Japan joins ugly contest with tsunami of money

Political tensions on the Korean peninsula have lately escalated. In February, North Korea carried out a nuclear weapons test, defying tighter United Nations sanctions.

Kim Jong Un’s regime has since been threatening pre-emptive nuclear strikes against Pyongyang’s enemies, the recently-installed 30-year old “supreme leader” clumsily attempting to rally the moribund population of one of the world’s most secretive states.

Last week, North Korea pulled workers from an industrial complex operated jointly with South Korea, in a move seen as deliberate provocation. What with this return to Cold War hostilities, then, Seoul is presumably deeply concerned about the aggressive antics of its Northern nemesis?

South Korea seems fixated, though, less on a theoretical nuclear war than on an actual financial war – not with nasty North Korea, but with Japan, a fellow Western-ally.

“Japan’s economic policies are doing their part to help the world economy recover,” said South Korean Finance Minister Hyun Oh-Seok, on the fringes of last week’s G-20 summit in Washington. “But if this causes problems, and then the problems cause new responses from partnering nations, for example a currency war, the world economy will have a hard time”.

Despite Hyun’s careful phrasing, there is no “if” about it. South Korea already has a big problem with “Japan’s economic policies”. Over the last six months, as new Japanese Prime Minister Shinzo Abe has scrapped Tokyo’s traditional policy caution and dramatically embraced “quantitative easing”, the South Korean won has risen by a fifth against the yen.

Japan may be late to the QE table, but with Abe having ordering the ultra-conservative Bank of Japan to flood the world with freshly created currency, Tokyo is making-up for lost time. That’s sparked outrage in some quarters, not least South Korea, where exports account for half of national income. The country’s vehicles and electrical goods, in particular, compete head-to-head on global markets with more established Japanese products. In recent years, they’ve made real headway, taking considerable market share. But now, an artificially-created 20pc hike in the won-yen rate yen has made South Korean goods less attractive, inflicting serious damage on the likes of Samsung and Hyundai and threatening to reverse the hard-fought trade gains of Asia’s fourth-largest economy.

“Compared to the North Korea risk, a sliding yen is having a considerable impact on the real economy of South Korea,” uttered Hyun, in a bid to place this issue firmly on the G-20 summit table and prior to this weekend’s Spring meetings of the International Monetary Fund and World Bank. The trouble is that very few big Western players want to talk about Japan and currency wars. That’s because when it comes to competitive depreciations, the unedifying truth is that countries such as the US and UK are guilty to an even greater extent than Japan.

Japan has been treading economic water for more than two decades, ever since its almighty real estate bubble burst in the early 1990s. Still the world’s second-largest economy when the credit crunch began in late 2007, the country has since slipped back to third-place, its GDP having contracted for six of the last eight quarters.

Since becoming Prime Minister, Abe has launched a policy shake-up, forcing the central bank to announce that it will raise its inflation target to 2pc, and reach that goal “at the earliest possible date”. As such, new Bank of Japan Governor Haruhiko Kuroda has committed to QE on a scale that is more drastic than anything so far attempted by America.

In September 2010, the Brazilian Finance Minister, Guido Mantega, pointed a rhetorical finger at the US, accusing the world’s largest economy of conducting a “currency war”. Suggesting that emerging markets were being unfairly squeezed by a falling dollar, and the boost that gave to American exports, Mantega lit the touch paper on a controversy that won’t go away.

In the aftermath of the credit crunch, some of the world’s most advanced countries have been using QE to bring down the value of their currencies. Such a tactic not only boosts exports, but the QE credits have also been used, via asset swaps, to provide bombed-out banking sectors with yet more implicit subsidies.

By lowering currencies, QE also reduces the value of, for instance, the US Treasury bills and UK gilts which have been bought in good faith by investors and which said advanced economies must ultimately repay. This is “soft default”. You don’t explicitly refuse to pay your creditors, as that would involve a lot of nasty headlines, messy rescheduling and related legal wrangling. You just make sure the currency you are paying them back in is worth less – which isn’t difficult when QE is used to create money ex nihilo.

This has been happening on an absolutely enormous scale. Since the Anglo-Saxon world embarked on QE in early 2009, the US Federal Reserve has roughly tripled America’s base money supply. In the Eurozone, the same measure has doubled over that period. The UK, which has pursued QE to a greater extent than any other large country, has seen its base money supply increase no less than four-fold. Until now, the Bank of Japan has held out, allowing only a 20pc rise in Japanese base money over the last five years – which goes a long way to explain the yen’s relative strength.

After resisting for a long time, Japan – heavily indebted, and with its exports under pressure from upstart competitors – has now joined the Western world’s “ugly contest”. Tokyo is aggressively expanding its base money and, given its determination to lower the yen, isn’t shy to admit it. In a stunning volte face, Japan now plans to double its monetary base from 29pc of GDP at the end of 2012 to 54pc of GDP by the end of 2014. While the Fed is currently expanding its balance sheet by an annualized 6pc of GDP, Japan’s QE onslaught involves an annualized expansion equal to 13pc of national income.

The yen spent 2012 oscillating around 80 to the dollar. Abe’s monetary tsunami has since seen the currency fall rapidly, with the yen now close to the psychologically 100-to-the-dollar threshold. Both Kuroda and Japanese Finance Minister Taro Aso told the G-20 summit that other nations “understood” Japan’s actions “weren’t about depreciating the currency”, but were geared towards “domestic aims”, such as escaping deflation. The official communiqué, also, re-affirmed the commitment of G-20 nations to avoid weakening their currencies to gain a trade advantage.
This is laughable. Faced with massive debts, and an unwillingness to confront fiscal reality, most of the leading Western economics are using currency debasement as their main response to the sub-prime debacle – and now Japan has explicitly joined them. With QE now being used to an unprecedented extent, many sophisticated investors, while happy at the positive impact “extraordinary measures” have had on asset prices, are now increasingly wondering how much longer the show can go on.
“Depreciation of the yen has caused a spillover-effect, so this is worth discussing,” ventured Finance Minister Huan. But no-one wants to discuss it. The Western world seems to have concluded that, whatever the objections of Japan’s competitors, it would be better for everyone if a major economy like Japan was once again firing on all cylinders.

That might be a reasonable position if QE was indeed the answer to Japan’s unsustainable fiscal position. But, of course, it isn’t. QE is merely a time-buying measure that, rather than facilitating genuine structural change and tough choices, merely puts such decisions off. That has been the recent Western experience and will, no doubt, be repeated in Japan.

Liam Halligan is Chief Economist at Prosperity Capital Management. The views expressed are his own.

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