar exchange rate is monetary policy and the economic
fundamentals underlying monetary policy. It is widely believed that, as long
as the Japanese economy remains weak and the US
economy remains strong, Japan
cannot raise interest rates and the US cannot lower rates. Therefore,
the yen must keep falling.
This position assumes that short term interest rate differentials and
in turn short term capital flows rule the foreign exchange the roost. Other
fundamentals that determine exchange flows do not. From this perspective,
current account imbalances do not matter. Neither does a county's
competitiveness, which should influence flows of foreign direct investment
(FDI) as well as the current account.
In fact, current accounts and FDI do matter. In the most recent month,
the Japanese current account improved sharply, probably in a lagged response
to the decline in Japanese domestic demand and the falling exchange rate.
With a large current account surplus, Japan can afford a comparable
outflow of short term capital and long term portfolio capital without a
depreciation of the yen. At the current deeply depreciated exchange rate,
Japanese firms should stop investing in plant and equipment in the US and US
firms should be buying cheap assets is Japan. We should expect net positive
flows of FDI from the US
into Japan
which allows for yet more in the way of outflows of short term capital and
long term portfolio capital without further yen depreciation.
 The
question, then, is how great are such capital outflows likely to be? Two
factors are relevant: investor expectations and the recent change in exchange
controls. Market participants focus on the former: it is widely believed
that, until there is a change in Japanese policy that makes future economic
growth credible, capital outflows will remain large owing to interest rate
differentials. Less attention is paid to the recent changes in the capital
account regime which has made it easier for Japanese households to make
portfolio investments abroad. This change, effective at the beginning of
April, led to a large ($20 billion plus per month) rise in portfolio capital
exports by households, which has no doubt greatly contributed to yen weakness
since then.
Economic Growth Expectations
In our opinion, US pressure on Japan for reforms that serve US
interests have distorted market perceptions regarding the outlook for
Japanese growth. The US
has called for fiscal stimulus to expand Japanese domestic demand. It wants
banking reforms that involve US
style bankruptcies and re-structuring that leads to labor
shedding. It wants reforms that open Japanese markets to US goods and
Japanese financial institutions and firms to US ownership. It has not formally
called for aggressive expansion of the monetary aggregates to stimulate
domestic demand. Since the Japanese have been slow to adopt US style reforms, the financial press and Wall
Street, who accept the US Treasury's diagnosis of Japan's
problems, have concluded that Japan
is not making meaningful policy progress. Hence, in their view, the yen must
decline.
In fact, the Japanese have moved substantially on several fronts. Some
noted US
economists like Milton Friedman and Paul Krugman
have emphasized the importance of an aggressive policy of monetary aggregate
expansion to revive Japanese domestic demand. And, in fact, the Japanese
monetary base has been growing at a very high rate since last November. In
their last policy deliberations, policy was decided upon by a majority, not
unanimously, which suggests as ongoing debate aimed at yet more rapid
monetary base growth. It is noteworthy that the monetary aggregate (M2 plus
CD2) growth rates have increased slightly, despite domestic recession, to the
highest rates in seven years.
On the fiscal front, the current fiscal stimulus package is large,
equal to 2% of GDP. The ups and downs of the Japanese economy in the 1990's
have tracked the injection and withdrawal of fiscal stimulus, suggesting that
fiscal stimulus has worked in the recent past. Because of the US Treasury's
pressure for a permanent tax cut in addition, Wall Street and the media
believe the current fiscal stimulus package will not be enough. The Japanese
are understandably reluctant to lower taxes on a permanent basis. Their
overall tax take is equal to only 32% of GDP versus 41% for the rest of the
industrialized world and they are currently running very large budget
deficits. Nonetheless, the international pressure is now so great that we now
expect a permanent tax cut in addition to the current public works spending.
On the banking front, Japan
has earmarked substantial funds for a bank bailout. One estimate (Kenichi Ohmae) of such funds earmarked for bank bailout is as
high as $215 billion. However, the Japanese public blames the current post
bubble crisis on the banks and bank bailouts are therefore not popular. It is
understandable that the Japanese are loathe to commit
to a bank bailout until after the Upper House elections in early July.
The Japanese fear, and rightfully, that allowing banks to fail
Western-style will have much higher deflationary repercussions in their
collectivist culture and economy than it would in a Western economy.
According to Kenichi Ohmae, when Japanese banks
fail, "…the banks will likely all fall together. Since Japanese
banks traditionally form syndicates to finance large projects, no bank will
be absolutely safe should one of its members fail. In effect, there is no
"good bank" or "bad Bank" in Japan. If a "good bank wants
to write off bad debts and separate itself from the syndicate, the remaining
banks threaten to withdraw funding from the projects the good bank is
leading."
The Japanese also fear that a bank bailout that results in
bankruptcies and layoffs will depress aggregate demand further. Something of
this sort happened with the failure of the Hokaido Tokushoku Bank. Japan is a collectivist culture
where the social safety net has been provided by the corporate sector and not
the government. We understand that moves by some firms toward Western type
employment and merit compensation policies has greatly increased household
uncertainty and has contributed to weaker consumer demand. The Japanese
authorities fear, and with good reason, that Western style bank restructuring
could be counter productive in that it could depress domestic demand. The
Japanese authorities have therefore been deliberating over alternative ways
to aid the banks without having large banks brokers, and firms fail. This
approach which lets the weak banks be supported by the stronger banks is
referred to as the "convoy" system---an approach the US opposes.
Marshall Auerback notes, "…the Financial
Times has criticized the proposed merger in Japan of LTCB and Sumitomo Trust
on the basis that it preserves the "convoy" system. To let banks
fail at this point would exacerbate Japan's deflationary problems
significantly. If this merger is followed by a big government purchase of
much of LTCB's bad debts, then it will illustrate
that Japan
is finally serious about addressing the bad debt problem, but doing so in a
Japanese way and not in the manner proposed by the US Treasury."
Over the last two weeks, Japan has focused on the creation
of a "bridge bank" which might reduce the incidence of failures and
employment losses in a major banking bailout. This program is being pushed forward
in the legislature rather than the Ministry of Finance, which may result in
faster progress. It is our guess that, after the elections, the Japanese will
use public funds extensively to remove the bad loans from the banking system
with a minimum of disruptive failures. Given the country's collectivist
culture, this will probably result in a solution which has a greater net
positive impact on domestic demand than the Western-type restructuring favored by the US.
When it comes to trade reforms, the Japanese are correct in resisting
US pressures. Trade reforms create severe dislocations for domestic economic
agents. Firms and even entire industries are put at risk. Such dislocations
threaten a loss of business and consumer confidence and a loss of income,
output, and employment to imports. Though such reforms may be advisable for
the long run, in the short run they will tend to be deflationary and
certainly will not encourage an economic recovery. In this regard, Japanese
resistance to such "reforms" is a policy move in the right
direction. It is most unfortunate that US Treasury rhetoric has convinced the
markets that such "reforms" are a prerequisite for a Japanese
recovery.
On balance, we believe that a US Treasury "wish list" has
distorted perceptions regarding Japanese policy. In any event, aggressive
monetary and fiscal policies are now in place. We expect a successful bank
bailout Japanese style in the second half of the year. These factors plus a
lagged improvement in trade after three years of steady exchange rate
devaluation could easily generate a surprising recovery. However, because the
US Treasury's wish list will not have been agreed upon by the Japanese,
global investor expectations will continue to be negative towards Japan,
thereby tending to weakening the yen, until positive
economic growth becomes very visible.
Japanese Capital Outflows
Much to our astonishment, there have been public calls by members of
the Japanese legislature for re-imposition of recently relaxed capital
controls. Simon Hunt tells us that his sources expect such a policy reversal
after the elections. Such a move would be of great, possibly momentous,
import.
To an increasing degree, it is obvious that ill-timed moves toward
liberalization of the capital account can create serious and dangerous
instabilities. This certainly happened in South East Asia, especially Korea, where
liberalization of the capital account without adequate government regulation
led to private market behavior by Korean borrowers
and Western lenders and portfolio investors that proved to be disastrously
destabilizing. There is no doubt that ill-timed capital account
liberalization can lead to private "market failure".
Given the precarious nature of the Asian economies, the recent
liberalization of the Japanese capital account looks very ill-timed. Suddenly
releasing a pent-up demand for US assets has provided a shock to the yen
which will not be sustained. It is logical, under current conditions, to
reverse course and await a later date when yen
strength can absorb such a shock which is likely to be transitory in nature.
This is especially the case under current conditions which call for
aggressive monetary expansion to "jump-start" an economic recovery.
If yen stability in Asia is important, Japan should reverse course on
this issue.
However, there can be no doubt that such a move will generate vehement
opposition from the US
and the OECD in general. The most recent postwar
decades have been characterized by a one way movement toward elimination of
capital controls. From the US
point of view, to move back toward capital controls by a US ally
represents an ideological heresy. It would also be a great affront to US policy: Japan
would solve the yen problem with more government intervention---the very
opposite of the direction toward Western style liberalization and reform the US wishes.
Vocal US pressure on the Japanese, and in particular the high handed
arrogance of Robert Rubin and Larry Summers, have generated great resentment
in Japan.
There is a possibility that the logic of changing course on capital controls
plus this resentment will lead to re-imposition of the controls that were
relaxed at the end of March. We would welcome it because it seems obvious to
us that global mobile capital has become speculative and destructive and that
a return to capital controls for emerging economies are desirable and
probably inevitable. However, the odds are that the Japanese will not go this
far. If they do, it will be a firm declaration to the US that Japan will stick with
"Asian" policies and resist US demands.
 Because
the US Treasury would vehemently denounce such a move, Western speculators
might be tempted initially to short the yen. However, cutting Japanese
capital outflows sharply amidst a growing current account surplus is likely
to eventually lead to short covering by today's massive outstanding yen
shorts.
Re-imposition of Japanese capital controls could lead to a surprising
yen rally.
By : Frank Veneroso
The Gold
Newsletter
www.goldnewsletter.com
Editorials and essays by Frank Veneroso
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From
1991 to 1994 Frank Veneroso was the partner responsible
for global investment policy formulation at hedge fund Omega Advisors. From
1995 to 2000 and prior to 1991, through his own firm, Mr. Veneroso
was an investment strategy advisor to global money managers and an economic
adviser to institutions and governments around the world in the areas of
money and banking, financial instability and crisis, privatization, and
development and globalization of securities markets. His clients have
included the World Bank, the International Finance Corporation, and The
Organization of American States. He has advised the Governments of Bahrain, Brazil,
Chile, Ecuador, Korea,
Mexico, Peru, Portugal,
Thailand, Venezuela and
the United Arab Emerates. Frank is a graduate from
Harvard and has authored many articles on the subjects of international
finance.
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