Whither the ¥en?

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.