By Kumiharu Shigehara
In his most recent speech, Donald Kohn, vice-chairman of the US Federal Reserve, said that the Fed had learned that the aftermath of a bubble can be far more painful than it had imagined.
He then carefully examined alternative strategies for monetary policy to deal with asset price bubbles. However, he did not specifically discuss a potential role of foreign exchange rates in the aftermath of a bubble in supporting aggregate demand through their influence on exports.
In fact, a number of Organisation for Economic Co-operation and Development countries which suffered from domestic asset market declines in the late 1980s or early 1990s, experienced large currency depreciations as a result of a loss of market confidence in their economies.
The resulting strengthening of international price competitiveness led to a sharp upturn in exports and helped the recovery of overall output activity.
In contrast, the Japanese yen followed an uptrend even after the burst of the bubble in early 1990s. Between the end of 1990 and April 1995, the yen appreciated against a basket of currencies of its trade partner countries by 64 per cent.
As a result, Japanese export volumes either declined or grew at a pace far below the growth of its markets each year, leading to a sharp decline in Japan’s share in the world export market. Thus, net exports made a negative contribution to gross domestic product growth. Nevertheless, Japan somehow maintained positive GDP growth with fiscal and monetary support to domestic demand growth.
The yen’s reversal started in the second half of 1995 and by April 1997 its effective rate declined by 24 per cent relative to the peak of April 1995.
A rebound of the yen took place in the second half of 1997. It coincided with a sharp tightening of fiscal policy and the outbreak of the crisis in emerging Asian economies, which was followed by the sudden collapse of several Japanese financial institutions late that year.
With weakened business and household confidence and their spending, Japan recorded a 1.1 per cent decline in real GDP in 1998, the first negative growth since the 1974 recession in the aftermath of the first oil crisis.
In a lecture given at Harvard University in 2001, Allan Meltzer, professor of political economy at Carnegie-Mellon University, commented on this episode: “Japan’s problems are mainly homemade. Mainly, but not entirely. The US Treasury had a role, too. It recommended publicly…that Japan should rely on fiscal stimulus and avoid sufficient monetary stimulus to depreciate the yen/dollar exchange rate.”
The recent sharp yen appreciation against the US dollar, euro and other currencies including those of emerging Asian economies has considerably weakened Japan’s international price competitiveness.
With a 22 per cent appreciation of the yen’s real effective exchange rate from mid-2007 to October 2008, it is now more than 11 per cent higher than the level of March 1973.
Recent large declines in the dollar prices of oil and other commodity prices coupled with a sharp yen rise have started to exert strong downward pressure on Japan’s average import prices in yen.
Moreover, incoming data indicate that the Japanese economy has already entered its first recession in seven years, and that slack in the economy will most likely widen next year.
Unless further expansionary domestic policy action is taken and/or significant yen exchange rate correction occurs, Japan will likely start to experience deflation much earlier than recently forecast by the OECD.
The sharp appreciation of the yen against the US dollar, euro, the British pound and other leading currencies reflects a considerable narrowing of interest rate differentials between the Bank of Japan policy rate and those of the Fed, the European Central Bank, the Bank of England and other central banks.
Most of the latter reduced them far more aggressively and by larger cumulative amounts given their higher initial levels, while the BoJ limited its cut to 0.2 percentage points.
At the same time, the Bank started a system of paying interest on excess bank reserves held at BoJ accounts, thus effectively providing a floor to interest rates in the overnight interbank money market.
In fact, interest rates on term money instruments have risen since the cut in the BoJ policy rate, with a widening of interest differentials between overnight and term monies, thus negating the policy effects on longer-term interest rates more relevant to borrowing costs of private enterprises and households.
Moreover, availability of credit to the private non-bank sector is being reduced with the more cautious lending attitude of banks whose capital bases have been weakened by declines in the market values of their equity holdings as well as the yen values of foreign currency assets.
Given this situation, more aggressive action by the Japanese monetary authorities is urgently needed.
First, the BoJ should stop provision of dollar funding to banks in Japan in need of dollar funds, and encourage them to borrow yen funds from the BoJ, letting them obtain dollar funds by selling yen in the foreign exchange market.
Second, the Japanese authorities should take appropriate direct action in the foreign exchange market, following the statement of G7 finance ministers and central bank governors on October 27, which specifically expressed concern about the adverse effects of recent yen movements.
Now that an extremely sharp turnaround has taken place, the authorities must not hesitate to intervene in the foreign exchange market as appropriate, in particular to smooth out volatile movements, with a clear commitment to conduct reverse operations to net out their balances over a reasonable, but unspecified time span as foreign exchange market conditions settle down.
Third, the BoJ should go quickly back to the earlier regime of zero-interest rate and to “quantitative easing”. Some simulations with econometric models suggest that the macroeconomic effect of moving to a regime of zero-interest rate and to the “quantitative easing”, measured essentially through the term structure channel, was very small.
However, “quantitative easing” may also influence foreign exchange and stock market conditions. A change in asset market prices will change the market values of banks’ equity holdings as well as the yen values of their foreign currency assets, thereby affects bank capital adequacy which can then influence credit availability.
Macroeconomic effects through these transmission mechanisms can be significant, though it is not easy to incorporate the working of these mechanisms in econometric models.
As Mr Kohn said, central banks need to improve their understanding of the workings of the financial system, its vulnerabilities, and its links to the real economy. The BoJ does not have the luxury of waiting for the results of rigorous empirical work before taking action.
Well-considered measures should be taken quickly as an insurance policy, given downside risks to the domestic financial systems and the real economy.
Kumiharu Shigehara was OECD deputy secretary-general from 1997-1999 and BoJ chief economist from 1989 to 1992. He is chairman of the International Economic Policy Studies Association