Look to Japan for a currency realignment
FRIDAY, JUNE 23, 2006
A little perspective, and the anecdotal evidence that confronts the periodic visitor, suggest an undervaluation of Japan relative to a world bloated by monetary excess. A currency shift reflecting this reality would, contrary to received wisdom here, be highly beneficial to Japan. In fact it is Japan, not China, that is key to the overdue realignment of East Asian currencies.
Ten years ago, the yen was at 108 to the dollar, having descended from a high of 84 the previous year. The peak caused agony for Japan and its exporters, but it was felt at the time that a rate of around 105 was acceptable. Now the rate is around 114. Meanwhile the cumulative price gap between a slowly inflating United States and years of deflation or zero price gains in Japan has opened a gap of close to 30 percent in relative prices. In theory at least, Japan should be able to live with an exchange rate of 75 to 80 yen to the dollar, just as the euro zone has been able to live with a shift from 85 to 125 euro cents to the dollar.
Things are not that simple, of course. Japan has its new competitors in South Korea and, to a lesser degree, China. The composition of trade has changed as imports of consumer goods have risen. But through all the years of deflation and write-offs of loans based on the absurd real estate prices of the late 1980s, Japan has maintained a large current account surplus. It is now $165 billion or 3.6 percent of gross domestic product.
It is not that Japan is cheap. Density and inefficient wholesaling and distribution systems see to that. But the price of housing now is unexceptional and the profitability of Japan's exporters is testimony to the competitiveness of industry and its gains in relative production costs.
So why is the yen so weak, even though the Bank of Japan has stopped intervening? The answer seems to lie not so much in the hands of foreign currency traders, or even in manufacturers shifting to China, but in the mind-set of Japan's institutional investors. Secure, they think, in years of relative stability in the yen-dollar rate, they have focused on yield - the 3 percent or more annual yield of U.S., British or Australian bonds relative to yen ones. Meanwhile, the other Asian central banks with excess reserves have been staying clear of the yen to avoid yen appreciation spreading to their own currencies.
Chasing yield might seem a mug's game for long- term investors. But it is the reality - for now. How long, however, before those institutions awake to the dangers of capital loss from a dollar decline like that against the euro in 2002 and 2003? How long before companies flush with cash from export profits, from a reviving domestic economy or from the end of years of bad debt write-offs start to pay dividends at a level that provides a reasonable return to institutions while eliminating exchange risk?
Dividend yields now average 1.2 percent and could hit 2.0 percent by the end of 2007. How long before Japan's army of small savers note that deflation has ended and shift a small portion of their assets from bank deposits into stocks or real estate? How long before it is widely recognized that Japan's public finances have turned the corner toward sustainability? The ratio of total public debt to GDP has stabilized at 200 percent as the borrowing requirement has fallen sharply. The danger of this debt can, in any case, be exaggerated: Only 40 percent is owed to the private sector and a mere 4 percent to foreigners.
All this makes a continued return to more normal interest rates very likely. That will lead to a more normal currency valuation based more on its fundamental external position rather than on countering deflation.
Higher interest rates and a big shift in the currency will also have two beneficial effects. First, they will force Japanese companies to focus attention on the very low returns to capital that have been endemic here. Second, they will bring pressure on the unreformed domestic sectors where outdated rules and oligopolies flourish.
Many of Prime Minister Junichiro Koizumi's reforms were accomplished because of the financial sector crisis. A sharp currency appreciation would make it easier for his successor to continue reforms by recognizing that future growth needs to come from domestic demand more than exports. That can only happen if service industries aspire to the efficiency levels of companies like Toyota and Canon.