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June 14, 2004

Geopolitical Risks in the Global Economy

Takatoshi ITO (Professor, University of Tokyo)

While the world economy is on a stable growth track, the largest risk factor is geopolitical instability observed most vividly in affairs in the Middle East. Japan should continue the current quantitative easing policy until the breakaway from deflation becomes unquestionable and the rate of inflation surpasses 1%.

G7 countries' growth exceeds previous year

The Financial Ministers Meeting of the G7 countries held on May 20, just before the Summit meeting on Sea Island, confirmed the stable growth of the world economy while warning against rising oil prices and appealing to the oil producing countries to increase production. World Economic Outlook, published by the IMF in April, forecasts all of the G7 countries to experience larger growth this year than last year.

Notably in the Outlook, Japan's economy is predicted to mark a hefty growth next to the US and the UK. Indeed, Japan's growth for the first quarter this year was 5.6% p.a., a figure that apparently backs up the forecast. The largest risks now seem to lie in the geopolitical field. There are a number of possible causes for the oil price hike in the Middle East. If the Iraqi situation deteriorates further, or if another terrorist attack occurs in the US, grave consequences for the global economy could develop.

The US economy last year registered growth but employment did not follow suit, so this growth was dubbed a "jobless recovery". But the number of persons employed has increased significantly since the beginning of this year. The reason for the seemingly slow rebound of the unemployment figure is due to the fact that those who were previously not motivated to work began to seek jobs after observing more jobs being offered, which increased supply in the labor market.

Policymakers in the US were concerned with the risk of deflation only a year ago. But now, because of the growing economy, a rise of interest rates is viewed as inevitable. Inflation this year is expected to reach 3%, and the increase of oil prices could further raise this prediction. The FRB (Federal Reserve Board), upon lowering the Fed Fund Rate to 1% in June last year, expressed its intention to maintain the low level for an extended period of time, seeking a "policy duration effect". This January, even when the fear of deflation had subsided, the FRB announced that "it can be patient" in sustaining the low interest rates.

Trauma of Mexican Currency Crisis of 1994

The policy statement released after the FOMC meeting of May 14, said that its "policy accommodation can be removed at a pace that is likely to be measured". The change from the expression publicized in January may be subtle, but important. While the January statement effectively said that the timing of raising the interest rate would be later than usual; and the May statement is interpreted as suggesting that the pace of increasing interest rates - not denying that it may occur - would be slower than normal. The market currently assumes the Fed Fund rate would rise 0.25% by the end of June, and a total increase of 1.25% would be realized by the end of December.

The increase of US interest rates, if it exceeds the pace of market expectations, could become a serious blow to the world economy. It could jolt the bond market accustomed to ultra-low rates of return. When a substantial interest rate hike last occurred in 1994, it contributed to triggering the Mexican currency crisis. If the rate increase this time in the US provokes capital withdrawal from developing countries or other risk investments, large debtor countries and hedge funds could suffer severe liquidity problems.

A topic intensely discussed in the US Congress and US think tanks since last year is the current account deficit of the US, and the necessity of foreign exchange rate adjustment to reduce the deficit.

As a corollary to such arguments, US industries have often claimed that China, Japan, and other Asian countries are intervening heavily in the foreign exchange market to keep the exchange rate of the dollar from falling. A problem with these accusations is that they bundle China, Japan, and other Asian countries into the same category. In Japan, although the volume of intervention has been large, the value of the yen has advanced 20% at one point this year compared to end-2002 under the flexible rate system. This differs significantly from the case of China, where the fixed rate system is enforced. Even arguments by professional economists often ignore such basic dissimilarities and claim "manipulation of exchange rates", such as in the case of C. Fred Bergsten's testimony before the Committee on Banking, Housing, and Urban Affairs of the Senate on May 19, 2004.

There is consensus among policymakers worldwide on the necessity of some form of foreign exchange rate adjustment in the face of a ballooning US current account deficit. But views of analysts and professionals are split as to which currencies and to what extent adjustments should be made.

Observing from Japan, it is too obvious that the most important policy measure the US needs to adopt to decrease its current account deficit is to reduce its budgetary deficit. In addition, as currently the strength of the US economy and the expectancy of the interest rate increase are attracting funds to recycle into the US, it is unlikely that the value of the dollar will plunge in the next few months.

Necessity to sustain policy of "quantitative monetary easing"

Japan's recovery is being lead by exports and capital expenditures. Particularly, exports to China are increasing significantly. Three factors can be identified with the increase of exports, despite the fact that the yen has appreciated almost 15% against the US dollar in the most recent 15 months. One factor is that the demand for Japanese goods have increased due to the income effect of high economic growth in the US and China. Second is that the competitive strength of Japanese companies grew during the past five years by curtailing costs to cope with the deflationary environment. The third factor is that the value of the yen, while appreciating against the dollar, has not gained so much in effective terms because those Asian currencies not pegged to the dollar have also appreciated more or less simultaneously against the dollar.

Looking more closely at the second factor--the strength of Japanese companies--the difference of inflation rates between Japan and the US during recent years has been about 2.5% per year. This means that the yen has effectively depreciated by 10% or so during the recent four years. Very simply put, the level of the yen desperately protected by the authorities in 2000 at 100 yen to the dollar can be interpreted as 90 yen to the dollar in present terms.

The tolerable level of the yen for Japan without hindering growth must be assessed with considerations not only against the US dollar but also against various Asian currencies. In particular, whether the Chinese renminbi would be freed from pegging to the dollar and become flexible will have a major effect on the outcome of the yen as well as other Asian currencies.

Major risk factors for Japan's exports are the slowdowns of the economies of China and the US, along with the appreciation of the yen. Slowdown of China and the US would also have damaging effects on all of Asia.

The best scenario for Japan

The best scenario for Japan is to sustain the economic recovery for now and shift the engine of growth from external demand to domestic demand, especially consumption, before China and the US lose steam. In order to accommodate such a scenario it will be necessary for the monetary policy to maintain the current zero interest rate and "quantitative monetary easing" until breakaway from deflation becomes clear.

It has been announced that as prerequisites to alter the current accommodative policy measures, the inflation rate based on the consumer price index should show positive figures successively for several months, and the majority of the board members of the Bank of Japan should forecast that the positive rate of inflation will be sustained.

However, because deflation has continued for so long it seems more prudent to wait for the inflation rate to remain over 1% for a certain length of time before amending the monetary policy. But there are those who fear that inflation could become uncontrollable once it starts. In order to accommodate such concerns, it should be effective for the Bank of Japan to express the target level of inflation, somewhere between 1 to 3 percent, so that expectations for inflation could be stimulated while the intention of the central bank could be conveyed to the whole economy.

(The original Japanese article appeared in the June 4, 2004 issue of Nihon Keizai Shimbun.)

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