OPINION: Is a currency war coming?

Andrew Sheng in Hong Kong/Asia News Network
Asia News Network

Hong Kong (ANN) - 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 (USD $116 billion, or 2.2% of GDP) stimulus package to end deflation and pressured the Bank of Japan to adopt a 2% inflation target. As a result, the stock market index Nikkei jumped 28.3% from mid November to current levels and the yen weakened by 20.1% from 75.7 to 90.9, its lowest level in over two years.

Such action has already provoked muttering about another currency war, invoked by Russian, German and South Korean officials.

Are we moving from a trade war to a currency war? Not yet.

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 (ECB, Fed, Bank of England and Bank of Japan) claim that they only have inflation targeting, rather than exchange rate targeting. In other words, currency rates are a consequence of the monetary policy, not a target. And we all know that if everyone devalues at the same time, there is no advantage to 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% 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 US$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 tradable sector will improve. Nevertheless, tourists will flood to Japan to take advantage of high quality food and service, so the non-tradable 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 to 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 South East 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 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 suasion. 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 had 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 yen to the dollar in April 1991 to 85 yen in April 1995, where it stayed there for 4 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 to January 2002, the currency fluctuated between 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 monetary and fiscal policy, but real structural reforms. The structural problem is that the strong export sector that has kept the economy afloat in spite of an inefficient non-tradable sector is beginning to sag under the combination of strong currency and allowing competitors in the motorcar and electronics sectors to eat into Japanese market share. On top of this, the aging population is also affecting overall productivity, with population declining by 200,000 in 2011 and 2012 respectively. If growth revives with some inflation to 2%, 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 would begin.

Watch that line.