Has Japan finally recovered?
By
Simon Nixon Mar 24, 2006
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It’s taken two decades and some drastic policies for the Bank of Japan to get the country’s economy moving. So is the medicine working?
What is the Bank of Japan up to?
It has signalled an end to the policy of almost limitless free money. For the last two decades, the Bank of Japan (BoJ) has been fighting to get the Japanese economy moving again. In the aftermath of the 1980s bubble economy, the Japanese banking system was crippled by bad debts as asset prices fell and firms were unable to repay their loans. Banks couldn’t lend, consumers wouldn’t spend and the economy ceased to grow. In 1999, the BoJ cut interest rates to zero, where they have remained almost ever since. In 2003, it backed this up by flooding the banking system with cash in an attempt to get banks lending again – a policy known as ‘quantitative easing’.
What has changed?
The medicine seems to have worked, and the Japanese economy now looks to have recovered. Last year, it grew 2.8% and 4.2% year-on-year in the fourth quarter. And inflation is coming back. Wholesale prices rose 2.9% in February, the fastest rate in 16 years. Retail prices rose 0.5% in January, having risen 0.1% in November and December. That’s a big change from the last two decades, when Japan was crippled by the deflation that made conventional monetary policy largely ineffective.
So are Japanese interest rates about to rise again?
Not just yet. The first step is to reduce the amount of money sloshing around the Japanese banking system. Thanks to the sharp rise in the Japanese stockmarket last year – the Nikkei was up 40% – most banks have been able to use their inflated equity portfolios to clean up their balance sheets. The BoJ is now worried that all this extra liquidity could fuel a new speculative boom.
But the amount of money in the system will need to fall dramatically before interest rates start to rise. That will take time. The market is currently expecting a first interest-rate hike of 0.25% in September, although some economists think it won’t come until early 2007.
How might this affect the global economy?
The big risk is that it undermines the so-called carry trade. During the era of low interest rates, some investors made fortunes borrowing money cheaply in one currency and using it to buy riskier, high-yielding assets elsewhere, such as emerging market bonds. Over the last few years, this one-way bet has driven up asset prices across the world. The trade only works if interest rates stay low and the currency used to borrow is stable or depreciating. As interest rates have risen in the US and eurozone, the action has become largely focused on the yen. The prospect of higher Japanese interest rates and a stronger yen has spooked investors.
Are there other risks?
Yes. The move may encourage Japanese savers to invest in the domestic economy rather than chase higher returns elsewhere. That could affect the US, which needs to find some $2bn a day to fund its giant current-account deficit. If capital inflows to the US fall, the dollar may fall and US rates will have to rise. That could burst the US house-price bubble and cause America’s resilient consumers to rein in spending.
Are these fears widely shared?
Not really. Bulls point out that the move to higher interest rates reflects buoyant global growth, which can hardly be a bad thing. Total yen borrowing in December was only one sixth of the peak in 1998 – the last time the carry trade unwound. Even with rates at 0.25%, Japanese rates will still be very low – well below the yield on many other assets. The BoJ has signalled its intentions well in advance, giving investors time to adjust.
Why is the BoJ likely to be cautious?
Because not everybody is convinced deflation is defeated. Excluding last year’s energy-price spike, inflation in January was only 0.1%, suggesting it will fall back when energy-price rises drop out of the data later this year. The Bank can’t change tack too fast without upsetting the domestic economy. It currently spends some ¥1.2trn buying Japanese government bonds. If it stopped, yields would shoot up. That would be disastrous for the Japanese government, which currently spends some 22% of its annual budget servicing its debt. The biggest risk to the global economy could be that the BoJ moves too soon.
Is the end of Japan’s loose monetary policy a threat to the global economy?
YES
- If it put an end to the carry trade, where investors borrow yen to invest in foreign high-yielding assets, it would hit markets hard.
- It is likely to reduce Japanese demand for US Treasury bonds, leading to higher US interest rates, which could burst the US housing bubble.
- The Bank of Japan may have moved too soon. Strip out last year’s energy-price hikes and inflation is still very low.
NO
- The Bank of Japan is only acting now because the economy is performing well; that’s good for the global economy.
- Japanese interest rates will remain zero for several months and will stay well below US rates, so the carry trade should continue.
- In fact, Japanese monetary policy is about to get even looser in real terms, since rates will be below the rate of inflation for the first time for years.
Simon Nixon is executive editor of Breakingviews.com
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