Economic bailout without structural changes will be ineffective because the economy's balance sheet remains impaired by numerous non-viable corporates and rising bad debts. All this creates a disincentive to spend, invest and lend. And do not be fooled by Japan's low unemployment rate, which gives an illusion that the bailout packages so far have worked.
It in fact reflects reform inertia, as resistance to change has combined with expansionary demand management policy to keep unemployment artificially low. Japan's average 3.3% unemployment rate in the past decade would be consistent with a booming economy, but yet its GDP growth averaged only 1.6% a year!
What follows from this ineffective bailout seems clear. The yen's decline will likely continue, as Japan's huge public debt overhang and zero interest rates have boxed the Japanese authorities in a policy corner with few options other than to let the yen fall to, hopefully, prevent an economic collapse. The recent plunge in reformist Prime Minister Kuozumi's popularity only deepens the market's pessimism about the future of the yen, as hopes for Japan's economic restructuring have faded.
Nevertheless, contrary to the market jitters that a falling yen would cause another round of competitive devaluation and drag Asia into a deeper economic recession, the fear is exaggerated. Ironically, the yen-threat could even be a blessing in disguise, provided that Japan doesn't collapse, because the weak yen's deflationary implications argue against the market consensus of global interest rate hikes later this year. This should ease concerns about pre-matured monetary tightening disrupting the global economic recovery. A weakening yen also serves as a wake up call for those investors who are overly optimistic about China's post-WTO outlook.
The yen threat
All this begins with the subtle relationship between a weak yen and China's exchange rate policy. A weakening Japanese yen creates worries about a renminbi (RMB) devaluation by China because of the perception that a falling yen could trigger competitive currency devaluation and push Asia into recession, dragging China with it. This would prompt the Chinese to devalue in response to the region's "beggar thy neighbour" policy, where one country's devaluation triggers a similar policy elsewhere.
Since there is a close and positive correlation between the yen/US dollar exchange rate and most Asian export prices in US dollar terms, a weakening yen is renewing threats of export price wars and competitive devaluation in Asia. Meanwhile, a collapse in Japan's economy would send a significant deflationary shock to the global system by throwing the foreign exchange and financial markets into chaos. This will, in turn, disrupt international trade and threaten global growth.
Yet, given a huge current account surplus, the Japanese will continue to repatriate their overseas funds back home during economic difficulties. This should prevent a sudden collapse in the yen exchange rate. More importantly, Japan's influence on Asia has diminished significantly since the bursting of its asset bubble in the early 1990s. For instance, Asia now sells only about 10% of its total exports to Japan, compared to almost 18% in the mid-1990s. Meanwhile, the region's exports to China have risen five-fold from 2% in the mid-1990s.
The declining Japanese influence is clearly seen in the economic growth divergence between East Asia, which averaged over 6% a year in the decade before the Asian crisis, and Japan, which averaged only 1.6%. As China has absorbed an increasing amount of imports from the rest of Asia, the region's export dependency on Japan has fallen. This trend will continue, as Chinese imports will continue to rise under WTO. Thus, the fears about the yen crashing Asia were exaggerated.
Cold comfort
But all this is still cold comfort for China and the rest of Asia because the sinking yen is intensifying the decline in tradable goods prices, weakening global pricing power and squeezing manufacturers' margins. Continued decline in the yen could also blunt Asian authorities monetary stimulus to boost economic growth, as the yen-induced deflationary shock destroys wealth, confidence and hence demand growth in the region. The pain of a falling yen is especially acute for the Chinese exporters, as they are operating under a de facto RMB peg.
South Korea has echoed China's concern about excessive yen weakness, and senior officials from both countries have warned about the risk of another regional currency crisis if the yen failed to stabilise. Such a risk is real, as competitive currency devaluation is a negative sum game amid shrinking foreign trade. Senior Chinese officials have pledged no devaluation so far, and such a pledge is still credible because economic and political forces remain supportive.
First, significant foreign capital inflows to China this year will likely overwhelm a potential current account deficit after WTO entry. Thus, China's balance of payments will remain positive to underpin the RMB. Second, given the still closed nature of the economy, Chinese authorities always have the option to boost economic growth via domestic demand management rather than using currency devaluation. Indeed, China's exchange rate is a policy choice. Senior leaders have reiterated that they would avoid any risk of instability, including currency devaluation, in the run up to the leadership change that will start later this year.
If the Chinese keep their no-devaluation pledge as further decline in the yen drags down other Asian currencies, something will have to give to keep Chinese exports competitive. And that will likely be Chinese profits because the falling yen will push down tradable goods prices across Asia, forcing the Chinese exporters to slash prices to remain competitive, and thus squeezing Chinese profit margins. This will only reinforce China as a source of deflation in Asia.
Unconventional bottom lines
Hence, a weak yen-induced competitive stress hurts China and intensifies the global deflationary squeeze. Together with an over-stretched consumer balance sheet in the US, which will constrain the pace of demand recovery, this argues against the consensus that the US would have to raise interest rates later this year, as there is not going to be any significant inflationary pressures. Indeed, for the first time since the US Great Depression, the world is facing the problem of too little inflation but not too much.
Meanwhile, since most of the Asian currencies are now floating against the US dollar, currency depreciation will help soften the blow from a yen-induced competitive stress on many Asian economies. But China will suffer more in terms of deflation and profit squeeze, due to her currency peg. When the RMB cannot adjust, domestic prices will have to fall more to compensate for the loss of competitiveness due to currency depreciation elsewhere. Corporate profits will thus suffer more under the weak global demand conditions. This same argument also applies to Hong Kong, Malaysia and to a large extent Taiwan, who also have currency pegs.
The yen-threat should also highlight China's post-WTO risk stemming from the economic pains from creative destruction and serve to wake up those investors who have overly optimistic expectations in China's post-WTO outlook. Together with the profit squeeze, these short-term economic pains will likely prompt the People's Bank of China to loosen its monetary rein further in the coming months. However, monetary easing could only do so much under China's structural constraints, and Beijing should not use it to eschew tough economic restructuring.
Chi Lo is an economist based in Hong Kong.
