Old-Guard Japan
January 19, 2007
By Stephen Roach | New York
In a stunning blow to central bank independence, the Bank of Japan seriously bumbled its January 18 policy decision. After setting up the markets for the second installment of a “normalization-focused” monetary tightening, the BOJ buckled under political pressure and passed -- electing, instead, to keep its policy rate unchanged at 0.25%. While this may end up being nothing more than a painful detour on the road to normalization, the incident speaks volumes about the Old Guard political dominance of Japan’s deeply entrenched LDP ruling party. It is a major credibility blow, with potentially lasting damage to the New-Economy image of a revitalized post-deflation Japanese economy.
Ironically, it’s not as if the BOJ did the wrong thing insofar as the policy decision itself was concerned. After all, the Japanese monetary authorities have established a 0 to 2% reference range for CPI-based inflation, and the latest reading on inflation is only fractionally in positive territory at +0.1% y-o-y. Moreover, as our Japan team points out, there is a very good chance that Japan’s so-called core CPI (excluding fresh foods) could dip back slightly into negative territory in March. Consequently, in light of the recent shakiness of private consumption demand, which raises understandable concerns about the sustainability of the Japanese recovery, there is good reason to question the wisdom of what could have well turned out to be a premature move on the road to policy normalization. It may well be that a glacial pace of monetary policy normalization is the correct choice for a still very fragile post-deflationary Japanese economy. The problem is that BOJ Governor Toshihiko Fukui had been direct and adamant for quite some time in offering his own take on policy wisdom -- in effect, leaving the distinct impression that a rate hike was all but inevitable in January. At the same time, the ruling LDP leadership has been equally explicit in warning against a premature hike -- fearing the risk of a deflationary relapse. In our judgment, and in the eyes of most market participants, the politically-independent central bank should prevail in any such dispute. Obviously, we were wrong in assessing the outcome of this power struggle (see Takehiro Sato’s 18 January dispatch, “Our Apologies for Erring”). The weakening of the yen and the Japanese government bond market in the immediate aftermath of the BOJ decision tells us we were hardly alone in our mis-impression. Sadly, Governor Fukui’s flinch says it all -- BOJ independence can now be drawn into serious question. Ironically, while the BOJ may have made the correct decision from a policy-targeting perspective, it made a communications blunder of epic proportions. By setting up the markets for a tightening that never happened, there could well be lasting damage to perceptions of the credibility and independence of the Japanese central bank. This sad incident runs very much against the grain of the current approach to central banking -- a transparent and increasingly rules-based policy path that doesn’t disappoint the markets. Perfected by the Greenspan Fed and emulated with increasing success by the ECB, such policy discipline is now viewed as one of the most essential ingredients of stable and well-contained inflationary expectations -- the ultimate goal of the modern-day monetary authority. The January 11 policy surprise action by the Bank of England -- an unexpected 25 bp rate hike aimed explicitly at managing inflationary risks -- is but the latest example of rules-based policy discipline (see David Miles and Melanie Baker’s January 11 dispatch, “MPC: Surprise Rate Rise”). Relative to the Fed, the ECB, and the Bank of England, the BOJ now looks weak and politically compromised. Sure, the BOJ can attempt to rectify this image problem by moving in February after the next round of GDP data have been released. But in my view, the damage has been done. Financial market participants have long memories. Expressions of BOJ policy intent will long suffer from the credibility fiasco of January 18. Trust in Japan’s central bank has been all but shattered. The consequences go well beyond the BOJ’s image problem. With Japanese short-term interest rates remaining near rock-bottom lows and now expected to do so for longer than previously thought, there’s little to stop a continuation of the so-called yen carry trade -- borrowing cheaply in Japan and reinvesting in higher-yielding assets nearly anywhere else in the world. With the steepness of the Japanese yield curve likely to remain an important source of excess global liquidity, this can only perpetuate the increasingly worrisome bubbles in risky assets, such as corporate credit and emerging-market debt. Moreover, once again, the yen is headed the “wrong way” for a Japanese economy in recovery. This paints the yen into the corner as perhaps the most mis-priced major currency in the world today -- underscoring the potential for wrenching adjustments in foreign exchange markets as well as the possibility of an escalation of external political pressure on Japanese currency policy. In the end, there may well be an even deeper meaning to all of this. This incident has as much to say about the heavy-handed role of the Japanese government as it does about the BOJ. The central bank’s capitulation underscores the long-standing dominance of a one-party political system in shaping the character of the Japanese economy. Under the Koizumi government, that character seemed increasingly enlightened. There was a renewed sense of hope that the reformers were both willing and able to undertake the heavy lifting that a new and modernized economy required. Under the new Abe government, that perception can now be drawn into question -- not just by the political pressure brought to bear on the BOJ but also by increasingly disappointing progress on financial sector reforms (see Robert Feldman’s 12 January dispatch, “Japan -- Financial Regulation at a Crossroads”). A Japan that lapses back into its old ways is an unmistakable triumph for the Old Guard. That could also prove to be a huge disappointment for Asia and for the broader global economy. I am far from a BOJ watcher. My colleague Takehiro Sato is the best in the business, in my view. My reactions above are those of an outsider looking in -- attempting to put the incident of January 18 into the context of the broader monetary policy debate that plays such an important role in shaping the global economy and world financial markets. Our Japan team does not share some of the conclusions above. Robert Feldman, in particular, rejects the notion that this is a painful relapse into the days of “Old Guard dominance” -- although he concedes that there has been a damaging blow to BOJ credibility (see his dispatch in today’s Forum). For me, the jury is out on the implications of this stunning development. Time will tell if the BOJ and the LDP leadership will be able to repair the damage.
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KRW: No Instant Satisfaction from Liberalization of Outflows
January 19, 2007
By Stephen Jen | New York
Summary and conclusions Korea’s MoFE (Ministry of Finance and Economy) announced on Monday (January 15, 2007) that, in an attempt to counter the mounting positive balance of payments (BoP) pressures on the Korean won, capital outflows will be further liberalized. While we believe that this set of measures is very prudent, we are skeptical of the MoFE’s view that it will lead to the instant alleviation of pressures on the KRW. We maintain our bearish call on USD/KRW for 2007, but applaud the Korean authorities for choosing to further liberalize the capital account rather than opting to restrict capital inflows. Over the longer run, a more ‘symmetric’ capital account (on inflows and outflows) will offer Korean entities better opportunities to manage their rapidly growing financial portfolios. A big-picture view on Korea’s foreign investment position We believe it is useful to first familiarize ourselves with the foreign investment position and capital flows in and out of Korea. Korea has by far the lowest gross foreign asset holdings compare to the China, Japan, Taiwan and US. Despite the large C/A surpluses that Korea has run since the Asian Crisis of 1997-98, Korea’s foreign asset holdings are only 46% of GDP, compared with 185% in Taiwan and 100% in Japan. Of this amount, the share of the foreign assets held by the private sector is as low as that of China, which we know is extraordinarily low mainly because most of the accumulation of foreign assets since 1978 has been carried out by the public sector, in the form of accumulation of official foreign reserves. But given that Korea is an OECD country, its low private sector holdings, at only 19% of GDP, are remarkable. One could say that Korea’s private sector has exhibited extreme ‘home bias’ in its collective investment portfolio. In our opinion, this may very well be less a result of voluntary choice by the private sector than an outcome of strict capital controls. The net international investment positions (NIIP) for the US is -20.4% (this figure should be familiar to most readers, since this figure has been widely mentioned/tracked in the three-year debate on the sustainability of the US C/A deficit. But Korea looks even worse than the US on this measure. The NIIP of Korea’s private sector is close to -50% of GDP! In other words, foreign investors’ holdings of Korean private sector assets are greater than Korean private sector holdings of foreign assets by a margin of close to 50% of Korea’s GDP. It would be misleading to conclude that ‘Korea is indebted’, despite these metrics. In any case, the key issue here is that Korea’s private sector simply holds too few foreign assets. For the US and Japan, their net financial flows in 2005 went in the opposite direction to their C/A balances. But, in the cases of Korea, China and Taiwan, the net financial inflows added to their C/A surpluses. No wonder the BoK, PBoC and CBC had to intervene that year, and allow their currencies to appreciate in 2005 and 2006. Our thoughts We have the following thoughts. • Thought 1. Two lessons from the Asian Crisis in 1997 have ironically become major policy problems 10 years later. A decade ago, we believe that most Asian countries took two lessons from the Asian Financial Crisis: (i) they learned that they should never put themselves in a position where they would be caught low on official reserves; and (ii) premature liberalization of capital outflows could leave the economy vulnerable to capital flight. Their policy reactions were, after the Crisis, to accumulate massive reserves as a form of insurance for themselves and as a signaling device for would-be foreign investors. Further, the popular view on capital account liberalization became that liberalization would be fine on the inflow side but not implemented too early on the outflow side. In a way, these two quite understandable policy reactions have gone too far, as the Asian central banks’ reserves are too large and they are witnessing their currencies being pressured into over-valued territory partly because their capital accounts are asymmetric. These two lessons from a decade ago should be abandoned, in our opinion. • Thought 2. Korea will likely experience sustained private capital outflows over the long run, just like China. As we mentioned above, while Korea may look like a highly indebted country in terms of its foreign investment position, in fact it is not, at least not for the same reasons that the US is indebted. The foreign asset holdings of Korea’s private sector are simply too low, similar to the situation in China. Both Korea and China have enjoyed ‘asymmetrical’ goods and financial globalization, as both economies have exported more than they have imported and received more foreign investments than they invested overseas, not counting the official reserve purchases. Correcting this asymmetry will lead to sustained capital outflows and a rise in imports in these two economies, which in turn should help rebalance their BoP positions and alleviate the appreciating pressures on their currencies. (Incidentally, we have argued in the past that the large reserve accumulations by China may be partly explained by the need for the public sector to ‘pre-fund’ the future private capital outflows, that if we consider the size of the private outflows that is more on par with the international norm, the PBoC would need to sell more than US$500 billion of US dollars just to offset this flow.) • Thought 3. It is questionable, however, whether these measures will offer an instant alleviation of pressures on the KRW. Opening the floodgates will not guarantee capital outflows, or at least outflows meaningful enough in size that the path of the KRW will be altered. We have in mind the experiences of both China and Japan. In the case of Japan, capital account liberalization was promulgated during 1998-2001 under circumstances similar to those in which Korea and China find themselves. These measures did not start to have a meaningful impact on USD/JPY until last year, when the first wave of baby boomers (those born during 1946-49) began to retire when they turned 60 last year. Retail capital outflows surged as a result of the combination of (i) a more liberal regulatory environment that had been in place for the prior eight years, (ii) changed risk-taking attitude partly because of the buoyant Nikkei, (iii) the super-low interest rate in Japan, and (iv) a structurally different view in Japan on foreign asset holdings. In sum, capital outflows from Japan did not surge until the overall conditions turned ripe; the regulatory constraint was only one of several factors that were important. Similarly, China has also been trying to encourage private entities’ investment in foreign assets. But with the general expectation that the CNY will continue to appreciate and that investment opportunities in China will remain attractive, there has been no meaningful increase in capital outflows yet. We believe that Korea will also experience a lagged effect, whereby new capital outflows will only increase gradually. For 2007, the KRW is likely to experience considerable upward pressure, in our opinion. • Thought 4. In any case, Korea’s decision to liberalize capital outflows is prudent. It is important to highlight how different Korea’s measures are compared with those imposed by Thailand in late December 2006. While the former further liberalized capital outflows, the latter went in the opposite direction by restricting capital inflows. The key here is to achieve a balanced capital account, in terms of restrictions. In this regard, sequencing of liberalization measures is important, since liberalization is very much a ‘one-way’ proposition: forward progress, however slow, is usually rewarded by investors. While we have long echoed the view of our Chief Economist Stephen Roach that protectionism (both of foreign capital and labour) is a major risk in 2007, we see this less as a ‘pandemic’ and more as a trend more likely to be adopted by some countries which have always had a higher propensity to turn inward and protectionist (Russia, Venezuela and Thailand). A key difference now, we believe, is that investors will not likely avoid AXJ assets altogether, but rather divert their investments toward those markets which are open, i.e., segmentation of markets is more likely than a wholesale withdrawal from Asia. Bottom line Our outlook for USD/KRW remains broadly unchanged. Though the latest announcement from Korea’s MoFE will likely have some muted but positive influence on USD/KRW, USD/KRW’s future trajectory is still likely to be down this year, but we need to be watchful of any surge in capital outflows, such as those which we have witnessed in Japan since last year. For now, the KRW will be treated as innocent until proven guilty.
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Ruled by the Shekel
January 19, 2007
By Serhan Cevik | London
The shekel’s excessive influence on price indices may result in sub-optimal policies. During the painful period of hyperinflation in the 1980s, Israel had become a highly dollarised country, as residents struggled to protect their purchasing power and to find a point of reference for economic transactions. However, as stabilisation efforts started bearing fruit over the course of the subsequent decade and brought down inflation from the peak of 425% to single digits, Israel also enjoyed a sustained phase of financial de-dollarisation (see Akiva Offenbacher, “Dollarisation and Indexation in Israel’s Inflation and Disinflation”, Comparative Economic Studies, September 2003). Today, people talk about the ‘mountain of shekels’ instead of the challenges of a system distorted by currency substitution and backward-looking indexation. Unfortunately, although dollarisation may no longer be a concern for the Israeli economy, price indices are still influenced by its legacy. With the widespread use of dollar-denominated and indexed prices in sectors like housing, the pass-through from currency movements to inflation is almost instantaneous and consequently weakens the effectiveness of monetary policy. More than half of the pass-through effect is a result of currency indexation in the housing sector. Imported goods and services make up more or less 40% of the consumer price index, but the overwhelming determinant of the pass-through effect is the behaviour of housing and professional services that rely heavily on dollar-denominated and indexed prices in contracts and transactions. For example, almost 90% of rental agreements are indexed to the dollar, resulting in an immediate pass-through from currency fluctuations to headline inflation. As a result, albeit declining in recent years, the currency pass-through effect on domestic prices accounts for approximately 30% of the change in the consumer price index with a three-month lag (see Yoav Soffer, Exchange Rate Pass-Through to the Consumer Price Index: A Microeconomic Approach, Bank of Israel, October 2006). This is of course an unusually high coefficient for a low-inflation country and also increases inflation volatility beyond the comfort zone for an inflation-targeting regime. The sudden drop in inflation is mainly a consequence of the shekel’s appreciation. The CPI posted a month-on-month drop of 0.9% in September — the largest monthly decline in more than two decades — and a cumulative increase of just 0.8% in the first nine months of the year. As a result, the annual inflation rate suddenly eased to 1.3%, from 2.2% in August and the recent peak of 3.8% in April. The fall in energy quotes certainly contributed to lower consumer prices, but the ‘big’ drop in the CPI was mainly an outcome of the shekel’s appreciation that lowered dollar-denominated and indexed prices across the economy. For example, the housing component (which accounts for approximately 20% of the CPI basket) declined by 0.8% in September, pushing the headline inflation rate to a lower plateau. Given the shekel’s strength and the correction in oil prices, inflation is likely to remain subdued in the coming months and below the 1% mark by the end of the year. Nevertheless, the increase in the CPI excluding energy prices and exchange rate effects is still close to the upper bound of the central bank’s target range. Even after a marked tightening in bond yields, the shape of the yield curve is still very attractive. The sharp drop in inflation rates led the Bank of Israel to cut interest rates by 25bp to 5.25% at the end of last month. With a benign inflation outlook and reasonably supportive global financial conditions, the authorities even signalled the possibility of further monetary easing, to at least 5% by the end of the year. That may well be justified in light of the latest inflation data, but we think that an episode of disinflation via currency appreciation could easily veil underlying inflation pressures in the domestic economy and worsen volatility in the future. After all, the current monetary policy stance could hardly be classified as restrictive, and is not a burden on the real economy. That said, we see no reason to revise our bullish assessment for Israel’s fixed income market. If anything, even after a marked tightening in 10-year bond yields, the shape of the yield curve is still very attractive.
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