In the midst of the fallout from the UK’s decision to leave the EU last week, Japan has become a haven for investors. Instead of providing reassurance to Japanese policymakers, this flight to safety is threatening domestic growth and monetary stability. How should the authorities respond?
Prime Minister Shinzo Abe launched “Abenomics” shortly after his victory in late 2012. Thereafter, the yen depreciated significantly, providing helpful relief to an economy struggling with chronic deflation and the aftermath of the global financial crisis. The monetary policy “arrow” of Abenomics, particularly the Bank of Japan’s “ quantitative and qualitative monetary easing”, launched in April 2013, was in large part responsible for this boon.
Recently, however, the yen has strengthened substantially: against the dollar, itself a strong currency, it has appreciated by 17 per cent since the beginning of 2016 and by 3.4 per cent since June 23, the date of the UK’s referendum. In trade-weighted terms, the real appreciation since June 23 has been close to 5 per cent. Core inflation is still running at 1 per cent, while consensus forecasts shows that the economy is expected to grow 0.5 per cent this year. Given this weakness, the jump in the yen might even push the economy back towards deflation.
The strong yen has stimulated demand for currency intervention. The main Japanese business lobby is pushing for a weaker yen, hoping that this would spur demand for exports. Some prominent politicians are tempted by the same option.
One objection to large-scale intervention in currency markets is that this would be the responsibility of the government and so risk undermining BoJ independence. More important, Japan might be condemned as launching a currency war. Beijing could even have the perfect excuse to debase its own currency. Yet friendly foreigners might accept that they have an interest in preventing a return to deflation in Japan.
Another objection to intervention in foreign currency markets is that the BoJ is able to raise inflationary expectations in other ways. Yet, in reality, this has proved very difficult, given the already ultra-low interest rates on long-term bonds and the sluggishness of domestic borrowing. Currency intervention might be more effective.
A more compelling objection is that fundamentals have mostly driven this appreciation. Independent estimates put the fair value of the yen at 106-108 to the US dollar. If so, the current level is not hugely overvalued. Intervention might push the currency down briefly but sentiment and capital flows are likely to drive it back up again.
On balance, there is still no case for a big effort to depreciate the yen substantially. A stronger argument exists for interventions aimed at convincing markets that the yen is no one-way bet. The best policy response of all, however, would aim at strengthening domestic demand, via fiscal policies.
A supplementary budget, which is expected to be unveiled in the autumn, could be brought forward as a way of stimulating and reflating the economy. Rather than spend money on improving Japan’s excellent infrastructure, such a fiscal stimulus should be directed towards the struggling members of Japanese society: the young families that feel unable to afford more than one child and pensioners who rely on the welfare system.
By getting more cash into the hands of groups that are likely to spend every extra yen they are given, the government would almost certainly have more success at stoking growth and inflation than by launching large-scale currency interventions.
