Defaltion in the Euro Zone, for real?

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Deflation is bad. Just ask Japan. First, by creating expectations that prices will be lower next year it gives consumers incentives to postpone purchases.As a result, aggregate demand declines putting further downward pressure on prices. Second, since private and public debts are fixed nominally, declining prices increase the real burden of the debt. Put differently, as prices decline government and private revenues decline while the service of the debt remains unchanged. This forces the private and public sectors to spend an increasing proportion of revenues to service the debt, forcing them to cut back their spending on goods and services. This in turn increases the intensity of the deflationary process. This is probably the most important negative effect of deflation.

Are these risks becoming a reality in the euro zone? The consumption-postponement effect is not yet operative. Prices are still increasing in the euro zone. Only if consumers actually expect prices to decline will it start operating. The second effect, the debt-deflation dynamics, however, is already working. It is important to stress that this effect does not crucially depend on inflation being negative. It starts operating when inflation is lower than the rate of inflation that was expected when debt contracts were made. Thus, during the last ten years inflation expectations in the euro zone have been very close to 2%, which was also the average rate of inflation during that period. Current nominal interest rates on long-term bonds reflect the expectation that inflation will be 2% for the next five to ten years.

Inflation in the euro zone has been declining since early last year and now stands at 0.8%. This disinflation exerts debt-deflation dynamics. The nominal debt increases with the nominal rate of interest (which includes a 2% inflation expectation), but the nominal income in the euro zone increases by only 0.8%. As a result, an increasing proportion of these revenues must be spent on the service of the debt. Less is left over to spend on goods and services. Thus, the euro zone as a whole already suffers from debt-deflation dynamics. It is not yet catastrophically intense, but surely it should be stopped before it gets worse when inflation turns negative.

Moreover, there is a tug-of-war starting between the euro zone and emerging markets (EMs). As American output and interest rates rise, capital outflows in one or both regions are likely to rise. What form these outflows will take, which region will suffer more, depends on each region’s financial vulnerabilities, and how their politicians are expected to operate under duress. That is, the main game that will be played now in capital markets. It resembles a tug-of-war because the effect of American economic recovery may greatly depend on the relative strengths of these regions. If the balance tilts against the euro zone, investors will shift the composition of their portfolios and deteriorate its credit channel. Whether or not this triggers deflation of euro-zone prices depends on the role of euro-denominated assets for collateral and in facilitating commercial transactions.

However, the euro area is a large currency zone where the euro is well-established as a unit of account, and a central bank which is strongly averse to inflation; therefore, the “flight to quality” may produce opposite effects, namely, strengthening of the euro and price deflation. This moght not be good at all for the euro-zone real sector because, to the weaker competitive conditions triggered by currency appreciation, price deflation may add two lethal factors: (1) debt deflation (A situation in which the collateral used to secure a loan decreases in value), and (2) the expectation that prices will continue falling. Factor (1) further dries up credit flows, while factor (2) increases the real return of cash balances and, hence, lowers aggregate demand. A major flight- to-quality episode would call for further relaxation of ECB credit, which is likely to meet major opposition in its board.

Moreover, EM banks have been largely free from “toxic assets” and can better fend for themselves than euro-zone banks that so far have survived partly due to the ECB help. Thus, if the ECB falters in coming to their rescue in a new flight-to-quality episode, their chances of surviving are bleak compared to EM banks. Moreover, despite their dysfunctionality as a trade or currency union, some key EMs (notably in the Middle East, Africa and Latin America) are resource-rich, and they still have vast expanses of unexploited resources. These areas will benefit from continued growth in China, while for the euro zone it may signify stiffer industrial competition from abroad.

Inflation in the United States followed a pattern similar to the euro zone between the end of 2009 and the end of 2010. After observing a few months of declining inflation readings, the Federal Reserve started to act. Firstly, in August 2010, the Federal Open Market Committee (FOMC) announced the reinvestment of principal payments from agency debt and mortgage-backed securities purchased during the first round of Large Scale Asset Purchases (LSAP). Secondly, in September of the same year, the FOMC statement introduced the first instance of post-crisis forward guidance language (“economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”). Thirdly, in November, the Committee announced the second LSAP program for $600 billion. While other factors may have played an important role, both headline and core inflation measures did bottom out between November and December 2010 and reverted back close to the 2% target within the next six months.

So, may be the time ripe for the ECB to follow in the Fed’s footsteps and become more aggressive against low inflation. but the ECB is unlikely to embark in quantitative easing, due to the Bundesbank’s concern about blurring the line between monetary and fiscal policy. The ECB is paralysed by internal dissension that prevents it from increasing liquidity in the system, the only sure way to prevent deflation.

At the moment, the risk of deflation for the euro zone is real. America lived through a similar experience in the recent past. The Federal Reserve ramped up its response, with a number of unconventional policy actions. Perhaps, now is the time that Europe moves one step beyond what America has done and experiments with more aggressive policy actions.

The above has been compiled  from an on going debate on Deflation in the euro zone in the Economist.


Unremarkable today might once have altered the course of history!

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Items that seem unremarkable today might once have altered the course of history. For centuries, the nutmeg tree grew only in the Banda Islands, a small chain in the southwest Pacific. Locals harvested the aromatic nuts of the tree and sold them to traders. Eventually, a spice made from these nuts became a luxury item in the European market, via Venetian merchants. Seeking a monopoly over this valuable spice, the Dutch attacked the Banda Islands, subjugating the native people in a mostly successful attempt to control the trade.

However, one island in the Banda chain remained in the hands of the British and was the object of much conflict between the Netherlands and England. After many battles, the British offered to cede control of the island in exchange for New Amsterdam, a Dutch outpost on the east coast of North America. Inveterate traders, the Dutch were more interested in the spice trade than in the small outpost of New Amsterdam. In 1667, the Treaty of Breda gave the Dutch complete control of the Banda Islands, and thus of the nutmeg trade, and gave the British New Amsterdam, which they promptly renamed New York. Today, nutmeg trees can be found in many countries and no one company or country has a monopoly on the trade.

Why was Nutmeg so important? (And a brief HISTORY associating it)

Spices have been used by human beings for millennia for food preparation and preservation, medicine, and even embalming. But until modern times they were largely an Asian commodity, and controlling their flow to the spice-obsessed West meant power and fortune for the middleman. Over the centuries, these hugely successful merchants were the Phoenicians, Persians, Arabs, and later, Venetians.

Many of the great European explorations of the 15th century were driven by the need to bypass the Arab and Venetian monopoly. Crying, “For Christ and spices,” the Portuguese explorer Vasco da Gama shocked the Arab world when he sailed around Africa’s Cape of Good Hope in 1498 and showed up in the spice markets of India. It marked the beginning of the decline of Arab dominance and the rise of European power. For the next 100 years, as Spain and Portugal fought for control of the spice trade.

Always in danger of being overwhelmed by their much larger neighbor, Spain, the Portuguese began subcontracting their spice distribution to Dutch traders. Profits began to flow into Amsterdam, and the Dutch commercial fleet swiftly grew into one of the largest in the world. The Dutch quietly gained control of most of the shipping and trading of spices in Northern Europe. Then in 1580, Portugal fell under Spanish rule and the sweet deal for Dutch traders was over. As prices for pepper, nutmeg, and other spices soared across Europe, the Dutch found themselves locked out of the market. They decided to fight back.

In 1602 Dutch merchants founded the VOC -the Vereenigde Oostindische Compagnie, better known as the Dutch East India Company.By 1617 the VOC was the richest commercial operation in the world. With sheer ruthlessness… and nutmeg.

By the time the VOC was formed, nutmeg was already the favored spice in Europe. Aside from adding flavor to food and drinks, its aromatic qualities worked wonders to disguise the stench of decay in poorly preserved meats, always a problem in the days before refrigeration.

Then the plague years of the 17th century came. Thousands were dying across Europe, and doctors were desperate for a way to stop the spread of the disease. They decided nutmeg held the cure. Ladies carried nutmeg sachets around their necks to breathe through and avoid the pestilence of the air. Men added nutmeg to their snuff and inhaled it. Everybody wanted it, and many will willing to spare no expense to have it. Ten pounds of nutmeg cost one English penny at its Asian source, but had a London street value of 2 pounds, 10 shillings -68,000 times its original cost. The only problem was the short supply. And that’s where the Dutch found their opportunity.

Why made nutmeg so rare? The tree grew in only one place in the world: the Banda Islands of Indonesia. A tiny archipelago rising only a few meters above sea level, the islands were ruled by sultans who insisted on maintaining a neutral trading policy with foreign powers. This allowed them to avoid the presence of Portuguese or Spanish garrisons on their soil, but it also left them unprotected from other invaders.

In 1621 the Dutch swept in and took over. The Dutch had their monopoly …almost. One of the Banda Islands, called Run, was under control of the British. The little sliver of land (a fishing boat could only make landfall at high tide) was one of England’s first colonial outposts, dating to 1603. The Dutch attacked it in force in 1616, but it would take four years for them to finally defeat the combined British-Bandanese resistance.

But the English still didn’t give up; they continued to press their claim to the island through two Anglo-Dutch wars. The battles exhausted both sides, leading to a compromise settlement, the Treaty of Breda, in 1667 -and one of history’s greatest ironies. Intent on securing their hold over every nutmeg island in Southeast Asia, the Dutch offered a trade: if the British would give them Run, they would in turn give Britain a far-away, much less valuable island that the British had already occupied illegally since 1664. The British agreed. That other island: Manhattan, which is how New Amsterdam became New York.

The Dutch now had complete control over the nutmeg trade. A happy ending for Holland? Hardly. By the end of the 17th century, the Dutch East India Company was bankrupt. Constant wars with rival powers, rebellion from the islanders, and just plain bad luck -some might say bad karma- eventually broke the back of the Dutch spice cartel.

  •  In 1770 a Frenchman named Pierre Poivre (“Peter Pepper”) successfully smuggled nutmeg plants to safety in Mauritius, an island off the coast of Africa, where they were subsequently exported to the Caribbean. The plants thrived on the islands, especially Grenada.
  •  In 1778 a volcanic eruption in the Banda region caused a tsunami that wiped out half the nutmeg groves.
  • In 1809 the English returned to Indonesia and seized the Banda Islands by force. They returned the islands to the Dutch in 1817, but not before transplanting hundreds of nutmeg seedlings to plantations in India, Ceylon (now Sri Lanka), and Singapore. The Dutch were out; the nutmeg monopoly was over. While they would go on to have success trading steeland coal (not to mention tulips), the Netherlands declined as a colonial power, and they never again dominated European commerce.

Source: Copied from here and there 😛

McDonald’s in India

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In 1995, McDonald’s entered the country by setting up joint ventures with two partners-turned-franchisees, Hardcastle Restaurants and Connaught Plaza Restaurants. McDonald’s India has been growing fast and plans to expand its outlets from 275 in 2012 to 500 by 2015. How did you pull that off?. According to Amit Jatia, the forty-year-old entrepreneur who manages the franchise in southern and western India: “Glocalization, in a word. We couldn’t cut and paste business models from other countries, but we needed to bring the McDonald’s brand and its expertise in supply chains and restaurant operations to India, and combine it with local requirements and culture.”

At the outset, the Indian partners had to convince McDonald’s that to succeed in India, it would need an entirely different menu, low price points, and a highly localized business model. Customer feedback had shown that many Indians would not even enter a restaurant that served beef or pork. India therefore became the first country in the world where McDonald’s does not offer beef or pork items. Other than fries, beverages, the McChicken sandwich, and the Filet-O-Fish, there is little in common between a McDonald’s in Bangalore and one in Boston.

It took McDonald’s and its partners five years to figure out a customer value proposition and business model that would deliver results in India. Called “branded affordability,” the strategy is to keep prices low while making profits. McDonald’s introduced a Happy Price Menu for Rs 20 (around $0.40) and refined its Indian business model to make profits on it. Since McDonald’s is a high-volume, lowmargin business, both Jatia and Vikram Bakshi, the franchisee for north and east India, figured out that at that price sales would have to be three to four times US store sales to break even. Since that was not likely initially, they had to find a way to reduce costs while maintaining global food safety norms and customer service standards.McDonald’s identified the must-haves in India as safe food and one-minute service. Everything else was only nice to have, so they eliminated most of it. For instance, the Indian franchisees localised most of the equipment, except for a few key pieces. For instance, McDonald’s specifies foodgrade stainless steel under the counters, but the India team, realising that was not critical for food safety, replaced it with less expensive material. The team found a lot of excess equipment, such as large vats, in the standard store design, so it developed three formats based on store size. Such tweaks together brought down the investment in each store by between 30 per cent and 50 per cent.The India team also brought down taxes in several ways. For instance, branded fries attract a 20 per cent excise duty, but McDonald’s India saved that by removing the supplier’s name. Similarly, it found that transporting chopped lettuce and milkshake mix attracted duties from the city government, but lettuce heads and milk didn’t do so. That seemed illogical, so it lobbied for change. Finding utility costs high in India, the company worked with IIT Bombay, one of India’s top engineering colleges, to design a system that recovers waste heat to boil water and to reduce the power consumed by air conditioners in each outlet by 25 per cent. Electronic ballast for all lighting and LED signs reduced costs further. All this saved about 20 per cent to 25 per cent in power costs. Such systematic examination of costs allowed the Indian partners to become profitable despite the low prices they charge Indian consumers.

McDonald’s success is also due to its supply chain. It spent six years and around $90 million (around Rs 450 crore) to set up a food chain in India well before opening its first restaurant. Creating the cold chain involved the import of state-of-the-art food processing technology from its international suppliers. It has brought about major changes in vegetable farming, benefitting India’s farmers.McDonald’s was fantastic in transferring knowhow,” says Smita Jatia, Amit’s wife and the managing director of Hardcastle Restaurants.

To learn the McDonald’s way, the start-up team went through a month-long training program in Indonesia. A global team then flew to India to figure out every aspect of the business. McDonald’s India hired people with high school degrees and invested millions of dollars in training them in Chicago and Asia. That investment has paid off in commitment and performance.The final element of McDonald’s success came from investing heavily in creating a trusted and aspirational brand. The challenge was to change consumer perceptions from American don’t-know-what-to-expect discomfort to Indian values, families, culture, and comfort. In short, it’s a friendly place where families can enjoy themselves and feel they are having a special time. The team designed everything around this – from the menu to the layout and decor.

Even with rising prosperity, most products and services from the developed world cater only to the top 10 per cent of the developing world – the superpremium and premium segments. Those goods and services are a stretch for the aspiring middle class and are out of the reach of millions of poor people. However, the big opportunity for companies Indian and Western isn’t the bottom of the pyramid, but the rapidly growing middle market, which could be nearly $1 trillion in size by 2020. This segment is very demanding and driven by the desire for value for money. Middle-market customers have limited disposable incomes but big aspirations; they will not accept products that compromise quality or functionality. That’s true not just of cellphones, fast foods, and shampoos but of trucks and tractors, too. This article is excerpted from Conquering the Chaos: Win in India, Win Everywhere.

Walt Disney’s Vision – how powerful!

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Walt Disney had left extensive notes and audio recordings concerning his experiences making animation, which were stored in the Disney archives. Walt Disney, however, left another, arguably even more valuable, recipe for his company. This was a strategic recipe or we can say a corporate theory of sustained growth. This corporate theory is largely captured in the adjacent drawing also from the Disney archives, published in 1957. It depicts a central film asset that in very precise ways infuses value into and is in turn supported by an array of related entertainment assets. This 1957 map of Walt Disney’s vision defined his company’s key assets, including a valuable and unique core, and identified patterns of complementarity among them. It implicitly revealed the industry’s future evolution and provided guidance concerning adjacent competitive terrain that Disney might explore. The asset and capability combinations that emerged from the theory have evolved with time, but the theory itself has not fundamentally changed. The fundamental patterns and the underlying insight and intuition of the firm is still quite consistent. The strategic vision that Walt long ago composed has revealed a succession of strategic possibilities that have fueled a remarkable record of value creating growth.

Disney synergy map

Illustration: @1957 Disney















The image depicts a range of entertainment-related assets—books and comic books, music, TV, a magazine, a theme park, merchandise licensing—surrounding a core of theatrical films. It illustrates a dense web of synergistic connections, primarily between the core and other assets. Thus, as precisely labeled, comic strips promote films; films “feed material to” comic strips. The theme park, Disneyland, plugs movies, and movies plug the park. TV publicizes products of the music division, and the film division feeds “tunes and talent” to the music division. Walt’s theory in words might read: “Disney sustains value-creating growth by developing an unrivaled capability in family-friendly animated (and live-action) films and then assembling other entertainment assets that both support and draw value from the characters and images in those films.” The power of this theory was perhaps most vividly revealed following Walt’s death. Within 15 years leadership at Disney seemed to lose sight of his vision. As the company’s films markedly shifted away from the core capability of animation, the engine of value creation ground to a halt. Film revenues declined. Gate receipts at Disneyland flattened. Character licensing slipped. The Wonderful World of Disney, the TV show that American families had gathered to watch every Sunday evening, in a nationwide embrace, was dropped from network broadcast. By the late 1970s, the Disney franchise many of us had grown to love as children had all but disappeared. Attesting to the depths of Disney’s disarray, corporate raiders in 1984 attempted the unthinkable: a hostile acquisition of the company with a view to selling off key assets, including the film library and prime real estate surrounding the theme parks. The capital markets embraced this idea, leaving the board with a critical choice: sell Disney to the raiders, who would pay a significant price premium but dismantle the company, or find new management. The board chose the latter and hired Michael Eisner. Eisner rediscovered Walt’s original theory and used it to guide a heavy investment in animated productions, generating a string of hits that included The Little Mermaid, Beauty and the Beast, and The Lion King. Over the next 10 years Disney’s box office share jumped from 4% to 19%. Character licensing grew by a factor of eight. Attendance and margins at the theme parks rose dramatically. Disney’s share of income from video rental and sales soared from 5.5% to 21%. Eisner opened new theme parks, made further investments in live-action films, and expanded into adjacent businesses consistent with the theory, including retail stores, cruise ships, Saturday morning cartoons, and Broadway shows. By essentially dusting off Walt’s theory and aggressively pursuing strategic actions consistent with it, Disney won growth in its market capitalization from $1.9 billion in 1984 to $28 billion in 1994. That cycle has repeated itself in the years since: Although the move into Broadway shows was complementary to animated films, character licensing, and theme parks, other strategic moves, such as the 1988 acquisition of a Los Angeles TV station, the 1995 purchase of Cap Cities/ABC, and the 1996 purchase of the Anaheim Angels, failed to reflect the theory’s logic. Meanwhile, Eisner allowed the core animation asset to atrophy again as the company failed to keep up with technology trends and the best-in-the-world animators migrated from Disney to Pixar. Disney gained access to their skills through a contract, but the relationship between Disney and Pixar grew contentious and was finally severed just before Eisner stepped down, in October 2005. His successor, Robert Iger, quickly moved not merely to repair the Pixar relationship but to acquire the company, for more than $7 billion. Disney’s recent acquisitions of Marvel and Lucasfilm fuel this central asset, although they carry the company into somewhat unfamiliar terrain: The Marvel and Star Wars casts are quite different from Disney’s traditionally princess-heavy character set. Whether this strategic experiment proves to be value-creating remains to be seen. But Walt Disney’s road map for growth has clearly endured long past his death, providing a remarkable illustration of posthumous leadership. This article was actually a part of the HBR article What Is the Theory of Your Firm. I actually found this part so fascinating that decided to blog it. Hope you enjoyed!

A must see on Disruptive Innovation

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Many people know him, many doesn’t. But I hope most would know. For them who doesn’t, his name is Clayton Christensen. Many believes him to be one of the few living geniuses. He is regarded as one of the world’s top experts on innovation and growth and his ideas have been widely used in industries and organizations throughout the world.In 2011 in a poll of thousands of executives, consultants and business school professors, Christensen was named as the most influential business thinker in the world.

He is the best-selling author of nine books and more than a hundred articles. His first book, The Innovator’s Dilemma received the Global Business Book Award as the best business book of the year (1997); and in 2011 The Economist named it as one of the six most important books about business ever written.

The video below is a lecture of his in the technology research firm, Gartner. This was first lecture I did see of him and have instantly became a fan of him. I hope you guys would like it too. Please click here to watch the video on disruptive innovation.

Is Japan Debt Crisis Next?

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Exact predictions of the date may differ, but the general consensus on Japan remains the same. In a matter of just three to 10 years, the world’s third-biggest economy may start running out of the savings needed to fund its massive public debt.

The days of Tokyo’s finance mandarins being admired for their fiscal prudence are long since gone. According to the IMF, Japan’s general government debt first crossed 100 percent of gross domestic product (GDP) in 1997 as the authorities tried hard to pump prime the economy out of its post-bubble scenario.

But, ending the credit binge – and its famous “bridges to nowhere” construction projects – has proved challenging for governments dealing with a deflationary downturn, rising welfare costs and dwindling tax revenues.

Since 1990, public finances have deteriorated significantly. In recent decades, Japanese governments have piled up debts worth some €11 trillion ($14.6 trillion). In 2011, general government gross debt totaled nearly 230 percent of GDP and is projected to reach 245 percent in 2013, with the government’s fiscal deficit currently around 10 percent of GDP. Net public debt, which subtracts from gross debt government assets such as public pension funds, has also increased tenfold over the past two decades to reach more than 125 percent of GDP. The US government has gross and net debt of 107% and 84%. Total gross debt (government, non-financial corporation and consumer) is over 450% of GDP, compared to around 280% for the US.

In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between 1971 and 1990. Since the collapse of the Japanese debt bubble in 1989/ 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the output gap (the difference between actual and potential GDP) being around 5- 7%.

The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981.

Despite the highest public debt to GDP ratio in the industrialized world, Japan remains the world’s biggest creditor with net foreign assets of around US$3.1 trillion, with its 2011 per capita GDP of US$34,294 above Italy, Spain and South Korea and four times the size of China’s. And in comparison with Europe’s indebted economies, Greece reached crisis point with its debt to GDP ratio of just 150 percent, while the Spanish government has faced a storm with a debt ratio below 100 percent. While Greece has recently had to cough up interest at double-digit rates, for example, the comparable figure for Japan has been a mere 0.75 percent. Even Germany, the euro zone’s healthiest economy, has to pay more.

The reason behind this is Japan has maintained a high corporate savings rate and low levels of fixed investment (both residential and nonresidential), making Japan a net exporter of capital. However, its fiscal profligacy is catching up with it: Its fiscal deficit has risen to more than 11% of GDP, where it remains today.

Household assets of an estimated 1,500 trillion yen, surplus funds held by the private sector and the demand from Japanese banks and other financial institutions for low-risk investments have given the government a ready market for its JGBs.

In addition, Japan’s low ratio of taxes to national income provides scope for increasing the burden. According to OECD data, Japan’s 27.6 percent ratio in 2010 compared with the United Kingdom’s 35 percent and was below the average 33.8 percent of tax revenue as a percentage of GDP.

Japan’s current account surplus has also allowed the government to run large budget deficits which can be funded domestically. Since 2007, the Japanese trade account surplus has fallen sharply, turning into a deficit in 2012..

“But Japan is not Greece as it funds its own debt, whereas in Greece 70 to 75 percent of government bonds were owned by non-Greeks. Crises happen when your creditor goes on strike, and the fact is that Japan’s debt is held almost exclusively by the Japanese themselves so any comparison just doesn’t make sense,” Japan economist Jesper Koll, Japan Director of Research at JP Morgan, said.

The reason is simple: Unlike countries in the euro zone, Japan borrows most of its money from its own people. Domestic banks and insurers have purchased more than 90 percent of the country’s sovereign debt using the savings deposits of the general population. What’s more, the Japanese are apparently so convinced that their country will be able to pay off its debts one day that they continue to lend their government a seemingly endless amount of money.

Unlike Greece, Spain and other members of the Euro zone’s monetary straightjacket, Japan has its own currency which could prove an important advantage, Koll added.

“If it comes to a point where domestic savings can’t fund the deficit any more, the currency is likely to weaken, making yen assets such as Japanese bonds more attractive. That’s something that is in fact already started.


The story begins with Japan’s post-war economic miracle. In order to rebuild its economy after the devastation of World War II, the Japanese government adopted an export model, like that in Germany, to boost export growth and import know-how. Japan invested heavily in education, research and manufacturing. A key element of the export model is, of course, accommodative monetary policy whereby a country uses credit creation, infrastructure development, and lower-than-market interest rates (known in monetary parlance as “financial repression”) to focus the country on exports. As the original “Asian Tiger,” Japan employed this strategy to great effect over the years, growing GDP sharply on the back of strong exports. As long as GDP and exports are growing, this model works. But when GDP stops growing and exports become slow, the model fails. In the post war period, Japan enjoyed decades of strong economic growth – around 9.5% per annum between 1955 and 1970 and around 3.8% per annum between 1971 and 1990.

The Plaza Accord signed on 22 September 1985 called for France, West Germany, Japan, the United States, and the United Kingdom to devalue the dollar relative to other major currencies (including the yen) by intervening in currency markets with the specific intent of reducing trade imbalances. Between 1985 and 1987, the Yen increased in value by 51% against the dollar.

Japan moved from an era of En’yasu, an inexpensive Yen, to a period of Endaka or Endaka Fukyo, an expensive Yen. The higher Yen adversely affected Japanese exporters. Japanese economic growth fell sharply, from 4.4% in 1985 to 2.9% in 1986.

Desperate to restore growth and offset the stronger Yen, the Japanese authorities eased monetary policy with the BoJ cutting interest rates five times from 5% to 2.5% between January 1986 and February 1987, leaving it finally at 2.5% — which remained in effect until May 1989. The BOJ was ferociously trying to stimulate the economy with aggressive easing. The lower rates led to a rapid increase in debt funded investment, driving real estate and stock prices higher. At the peak of the “bubble” economy, the 3.41 square kilometer (1.32 square miles) area of the Tokyo Imperial Palace had a theoretical value greater than all the real estate in the state of California. The point of failure for Japan was when it’s easy monetary policy stimulated a real estate and stock market bubble instead of fueling exports.

Seeking to reverse the unsustainable asset price inflation, the authorities increased interest rates to 6% between 1989 and 1990 triggering the collapse of the boom. The bubble manifested itself in both real estate and the stock market. It finally popped as the BOJ raised interest rates in 1989–1990(with historic collapses from which — even now, some 22 years later — the country has not recovered).As Japan’s economic problems worsened rapidly, the government responded with large fiscal stimulus programs. The BoJ cut interest rates to zero. But the policy measures failed to revive the economy, which slid into deflation.

Following the collapse of the bubble, policymakers implemented a variety of economic stimulus programs. Japan’s budget surplus of 2.4% in 1991 has become a chronic budget deficit, increasing from 2.5% in 1993 to about 8% by the end of the 1990s. It has remained high during the 2000s. The BoJ has tried unsuccessfully to increase inflation to reduce debt. Japanese inflation has averaged minus 0.2% in the 2000s, a decline from levels of 2.5% in the 1980s and 1.2% in the 1990s. The policies have failed to restore economic growth, trapping Japan in a period of economic stagnation.

Since the collapse of the Japanese debt bubble in 1989/ 1990, Japanese growth has been sluggish, averaging around 0.8% per annum. Nominal gross domestic product (“GDP”) has been largely stagnant since 1992. Japan’s economy operates far below capacity, with the output gap (the difference between actual and potential GDP) being around 5- 7%.

The Japanese stock market is around 70-80% below its highs at the end of 1989. The Nikkei Index fell from its peak of 38,957.44 at the end of 1989 to a low of 7,607.88 in 2003. It now trades around 8,000-12,000. Japanese real estate prices are at the same levels as 1981.

There was a parallel deterioration in public finances. At the time of collapse of the bubble economy, Japan’s budget was in surplus and government gross debt was around 20% of GDP. As the Japanese economy stagnated, weak tax revenues and higher government spending to resuscitate growth created substantial budget deficits.

Japan’s total tax revenue is currently at a 24 year low. Corporate tax receipts have fallen to 50 year lows. Japan now spends more than 200 Yen for every 100 Yen of tax revenue received.

The period of Japanese economic decline was known as the Lost Decade or Ushinawareta Jūnen. As the economy failed to recovery and the problems extended beyond 2000, it has come to be referred to as the Lost Two Decades or the Lost 20 Years (Ushinawareta Nijūnen).

Japan’s large pool of savings, low interest rates and a large current account surplus has allowed the build-up of government debt. Japan has a large pool of savings, estimated at around US$19 trillion, built up through legendary frugality and thrift during the nation’s rise to prosperity after World War II. High savings rates also reflected the country’s young age structure especially until the 1980s, the low level of public pension benefits, the growth of income levels through to the late 1980s, the bonus system of compensation, the lack of availability of consumer credit and incentives for saving.

In recent years, household savings were complemented by strong corporate savings, around 8% of GDP. This reflects slow growth, excess capacity, lack of investment opportunities and caution driven by economic uncertainty.

Much of these savings are invested domestically. A significant amount of the savings is held as bank deposits, including large amounts with the Japanese Postal System. In the absence of demand for credit from borrowers, the banks hold large quantities of government bonds to match the deposits, helping finance the government. Japanese banks hold around 65-75% of all Japanese government bonds (“JGBs”) with the Japanese Postal System being the largest holder. Around 90% of all JGBs are held domestically.

The high levels of debt are sustainable because of low interest rates, driven by the BoJ’s ZIRP and successive rounds of JGB bond purchases as part of quantitative easing (“QE”) programs since 2001. The BoJ balance sheet is now around US$2 trillion an increase from around 10% of Japan’s GDP to 30% since the mid-1990s. BoJ holdings of JGBs are around US$1.2 trillion, around 11% of the total outstanding.

Low interest rates perversely have not discouraged investment in bank deposits or government bonds. This reflects the poor performance of other investments, such as equity and property, during this period. The strong Yen has increased the risk of foreign investments. Although nominal returns are low, Japanese investors have received high real rates of return, because of falling prices or deflation.

Over the last 50 years, Japan has also run large current account surpluses, other than in 1973–1975 and 1979–1980 when high oil prices led to large falls in the trade balances. The current account surplus has resulted in Japan accumulating foreign assets of around US$4 trillion or a net foreign investment position of approximately 50 % of GDP. This helped Japan avoid the need to finance its budget deficit overseas and also boosted domestic resources, increasing demand for JGBs.

These foreign currency holdings generate substantial amounts of investment income each year. However, the control of these vast sums is concentrated in a few hands. Likewise, the bond market (and hence, interest rates) is controlled by many of these same hands. And because bonds are priced in a market, if and when the managers of this capital decide to sell, they can cause a stampede for the exit.

Since the global financial crisis and more recent European debt crisis, Japan has been viewed as a “safe haven”. Investors have purchased Yen and JGBs, pushing rates to their lowest levels in almost a decade and increasing foreign ownership of JGBs to around 9%, the highest level since 1979, the first year for which comparable data is available. These factors have assisted Japan to finance its budget deficit.

These factors which allowed Japan to increase its government debt levels are unlikely to continue.

Private consumption is weak, further reducing domestic demand. This reflects weak employment, lack of growth in income and the aging population. Strong exports and a current account surplus have partially offset the lack of domestic demand, as firms focused on overseas markets.

With investment and consumption weak, large budget deficits have supported economic activity, avoiding an even larger downturn in economic activity. In a balance sheet recession, monetary policy is ineffective with limited demand for credit. Government stimulus spending is the primary driver of growth.

The Japanese government’s ability to finance spending is increasingly constrained by falling Japanese household savings rates, which have declined from between 15% and 25% in the 1980s and 1990s to under 3%, a level below the US until recently. This decline reflects decreasing income and the aging population.

In terms of debt capacity, the net assets of Japanese households reach 1,156 trillion yen; while the national debt is 1,133 trillion yen. The difference is around 23 trillion yen. The increase in assets buyback already hits 10 trillion yen, which means there is not much domestic capacity left for absorbing any newly issued debt, which means there is not much domestic capacity left for absorbing any newly issued debt. In other words, if the Japanese government continues with its current economic policies and has no way out in economic development, it has to go to foreign lenders for funds. Worst still, it is doubtful if the Japanese government can issue debt at such interest rates. With the worsening debt to GDP ratio and an unreasonable debt level, new lenders are likely to ask for a fair premium for the lending.

Wage have fallen with average annual salaries including bonuses falling every year since 1999 and decreasing by around 12% in total. Between 1994 and 2007, labor costs as a percentage of manufacturing output declined from 73% to 49%. Japanese worker’s share of GDP fell to 65% in 2007, from a peak of 73% in 1999.

Compounding matters, Japan’s manufacturing prowess is weakening while the country as a whole is becoming less competitive. They have lost leadership positions in a number of key industries and the rise of the yen is making their exports less competitive as well. Moreover, pressured budgets make it more difficult to engage in the long-range R&D spending that had helped the country become a global leader in manufacturing. As an example, once a stalwart in consumer technology, Sony recently announced the layoff of 10,000 workers.

Since the epic global financial meltdown in 2008, the U.S. Federal Reserve has maintained an aggressive policy of depreciating the U.S. dollar. The yen has appreciated some 30% against its post-bubble average, as well as against the dollar, since the collapse in 2008.

This recent appreciation of the yen is exacerbating all of Japan’s problems — its export products are now 30% more expensive on global markets. Its profile is similar against other major currencies. For the first time since the Japanese bubble collapsed, Japan will now need substantial alternate forms of funding to keep the government afloat.

Japan’s demographics parallel its economic decline. Japan’s population is forecast to decline from its current level of 128 million to around 90 million by 2050 and 47 million by 2100. A frequently repeated joke states that in 600 hundred years based on the present rate of decline there will be 480 Japanese left.

The proportion of Japan’s population above 65 years will rise from 12% of the total population to around 23%. Japan’s work force is expected to fall from 70% currently by around 15% over the next 20 years. For every two retirees there will be around three working people, down from six in 1990. This aging population further reduces the savings rate. Household surveys indicate that around a quarter of households with two people or more have no employment.  In aggregate, the amount of money being paid to retirees from savings exceeds the amount of new money that is going into savings funds. This is compounded by low returns on investments which accelerates the rundown of savings.

The secular factors driving the fall include an appreciating Yen and slower global growth, which has reduced demand for Japanese products, such as cars and consumer electronics. In late 2012, territorial disputes with China exacerbated the decline in exports. It also reflects the impact of the Tohoku earthquake and tsunami as well as the subsequent decision to shut down Japanese nuclear power generators, which increased energy imports, especially Liquid Natural Gas.

Deep seated structural factors also underlie changes in the trade account. Since the 1980s, rising costs and the higher Yen have driven Japanese firms to relocate some production facilities overseas, taking advantage of lower labor costs and circumventing trade barriers. More advanced, technologically complex and high value manufacturing was kept in Japan. But post 2007 Japanese firms have increasingly been forced to close these domestic production facilities as they have become uncompetitive.

The combination of falling exports, lower saving rates, declining corporate earnings and cash surpluses is likely to move the Japanese current account into deficit. In turn, this will force Japan to become a net importer of capital to finance government spending, altering the dynamics of its finances.

If Japan continues to run large budget deficits, as is likely, then the falling saving rate and reversal in its current account will make it more difficult for the government to borrow, at least at the current low rates.

Ignoring foreign borrowing and debt monetization by the central bank, the stock of private sector savings limits the amount of government debt. In the case of Japan, this equates to around 250-300% of GDP. Japan’s gross government debt will reach this level around 2015, although net government debt will not reach this limit until after 2020.

Even  before Japan’s government debt exceed household’s financial assets, the declining savings rate and increasing drawing on savings by aging households will reduce inflows into JGBs making domestic funding of the deficit more difficult.

Insurance companies and pension funds are increasingly selling their holdings or reducing purchases to fund the increase in payouts to people eligible for retirement benefits. Institutional investors and to a lesser extent retail investors are also increasingly investing in other assets, including foreign securities, in an effort to increase returns and diversify their portfolios.

Japan’s large portfolio of foreign assets will cushion the effects for some time. Japan has accumulated large foreign assets totaling around US$4 trillion, making it the world’s biggest net international creditor. The BoJ is the largest investor in US Treasury bonds, with holdings of around US$1 trillion.

Unless public finances improve, Japan ultimately will be forced to finance its budget deficit by borrowing overseas. Where the marginal buyers of JGBs are foreign investors rather than domestic Japanese investors, interest rates may increase, perhaps significantly. Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.

Higher interest rates will also trigger problems for Japanese banks, Japanese pension funds and insurance companies, which also have large holdings of JGBs.

In fact, the major banks, such as Bank of Tokyo-Mitsubishi UFJ, Sumitomo Mitsui, and Mizuho, regularly buy JGBs — even viewing it as a “public mission” to support Japan. In addition, the Bank of Japan buys lots of JGBs on the open market, trying to drive up prices and drive down yields, thereby manufacturing low rates. While this monetization of debt creates inflationary pressures, it has thus far been offset by the deflationary pressures of a declining workforce and declining population. Looking forward id there happens to be some mild inflation of, perhaps, 2–4% (depending on how much monetization and how much debt issuance occurs), but it would likely be enough to re-calibrate the bond market’s expectations. And if JGB yields rise from 1% to just 2%, Japan’s debt service will explode. Thus, a vicious cycle of higher yields, greater fiscal deficits, greater monetization, and greater inflation will occur.

There are also short-term fluctuations from year to year, but it is clear when looking at the averages decade by decade that funding pressures in Japan have been growing over time. JGBs total around 24% of all bank assets, which is expected to rise to 30% by 2017. An increase in JGB yields would result in immediate mark-to-market large losses on existing holdings, although higher returns would boost income longer term. BoJ estimates that a 1% rise in rates would cause losses of US$43 billion for major banks, equivalent to 10% of Tier 1 Capital for major banks or 20% for regional banks.

This cash flow cycle is how Japan has funded itself over the past 22+ years. Only now, the profile is changing. The Japanese debt crisis is being spawned by a burgeoning fiscal deficit. As the fiscal deficit has expanded, it has placed greater pressure on the Japanese government to sell debt and on the Bank of Japan to purchase it. Of course, the BOJ has been stepping in and buying JGBs when corporate demand has not been strong enough to keep rates low.

To avoid the identified chain of events, Japan must address the core problems. But reductions in the budget deficit are difficult. Spending on social security accounts and interest expense now totals a major part of government spending. Increasing health and aged care costs are expected by 2025 to be around 10-12% of GDP.  An aging population and shrinking workforce will continue to drive slower growth and lower tax revenues. Tax increases are politically unpopular. Reductions in the budget deficit are likely to reduce already weak economic activity, compounding the problems.

Prime Minister Ryutaro Hashimoto tied in 1997 to raise the sales tax. Hashimoto’s move cost him his job.

According to the OECD, Japan’s tax revenue in 1991 totaled some 66 trillion yen in individual and corporate income taxes. By 2009, this had fallen to 36 trillion yen, with bond issuance exceeding tax revenues in fiscal 2012 for the third straight year.

The IMF has warned that the increase in consumption tax goes only halfway toward achieving a desired fiscal adjustment of 10 percent of GDP over the next decade to put the debt ratio on a downward path. With some fiscal adjustments, the public debt to GDP ratio is forecast at 300 percent of GDP by 2030, with further cuts deemed necessary to stabilize and then start reducing the ratio.

The government has forecast a primary deficit of between 1.9 and 3.1 percent of GDP by fiscal 2020, compared with the fiscal 2011 deficit of 7.4 percent.

Bringing the primary balance, where fiscal expenditures can be covered without borrowing, into equilibrium is estimated to require an additional 5 to 6 percent hike in the consumption tax.

But, some have argued that Japan can ameliorate its budget shortfall by raising tax rates. In economics, there are no grand solutions, only trade-offs. So, it is a fallacy to think that increasing tax rates necessarily increases tax revenues to the government. Many governments and countries have tried raising tax rates and failed to increase tax revenues either due to tax avoidance or damage to economic growth (or both).

Other analysts have compared Japan’s relatively low tax revenue/GDP ratio with that of other countries, claiming that there is ample room to raise taxes. However, this belies the welfare society construct that Japan has developed in the past 75 years. In contrast to the welfare state, the welfare society provides social benefits through private employers. Japan’s welfare society attempts to maintain near-total employment via liberal government loans to private companies, often circumventing the need for unemployment benefits. Also, retirement pensions come largely from personal savings and company compensation rather than as benefits from the state. So, the state has intentionally shifted the cost of its social programs to companies. Should it raise taxes on the private sector, additional pressure would be placed on corporate budgets, and thereby weakening the economy.

When Hashimoto increased the rate by just two percentage points to its current level, the economy plunged into a 20-month recession, albeit worsened by the Asian financial crisis.

Proposed solutions to Japan’s economic woes have included measures to deregulate the agricultural, electricity and service sectors, along with the politically sensitive measures of joining the Trans-Pacific Partnership and increasing immigration.

The IMF has suggested the fiscal consolidation include raising the consumption tax rate to 15 percent – closer to the OECD average – while reducing corporate taxes, broadening the personal income tax base and increasing the pension retirement age to 67.

In its August 2012 report, the IMF warned that “even a moderate rise in yields would leave the fiscal position extremely vulnerable…Failure to implement a credible fiscal consolidation plan could lead to sovereign downgrades and trigger similar actions for financial institutions, which could eventually erode confidence in the JGB [Japanese government bond] market.”

Higher JGB yields would further damage public finances, with the government’s budget already at a point where bond issuance exceeds taxation revenues. The IMF calculates that a spike in bond yields would slash output by 6 to 10 percent over 10 years, potentially harming not only other Asian economies but also the United States and Euro-zone.

In 2012, for example, the Japanese government needs to issue debt amounting to 59.1 percent of GDP; that is, for every $10 that Japan’s economy generates this year, the government will need to borrow $6. It will probably be able to do so at very low interest rates—currently well below 1 percent.

The fact that government debt is held mostly by Japanese citizens is not sufficiently reassuring. The same was true in Germany during the 1920s and Russia during the 1990s, yet in both cases the elderly lost their savings to high inflation.

Japan’s problems have been compounded by two major natural disasters – the 1994 Kobe earthquake and the 2011 Tohoku earthquake and tsunami.

In the face of the nation’s long term decline, Japanese politics has become increasingly fractious. Frequent changes of leadership, often driven by arcane internal factional politics, have created an unstable environment and a lack of policy continuity. Japan has had seven prime ministers in six years and six finance ministers in three years. Former Brazilian President Luiz Inácio Lula da Silva once joked that in Japan you say good morning to one prime minister and good afternoon to another.

What makes the problem so serious in Japan is the country’s refusal to do what other countries have done: admit massive immigration of younger people from overseas. It is very difficult to immigrate to Japan, and (having immigrated) even harder to obtain citizenship. Japan is the world’s most homogeneous large country.

Japanese policy makers have other options. Financial repression forcing investment in low interest JGBs is one alternative. The BoJ can maintain its zero rate policy and monetize debt to finance the government. Japan can try to inflate away their debt. But ultimately, Japan may have no option other than a domestic default to reduce its debt levels.

Rising inflation helped the United States nearly halve its debt burden from World War II over the period from 1946 to 1955, but Japan’s policymakers, including the Bank of Japan (BOJ), have struggled in recent years to overcome persistent deflationary expectations.

Older Japanese, especially retirees who are major holders of JGBs, would suffer large losses. Younger Japanese would benefit from the reduction in debt and reduced claims on future tax revenues. Such a drastic alternative, with its massive economic and social costs, is difficult to conceive other than as the last option.

However, the status quo in Japan — if left unchanged — will see to it that the funding deficit widens materially. As debt continues climbing and GDP continues falling, the growth in the debt-to-GDP ratio accelerates. The combination of a rising yen and stagnating corporations will result in the structural trade surplus deteriorating over time (which is why the BOJ is trying to get the yen to decline somewhat). Additionally, debt service and social security spending will continue growing as percentages of the federal budget — all without any increase in interest rates. So there is a widening funding deficit that must be made up for with some combination of debt issuance and/or monetization. The combination of large fiscal deficits, funding shortfalls, and private sector not able to save will ensure that Japan must seek investors on the international markets. Consequently, the (natural) domestic demand base for JGBs will fall, while the government’s need for foreign investors is rising. Although some have suggested that the Bank of Japan could devalue the yen. (Remember that Japan imports virtually all of its raw materials, such as energy and hard commodities.) If it chopped the yen in half and many of its input costs doubled, could its export companies be competitive? What would happen to the balance of trade (all else being equal)?

While the underlying economics will change gradually over time, the crisis will erupt when the bond market breaks from the past. When the market realizes that the status quo has changed, rates will rise and force the government’s fiscal budget to explode, creating a sequence of cascading events. Watch closely to see what the major Japanese banks do with their JGB holdings. In addition, watch pension fund managers. The stewards of capital changing their policy allocations will determine when the status quo shifts.

Moreover, Japan has an average debt maturity of 6 years, shorter than Spain, Italy and France. Around 60% of its debt must be refinanced in the next 5 years. This will expose Japan to the discipline of market investors at a vulnerable moment.

Venture capitalist Hitoshi Suga suggested a “debt-equity swap” where the government converted JGBs into 100-year debts, similar to Britain’s “perpetual bonds” issued after the First World War, as well as more fiscal prudence.

Ironically, despite its recent crises, Europe offers an example to Japan of managing fiscal reconstruction while also raising growth. Both the Netherlands and Sweden achieved this feat in the 1980s and 1990s through persistent public finance reforms along with greater labor market mobility and other market opening measures.

The Bank of Japan’s 63-year-old governor, Masaaki Shirakawa — a thin man with neatly parted hair — no longer adheres to the disciplined monetary policies his Western counterparts preach. Instead, Shirakawa keeps the money printers going to stimulate the economy. Since 2011, his bank has launched emergency programs with a total volume of around €900 billion. In comparison, the euro bailout funds jointly financed by the euro zone’s 17 member states only add up to €700 billion.

So far, though, his strategy has done little to help. “At the moment,” Shirakawa admits, “the effect of our monetary policy in stimulating economic growth is very limited.” The cheap money is stuck in the banks rather than flowing into the real economy. “The money is there, liquidity is abundant, interest rates are very low — and, still, firms do not make use of accommodative financial conditions,” Shirakawa adds. “The return on investment is too low.”

Money is only a means with which “to buy time,” he says. “It can alleviate the pain. But the government has to implement reforms too.”One thing is sure, warns central banker Shirakawa, “If we don’t deliver fiscal reform, then the yield on Japanese government bonds will rise.”

At any rate, one thing is clear: change is coming to Japan.

Once the problems emerge, they will be difficult to contain. As Economist Rudiger Dornbush once observed: “The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”.

To learn more about Asset bubble Crisis of Japan in 1980, click here 🙂

The Currency Wars!

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Suddenly the press and media were buzzed with the word ‘Currency War’. People are discussing that sooner than later all countries would go for this currency war. This got my curiosity and I decided to look into what is called as ‘currency war. I found some general things. I would like to share them with you all and discuss how it all started. But to start with, I would like to add that with much of Europe in a recession, Japan struggling with deflation, and the weak American economy potentially falling back into a recession if the automatic spending cuts go through, the global economy is fragile. The last thing the world needs is a currency war. Hehehe, anyways to start with:

Brazil’s finance minister coined the term “currency wars” in 2010 to describe how the Federal Reserve’s quantitative easing was pushing up other countries’ currencies. In mid January, 2013 Alexei Ulyukayev, the first deputy chairman of the Russian central bank, resurrected the phrase to warn of another round of competitive devaluations.

The starting-point for this skirmish was the election of Shinzo Abe as prime minister of Japan in December, and his promise to reorient economic policy. Mr. Abe stormed to an election victory in December with bold promises to end decades of intermittent growth. He wants the Bank of Japan to double its inflation target to 2% and to buy government bonds until that target is achieved. If his goal is realized, Japanese interest rates would finally become negative in real (i.e., after inflation) terms. Because of deflation, real rates have been positive for much of the past decade, even though the economy has been sluggish. That has kept the yen strong, making life more difficult for exporters.

Mr. Abe’s move has had a tremendous impact on the currency markets, pushing the yen down from 78 per dollar in October to 90. According to Alan Ruskin of Deutsche Bank, this was the fifth-fastest decline in the yen since the collapse of the Bretton Woods exchange-rate system in 1971. The yen, for instance, has fallen by about 11 percent against the dollar since the recent election in Japan of Prime Minister Shinzo Abe. The Bank of Japan, the central bank said it would pump more money into the economy via a new, open-ended commitment to buying assets beginning in 2014 — measures known as QE and intended to lift the country out of its fourth recession since 2000. Critics say those policies are aimed at lowering the value of the yen, which Mr. Abe’s government has denied, saying that the Bank of Japan is trying to end nearly 20 years of deflation — not manipulate the yen.

Even the Japanese seem to have been slightly taken aback by the yen’s fall. Japan is heavily dependent on foreign energy supplies, and Akari Amari, the economy minister of Japan, warned that excessive yen depreciation would force up import prices.

The yen’s weakness has added to the pressures on other economies. One of the strongest currencies so far in 2013 has been the euro, which has been buoyed by a feeling that a break-up of the single currency has become less likely.

President François Hollande of France proposed that euro-zone nations should adopt a policy to manage the value of the common currency to maintain the competitiveness of European goods. (The euro has appreciated about 2 percent against the dollar and nearly 10 percent against the yen this year.) Even Chancellor Angela Merkel of Germany waded into the currency debate Thursday, singling out Japan as a source of concern following the Bank of Japan’s moves.

“I don’t want to say that I look towards Japan completely without concern at the moment,” she said at the World Economic Forum in Davos. “It is known that in Germany we are of the opinion that central banks are not there to clean up political bad decisions and a lack of competitiveness.”

The euro has even risen against the Swiss franc, a currency that was so strong in 2011 and 2012 that the Swiss accumulated more foreign-exchange reserves than any other country in the world. The Swiss National Bank acquired those reserves as part of its pledge to prevent the franc from rising above 1.20 to the euro by creating unlimited amounts of francs and buying foreign currencies with the proceeds.

Developing countries like Brazil and Mexico also complain that looser monetary policy in industrialized nations can produce effects similar to currency manipulation. When central banks in countries like Japan and the United States pump more money into their financial systems, investors are driven to put their money into emerging markets where interest rates are higher. That pushes up currencies like the real and peso, making exports from those countries more expensive on the world market.

Typically, a central bank eases by lowering the short-term interest rate. When that rate is stuck at zero, it can buy bonds, i.e. conduct quantitative easing (QE), or verbally commit to keep the short rate low for longer, or it can raise expected inflation. All these conventional and unconventional actions work the same way: by lowering the real (inflation-adjusted) interest rate, they stimulate domestic demand and consumption. America, Britain and Japan are all doing this, although only Japan has explicitly sought to raise expected inflation; America and Britain have done so implicitly. This pushes the exchange rate down in two ways. First, a lower interest rate reduces a currency’s relative expected return, so it has to cheapen until expected future appreciation overcomes the unfavorable interest rate differential. This boosts exports and depresses imports, raising the trade balance. Second, higher inflation reduces a currency’s real value and thus ought to lead to depreciation. But higher inflation also erodes the competitive benefit of the lower exchange rate, offsetting any positive impact on trade.

If this were the end of the story, the currency warriors would have a point. But it isn’t.  The whole point of lowering real interest rates is to stimulate consumption and investment which ordinarily leads to higher, not lower, imports. If this is done in conjunction with looser fiscal policy (as is now the case in Japan), the boost to imports is even stronger. Thus, QE’s impact on its trading partners may be positive or negative; it depends on a country’s trade intensity, the substitutability between it and its competitors’ products, and how sensitive domestic demand is to lower rates. The point is that this is not a zero sum game; QE raises a country’s GDP by more than any improvement in the trade balance.

There are other spillovers. Lower interest rates in one country will generally tend to send investors searching for better returns in another, lowering that country’s interest rates and raising its asset prices. By loosening foreign monetary conditions, that boosts growth, though this may not be welcome if those countries are already battling excess demand and inflation. Countries like Brazil and Mexico fall in this category.

Determining whether QE is good or bad for a country’s trading partners requires working through all these different channels. In 2011, the International Monetary Fund concluded the spillover of the Fed’s first round of QE onto its trading partners was significantly positive, raising their output by as much as a third of a percentage point, while the spillover of the second round was slightly positive. The IMF concludes the weaker dollar was indeed slightly negative for the rest of the world, but this was more than offset by the positive impact of lower interest rates and higher equity prices. This became a motivation for Japan’s stepped-up assault on deflation. The combined monetary boost on opposite sides of the Pacific has been a powerful elixir for global investor confidence.

Currency warriors regularly invoke the 1930’s as a cautionary tale, but they actually show something quite different. In the 1980s, Barry Eichengreen at the University of California, Berkeley and his co-authors demonstrated that the first countries to abandon the gold standard recovered much more quickly from the Depression than those that stayed on gold longer. The direct spillover of depreciation was negative, while the spillover of increased money and credit was positive, as capital outflows “helped to relax conditions in money and  credit markets and moderate expected deflation in other countries.” Nonetheless, he concludes that from both calibration exercises and historical literature, the spillover effect was net negative. This might have been averted if everyone adopted the same monetary policy, i.e. quit gold at the same time:

The irony is that to the extent devaluation led to protectionism and falling trade volume, it was more due to countries that did not devalue. In an earlier paper, Mr Eichengreen and Doug Irwin of Dartmouth College note that countries that remained on gold were more likely to erect protectionist measures against imports than countries those that quit. So while imports did collapse, they fell far less for countries that abandoned gold (like Britain, whose imports rose slightly between 1928 and 1935) than for those that stayed with it, like France, whose imports fell 15%.

The key insight of Mr Eichengreen’s work was that the more countries abandoned gold, the more positive become the spillover effects: “what are now referred to as currency wars were part of the solution, not part of the problem.” The analogy for today is that countries whose currencies are rising because of easier foreign monetary policy should ease monetary policy as well, assuming they, too, suffer from weak demand and low inflation. In fact, America’s QE and the resulting upward pressure on the yen was one of the key reasons Shinzo Abe, Japan’s prime minister, demanded the Bank of Japan take a more determined assault against deflation. The fact that global stock markets have been chasing the Nikkei higher as Mr Abe’s programme is put in place suggests investors believe this is virtuous, not vicious, cycle. This also implies that the euro zone ought to respond with easier monetary policy which would both neutralize upward pressure on the euro and combat recession in the euro zone.

But Mr Eichengreen notes that unlike in the 1930’s, today there is a large group of emerging economies who did not suffer a deflationary shock and thus would not benefit from easier monetary policy. Their optimal response, he says, would be to tighten fiscal policy, which would cool demand, putting downward pressure on interest rates and their currencies. But, as in the 1930’s, he notes that there are political and institutional barriers to doing so, and instead they are opting for second-best policies such as capital controls, currency intervention, and in some cases, import restrictions. To read more about Mr Eichengreen, click on the link at the end of the article.

There’s an interesting debate over whether even intervention constitutes currency war. Economists traditionally thought such intervention had limited effect. If the central bank intervenes but does not change expectations about interest rates, investors will simply buy up all the currency that the central bank sells until expected returns were once again equal across all markets.

But Joseph Gagnon of the Peterson Institute for International Economics challenges this conventional wisdom. Studies that found intervention does not work were done in the 1980’s and 1990’s when the sums were far smaller, he says. Central bank intervention is now hundreds of times larger. He explains in an interview:

“Japan did $177 billion of intervention in 2011. When countries intervene on that magnitude, I don’t think all the hedge funds and investment banks in the world are enough to neutralize that effect. They’re not willing to gamble more than a few tens of billions. Hedge funds need differential rates of return to induce them to take opposing positions. And the riskier it is, the more they have exposed, and the higher return they need. They expect to make money because government is distorting markets in a way they think is not sustainable, but governments can distort markets longer than you can stay solvent. “

This has parallels to the debate over QE. Skeptics believe that if the central bank does not change the public’s expectations of interest rates or inflation, no amount of bond buying will alter asset values or stimulate growth. But advocates believe investors have a “preferred habitat;” they hold certain types of bonds or assets because of legal or institutional constraints, even if their returns seem too low relative to their own expectations of interest rates.

Most intervention is sterilized: the central bank is selling currency previously held by the public, so the money supply does not change. Unsterilized intervention, in which the central bank prints the currency it sells, as the Swiss National Bank has done, has different implications. It is, in practice, QE plus sterilized intervention. Imagine an investor sells Euros to the SNB and gets newly printed Swiss francs. He invests them in Swiss government bonds, buoying their prices. The result is exactly the same as if the SNB had bought Swiss government bonds with newly printed money, then sold those bonds in order to buy foreign exchange. Based on our analysis here, it is getting one thing right (the QE) and one wrong (the intervention). The SNB justified its action based on the fact that its domestic bond market was too small to accommodate QE in sufficient size. Its trading partners must have agreed, because they didn’t kick up much fuss. Or perhaps Switzerland is too small to matter. Japan should not assume it would get the same, hands-off treatment.

Should Japan’s attack on the yen move beyond rhetoric to actual intervention in the markets to drive its value down, then the rest of the world would be right to condemn it (Because If all countries were to competitively devalue their currencies, the result would be a downward spiral that would benefit no one, but could lead to high inflation.). Until that happens, other countries should avoid groundless outcries about currency wars.

The president of the European Central Bank on 14 February, 2013 cited the rising value of the euro as a possible threat to the region’s economic recovery, comments that immediately sent the euro down sharply against the dollar and yen. Mario Draghi, the E.C.B. president, denied that the central bank was trying to influence the value of the euro, no doubt mindful of provoking a currency war with Japan or the United States. But he then made statements that investors interpreted as meaning the E.C.B. could take action if the euro rose too much.

Source: Economist, The New York Times
Click here to read Barry Eichengreen Paper 🙂

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