Despite the current signs of relief in Japanese and other Asian financial markets, deflationary forces in the region are set to grow. That will force the US and Japan to signal the end of the Asian crisis with a new global policy framework and massive fiscal stimulus in Japan. Investors should prepare for a policy reversal.
It will most likely happen only after further economic pain in Asia, renewed equity market weakness around the world and a steady build-up of deflationary waves hitting OECD economies. At first, that could well send the yen back down to ¥135 to the dollar. But after the switch in global policy, I expect the dollar would fall to around ¥110 by the end of 1998.
There are still some big shoes to drop in the emerging-markets crisis: a renminbi devaluation by China and disorderly succession in Indonesia. But a new Plaza-type accord has the potential to provide a full stop, at least until the Chinese renminbi and the Hong Kong dollar fall.
How would it work? First, the US Fed and the Japanese monetary authorities, with the participation of the European central banks, would intervene massively in support of the yen by selling the US dollar. This would tighten Japanese monetary conditions and loosen those in the US. In effect, the US would be printing money into global markets – and the markets would like that.
The dollar’s decline would be less than the 33% recorded between 1985 and 1987 after Plaza 1. This Plaza 2 would probably target a 15% to 20% dollar depreciation. As at the time of the first Plaza accord, the US might try and keep real interest rates relatively high, but its ability to do so would be severely curtailed by the risk of sterilizing the forex intervention that aimed to increase the global supply of dollars.
The significance for Japan and Asia would be twofold. In a deep psychological sense, a currency is the equity of a country. A stronger yen would work wonders for Japan. And a weaker dollar would be great news for Asia’s problem states. They could re-peg their currencies to a falling dollar, so winning a little credibility. That’s a lot easier than trying to stabilize exchange rates against a super-dollar.
The other part of this new framework would be for Japan to introduce a significant fiscal package, through tax reductions to households, entailing a real stimulus to the economy worth at least 2% to 3% GDP. This would offset the contractionary effects of the tighter monetary policy entailed by Bank of Japan purchases of yen against the dollar. By corollary, the US ought to tighten fiscal policy as well, but given its political system we can certainly forget that.
The Japanese fiscal package would probably work if it were significant and sustained. The very least it would achieve would be to take Japan out of the Asian crisis. That would ring-fence Asia’s problems as a regional instead of a global crisis, at least for a while. And it would lessen the danger of Japan becoming the port for Asian deflation to enter western economies and markets.
That’s a threat that would otherwise be realized through cut-throat competition from Korea and other Asian economies, forcing down the price of Japanese exports. Then the collapsing profitability of Japanese exporters would bring the Nikkei to 13,000 and the banks would go bust (again).
A new Plaza-type policy would not assuage the pain of economic adjustment for Asia’s problem states. But it could end the atmosphere of crisis and make it easier to restore confidence in their currencies. No rational adjustment programme can be implemented while regional currencies are crashing.
Most important of all, a stronger yen and renewed domestic demand growth in Japan would boost demand for the 25% of exports from east Asia (excluding China) that go there. And it might encourage Japanese corporations to look at reinvesting in Asian problem states, which are now super-cheap production platforms for exports to the OECD countries.
Sooner or later, a Plaza plan will have to happen. It will be sooner if the US puts global stability ahead of domestic economic needs for a prudent monetary policy. It will be later if we have to wait for a US stock-market crash or surging imports from Asia and other emerging markets to cut the head off the US economic cycle.
Two things seem pretty sure. First, the US has the scope to cut interest rates, as it is the only G7 country to have tighter monetary conditions than the historical average. Second, the tidal wave of imports and the crash in exports that will hit US trade with emerging markets will knock 1% off US GDP growth in 1998. This will not be fully offset by the current above-average growth in domestic demand. So US real GDP growth will slow to under 2% a year by the second half of the year.
That brings us to Japan. Last month’s economic stimulation package was a damp squib, concentrating on longer-term measures to deregulate financial markets. So everybody is still waiting for the next fiscal move, presumably some time this month. It will need to be a big one. Fiscal policy is set to tighten a further 0.4% of GDP in fiscal year 1998. Even if the government extends the income-tax cut planned for fiscal year 1997 into the following year, that would create only a neutral budget.
The programme passed by the Japanese parliament last month to inject trillions of yen into the banking system, or provide deposit guarantees, will be useful. It will help prevent a deflationary collapse in the Japanese banking system, but not in isolation. What is needed is a pro-growth fiscal policy in Japan, not just a programme to replace depositors’ money lost by the banks.
That alone is unlikely to encourage households to spend, or banks to lend, much more than before.
David Roche is president of Independent Strategy, a London based research firm.
