A brewing currency war

If the yen were to weaken substantially, the yuan cannot be far behind. A world currency war looks imminent
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First Published: Mon, Nov 19 2012. 06 32 PM IST
A file photo of Shinzo Abe, the head of Japan’s main opposition Liberal Democratic Party. Photo: Reuters
A file photo of Shinzo Abe, the head of Japan’s main opposition Liberal Democratic Party. Photo: Reuters
Updated: Mon, Nov 19 2012. 06 44 PM IST
After appreciating against both the US dollar and the euro quietly and steadily over the last two years, the Japanese yen has now crossed the 80 yen-to-a-dollar mark and is now above 81. The Japanese parliament has been dissolved and the Democratic Party of Japan (DPJ) looks set to lose its control of Diet (the lower house of Parliament) that it wrested from the Liberal Democratic Party (LDP). The LDP had ruled Japan for decades. Its defeat in 2009 was expected to lead to political reforms and economic restructuring. In the end, nothing of that sort happened and the DPJ simply proved inadequate to govern a complex and ageing country. LDP’s Shinzo Abe appears confident of winning the elections and becoming the prime minister, again. He has called for unlimited easing of monetary policy from the Bank of Japan (BoJ) (see http://www.ft.com/intl/cms/s/0/7e64027c-2f04-11e2-b88b-00144feabdc0.html). Superficially, he is justified in calling for a weaker yen as the country has just recorded its first current account deficit in September. It had begun recording a sustained trade deficit since April 2011.
If he wins the elections and if BoJ responds, it is sure to trigger a major currency war among the G-3 (US, Europe and Japan) and between G-3 and the developing world. He has set the cat among the pigeons. The anticipation of an LDP victory and, hence, loose monetary policy will keep investors salivating on Japanese stocks since Europe looks too weak and the outlook in the US is uncertain, at least in the short-term. The Nikkei 225 stock index went up by more than 4% in the week of 12 November. Investors will be betting on the yen carry trade again and that is not particularly good news for the euro zone. It will come in the way of a rapid depreciation of the euro. There is no discernible reason as to why the euro should be holding up around 1.28 to the dollar. It deserves to go a lot lower, unless the US has expressly forbidden a steep decline in the euro.
Regardless, it is doubtful if Japan could recapture economic growth through a weaker currency, especially when global demand is weak. It will merely rile Japan’s smaller Asian neighbours and the big one too. Apart from his belligerence vis-à-vis BoJ, Abe has talked tough to China on territorial claims. More than the recent disputes, Abe’s re-election may be the real game changer in the Asian theatre.
Jim Walker of Asianomics (disclosure: I am a consultant-economist for Asianomics) has consistently argued that a weak currency is a disaster for an ageing society. Japan’s elderly people need the enhanced purchasing power afforded by deflation and a strengthening currency. More importantly, with the bulk of Japan’s export industries located outside, it is hard to see how a weak yen will bolster its exports. It might well raise import costs. Will an ageing society respond to incipient inflation by bringing spending forward or will it hunker down and save more? Further, it is possible for one country to stimulate its way out of trouble if others are doing well. If everyone tries to stimulate the same way, the result will only be economic and political tension and not economic recovery. The only thing that is clear is that Abe has signalled to foreign exchange traders that it is time to put the yen carry trade back on the table.
With US stocks swooning after the presidential election, financial markets are now looking up to the Federal Reserve to provide additional stimulus. They are now hoping the Fed will announce specific targets for rates of inflation and unemployment and that it will refrain from tightening monetary policy until those rates are reached and sustained. However, the third round of quantitative easing has not delivered the goods for financial markets as is evident from the recent swoon in US stocks. A shift to an outcomes-based monetary policy as opposed to a calendar-based monetary policy will do little to boost stocks. All that it will do is to formalize the permanence of easy monetary policy in the US, as in Japan. And as was observed in Japan, this will have little or no effect.
With China’s political transition seemingly out of the way, it is time to focus on the Chinese economy. According to Fitch Ratings, China’s total social financing (TSF) accelerated in the third quarter and that is one of the reasons behind the seeming improvement in macroeconomic data. Fitch notes: “This marks the fourth year in a row that net new credit will exceed one-third of GDP…since the global crisis, China has been caught in a trap of investment-driven growth funded by massive credit. Escaping this is a challenge—reduce credit and the economy slows as in H112, leading to asset-quality stress—and becomes more difficult the larger the credit stock.” Chinese economic uncertainty looks set to return in 2013. In this milieu, if the yen was to weaken substantially, the yuan cannot be far behind. A world currency war looks imminent.
V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk-
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First Published: Mon, Nov 19 2012. 06 32 PM IST
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