Read Part 1 here
Some history
After WW2, the Bretton Woods Conference instated the fixed
currencies system, in which a currency's price is indexed
on the US dollar. The USD dollar is convertible in gold at the fixed price of 35 dollars per
ounce. In the 1960s the US were facing increasing demand for more bounce to the ounce but they didn't have enough bullions in their vaults.
On 15 August 1971, Nixon unilaterally terminated the
convertibility of the dollar to gold, putting an end to the Bretton
Woods system. The US dollar became a free-floating fiat
currency effectively used by Central Banks all around the world. IMF member countries were stuck with loads of US dollars loaned by the USA for reconstruction after the war, and they eventually signed the Smithsonian Agreement, making their currencies free-floating as well.
The free-floating system allows currencies' values to fluctuate according to demand/supply mechanisms. A free market system is good until it is not. And in the 1980s Japan's industrial and economic power was growing so fast that it was threatening the USA.
Japan became an export super-power thanks to cheap and hard-working labor, investment in R&D, backed up with a cheap currency. Between 1980 and 1985 the US trade deficit with Japan was ballooning and the dollar had appreciated by about 50% against
the Yen (as well as against the Mark, Franc and Pound) - possibly due to the Fed raising rates in the 1970s. The US
imposed negotiated an agreement with Japan, Germany, and the UK to appreciate the Yen. The Central Banks signed the Plaza Accord in 1985 in New York, and their coordinated intervention caused the value of the US dollar to fall by 50% versus the Yen in two years.
The consequences
The consequences for Japan were mixed.
On the one hand, the strong appreciation of the Yen hit badly Japan's export-dependent economy, causing an "endaka" (appreciating Yen) recession. The BOJ quickly responded with an expansionary monetary policy (monetary easing), cutting interest rates from 5% to 2.5%. But this failed to curb the appreciation of the Yen.
On the other hand, after a decade of incredible industrial growth and export madness, Japanese companies had loads of cash surplus to invest. The monetary easing policy boosted investments in Japanese assets, and the stock market and land prices surged. In 1986 the Nikkei jumped from 13,000 to over 20,000, and land prices in Tokyo more than doubled in three years.
The strong Yen made it cheap for Japanese companies and financial institutions to purchase foreign
assets. Borrowing money was also cheap and easy. Japanese companies bought loads of prestigious
properties in the US (the Rockefeller Center in New York), companies and other assets.
This nascent asset bubble put an end to the recession. But with excessive easing, inflation had become the new looming threat. So the BOJ tightened its monetary policy, introducing consumption tax in 1987 and raising interest rates to 6%.
The investment bubble kept growing as the Yen was still appreciating : the Nikkei reached 26,000 in 1987, and 38,900 in 1989. By 1990 commercial land prices had risen 300% compared to 1985. Price-to-earnings ratios of the Nikkei reached 70 times and 100-year mortgages
were created to allow investors to afford properties in Japan's big cities. It was a time when a deposit account yielded up to 9% and companies would pay first-class plane tickets to their employees.
Then the bubble burst in 1990 with the Japanese market crash : the Nikkei fell from 37,000 to 23,000 and land prices were down by over 35% by the end of the year. It is usually said that what caused the bubble also caused its burst : easy credit and bank lending that encouraged excessive spending, building, rising
equity prices, and even excessive export activity.
Since then, the "lost decade", and the not-so-good decade that followed, have been times of deflation and low economic growth. High savings rates and risk-adverse culture (investors prefer bonds over equities) have been accused of being the cause of low interest rates and deflation.
But the initial cause of all this mess was the Plaza Accord. What happens if you are playing cards with a few friends and winning, and that one of your friends decides to impose new rules to the game because they don't like to lose?
What is the BOJ doing now ?
The BOJ introduced its QE in April 2013 to
achieve the price stability target of 2% within two years. The BOJ intends to:
- Double the
monetary base : $730 billion are created annually.
- Double the amounts outstanding of JGBs and exchange-traded funds (ETFs) to bring down JGB interest rates : 50 trillion yen worth of JGBs are purchased annually, including long-term bonds (40-year).
- Bring the
average remaining maturity of JGB purchases up to seven years from three years now.
What to expect from this policy ?
In my opinion, nothing good.
Fighting deflation with money printing does not necessarily work.
Japan is in a recession, meaning that there is much spare capacity in
the economy. Increasing the money supply won't help to get
unemployed resources used.
Moreover, the central bank 'prints'
money to buy bonds from commercial banks. But these banks with growing
reserves don't necessarily lend this money out. Looking at the Nikkei and Japanese P/E
reaching levels unseen since 2007, there is little doubt that this money
is not re-injected elsewhere that in the financial markets.
And even if the
growth of the money supply could trigger inflation, lowering the purchasing-power in times of recession is a questionable strategy.
Looking at debt financing : one of Japan's largest debt creditor, the Government Pension Investment Fund, has announced that it will redefine its asset allocation, raising stocks to 50% and reducing domestic debt to 35%.
This is a paradigm change. In the monetary war, Japan was hit hard in 1984 but adapted to the situation, managing to self-finance its debt through domestic banks and funds who purchased bonds at low interest rates. This cheap private-sector debt financing was only possible because of the deflation. Charging 1% when inflation is -1% leaves you with a 2% spread.
But now Abe's policy it to make JGBs more attractive to foreign investors, with lower bond prices, higher yields, and cheaper Yen. The GPIF example hints that the government is 'forcing' domestic lenders to give up the lion's share.
Therefore, when (if?) inflation reaches the 2% target, Japan will have to pay at least 2.xx% on its debt to foreign banks and funds. And the cheap Yen will make this foreign-owned debt more expensive to repay.
