Caution for Yen Depreciation: Structural Problems to be Solved First
Toyoo GYOHTEN (President, Institute for International Monetary Affairs)
Japan's "Plus Alpha" Problems
As is widely discussed these days, there seems to be some concern about the future of the Japanese economy. This concern, whether it is valid or not, may be affecting the market in general and the foreign exchange market in particular, yielding downward pressure on the yen.
According to the traditional theory of foreign exchange, the Japanese yen should have moved higher, as Japan is still enjoying a current account surplus which is about 2% of its GDP, highest among advanced nations, and also has the lowest inflation rate among them. In reality, however, the yen has been moving downward, due to the strong impact that the flow of capital has on the foreign exchange market. The yen is largely affected by the fact or the perception that there is no incentive to invest in the yen or no profitable opportunity to invest in Japan. As a result, the yen is sliding further.
Some people, particularly U.S. observers, are worried that when the gap between Japan and the U.S. widens due to a strong recovery of the U.S. economy and Japan's continued stagnation, the yen might fall drastically, and that could become a disruptive factor in the international monetary market, although I myself do not believe that would likely happen. I do believe, however, that yen depreciation is reflecting Japan's structural problems or what I call "plus alpha" problems such as the weak financial system, non-performing loans, delayed structural reform, political chaos, etc. that Japan has not been able to deal with since the bursting of the bubble in the 1990s. In trying to tackle these problems, I think Prime Minister Koizumi is on the right track with some positive results already obtained, but time is surely running out and the market will not wait too long.
Public Fund Injection Into Banking System
While the Japanese government is currently working on its anti-deflation policy, including a further easing of monetary policy on the part of the Bank of Japan, I do not think such a policy would be too effective. Short-term anti-deflation policies such as purchasing foreign government bonds by the Bank of Japan or increasing public investment by the government would surely aggravate the "plus alpha" problems, leading to a lower value of the yen and a fall in the government bond market.
The structural problems should be solved first. The next round of inspection on banks by the Financial Services Agency should be strictly administered with credible and convincing results to be obtained. Based on such results, the government should decide which banks should be targeted for public fund injection. I think we should prepare for compulsory injection of public funds by changing laws, if necessary, as the world is closely watching Japan's "plus alpha" problems.
Some people argue that yen depreciation would help improve the profitability of export industries, recover the general economic condition, and slow down the speed of hollowing out of manufacturing industries, but they are not too persuasive because the reality is not moving in that direction after all. Due to weakening demand, domestic prices continue to decrease and importing industries are losing because they cannot increase their prices despite yen depreciation. In fact, Japanese business executives are not really demanding yen depreciation but rather stability and predictability for the future. Regarding the hollowing-out phenomenon, Japan's overseas production ratio is still 20 percent or so, which is about half of the U.S. ratio. Because it is desirable for Japan to see Asian economies develop further in the long run, yen depreciation for the sake of protecting Japanese industry would not be beneficial but rather harmful for Japan itself.
In my view, a permissible range for the yen may be between 110 and 130 yen per dollar. It is important to provide a sense of confidence that the yen will stabilize within that range. Further depreciation, for example down to 140 or 150 yen, would yield more minuses than pluses.