International Herald Tribune
The spineless Bank of Japan
Sunday, February 4, 2007

HONG KONG: The tendency of the rest of the world to ignore Japan may be understandable, given the country's inward-looking attitudes and appearance of stagnation. But Japan has become, if only by sins of omission, a malign influence on the global economy. Finance ministers of the Group of 7 industrial countries meeting in Germany this week would do well to focus on those sins, the least-recognized cause of the bubbles and imbalances in the global economy and financial markets.

The prognosis is not encouraging. The Europeans are increasingly concerned about the weakness of the yen, which is causing the euro to bear the brunt of the dollar's decline. But the United States remains fixated on the value of the Chinese yuan, not the Japanese yen, and the size of China's current account surplus, not that of Japan. The U.S. Treasury secretary, Henry Paulson, seems in a state of denial, suggesting that the yen's weakness is market-driven while China is deliberately keeping its currency undervalued.

Most central bankers, both in Asia and the West, are also guilty of lax monetary policies and are under political pressure to keep interest rates low. So there is limited appetite for finger-pointing at Japan. And with no Asian nations other than Japan represented at the G-7 meeting, pressure on Tokyo looks likely to be modest.

But let there be no doubt about the pernicious effects of Japan's interest rates being held near zero, despite steady economic growth and the end of deflation. The policy is sustained by pressure on a spineless Bank of Japan by Shinzo Abe's myopic government.

The three major consequences of Japan's low interest rate, ultra-cheap yen policy are:

The so-called carry- trade, by which yen are borrowed for investment in higher yielding currencies and assets ranging from New Zealand bonds to corn futures. The size of the carry-trade is in dispute, as leverage is provided through derivatives, but naked exposure could be as much as $1 trillion.

The carry-trade is a major contributor to the very low global cost of money and the collapse of the price of risk, which together have enabled global asset markets to rise almost in unison. This rise, most dramatically reflected in China and India, is potentially destabilizing. As for the carry-trade itself, a sudden reversal could be catastrophic. It is a gigantic gambling game, reflected in the dramatic increase in the balance sheets of investment banks and the explosion in assets of private equity and hedge funds. The phenomenon is also perpetuating global trade imbalances by allowing deeply indebted countries — including the United States and Australia — to continue to over-borrow.

The continued undervaluation of other east Asian currencies. Some of these are also used for carry- trade activities as interest rates are held down to prevent currencies rising against the yen. Countries that have allowed their interest rates and exchange rates to reflect economic conditions, such as South Korea and Thailand, have found their currencies rise rapidly, to the discomfort of exporters, pressuring them to impose capital controls. The necessary re-alignment of all East Asian currencies cannot take place while the yen is held back by the Bank of Japan's interest rate policy. To expect China to agree to faster revaluation while Japan does nothing defies common sense — and exacerbates China's sense of grievance. The United States is unwise to focus on China, meanwhile Japan can never claim leadership in Asian financial affairs while it sustains a policy dictated by the narrow political interests of the Abe government.

Tokyo's ultra-low interest rate policy was necessary when Japan was still clearing up its financial sector after the decade-long property price collapse. But that is over and property prices are on the rise again. A weak yen inflates exporters' profits and low interest rates help the government's budget. But it is doing nothing for what Japan most needs — a pick-up in consumption. Indeed, negligible interest rates hold down household incomes and encourage savings. Meanwhile companies are hoarding cash — which is then borrowed by foreign hedge funds and investment banks playing the carry-trade.

Japan seems to be relying on America's pre-occupation with Chinese currency and trade issues to shield its economy. But for Tokyo's own sake — as well as that of global stability — Japan should not be allowed to get away with this. The rest of the world, especially East Asia, must speak up.