Exchange Rates as Policy Target: The Japanese Case

How do we explain the behaviour of the Japanese yen — which has not only avoided the major appreciation (against the U.S. dollar) that other major currencies have experienced (most acutely including Canada’s), but is actually down by over 15% since 2005 (despite Wall Street’s financial wobbles)?

Japan has the world’s third largest trade surplus, so if exchange rates reflect real trade flows and competitiveness factors, it should have risen against the dollar at least as much as other G7 currencies.  (Excluding the yen, other G7 currencies have appreciated more than 30% against the dollar in the past 5 years; Canada’s loonie is up 50% in the same time.)

Clearly the yen’s movement (or, rather, non-movement) reflects active policy, not market “fundamentals.”  Vibrant exports have been essential to Japan’s success in finally escaping the glum tentacles of its decade-long 1990s depression.  Economic policy-makers, including the central bank, have been absolutely determined to ensure that a rising currency does not undermine that success.  Ultra-low domestic interest rates (currently at 0.25 percent) are now motivated more by depressing the yen than the need to stimulate domestic demand (which is bubbling along nicely).  The central bank’s mission in this regard has been helped along mightily by global financial speculators, who have developed a lucrative “carry trade”: borrowing money in Japan at ultra-low interest rates, and re-lending it in other countries (including Canada) where they can earn an easy 3 or 4-point interest spread.  This further suppresses Japan’s currency, but boosts those of its trading partners.

Japanese exports have been vibrant: growing at 9% per year over the past five years (by far the fastest in the G7).  Over half of Japanese auto production is now exported; vehicles exported from Japan (as opposed to produced in “transplant” facilities in North America) now account for more than half of all Japanese-brand vehicles sold in North America.  Japan’s own domestic auto sales are weaker than they’ve been since the mid-1970s, mostly because of demographic factors: an ageing population buys fewer vehicles.  Yet Japan surpassed the U.S. last year to become the world’s largest auto producer, thanks to this yen-fueled export surge.

Japan’s targeting of a weak yen has made a crucial contribution to its export success.  If the yen had tracked against the U.S. dollar the same way as other G7 currencies on average, it would be 30% more valuable today.  That would raise the U.S. landed price of a $35,000 Lexus by at least $10,000 per unit.  If any government paid out a direct 30 percent subsidy to export-bound production, they’d have their butts halued before a WTO panel before you can say “coutervail.”  But if the central bank arranges for the same result indirectly, everything is somehow considered kosher.

An interesting recent IMF report provides more grist for my mill.  It ranked the central banks of the world according to their supposed degree of political independence.  Here’s the reference and web link:

“Central Bank Autonomy: Lessons From Global Trends”, by Marco Arnone, Bernard J. Laurens, Jean-Francois Segalotto, and Martin Sommer.  IMF Working Paper WP/07/88, April 2007.

http://www.imf.org/external/pubs/ft/wp/2007/wp0788.pdf

Appendices 1 and 2 (beginning on p.29 of the report) list the political autonomy scores assigned to advanced and emerging economy central banks. The IMF bases these scores on a range of indicators regarding each bank’s structure and accountability.  Japan’s central bank scores 0.13 for political autonomy – the lowest of any advanced economy.  Stunningly, even Communist China scores higher for political independence, at 0.38 (the same, curiously, as our own Bank of Canada!).  Almost all other emerging economies have central banks that are clearly more independent than Japan’s.
Of course, I am deeply skeptical of the IMF’s starting assumption that a more “independent” central bank necessarily means a better-functioning economy.  But this report certainly buttresses my view that Japanese monetary policy is conducted with a goal to very broad, politically-mediated goals (not narrow inflation-control) and that the yen itself is a policy target.

What are the policy implications of Japan’s obvious and successful effort to suppress the value of its currency on international markets, and hence to stimulate stronger demand for its products?  This is a “beggar-thy-neighbour” policy, in that it passes off demand-related troubles to someone else (in this case, clearly including Canada), so it can’t be advocated as a universal policy.  But in the absence of some kind of international mechanism to manage exchange rates (and their impact on real trade flows and aggregate demand), other countries have to recognize that these policies are being used (rather than continuing to politely pretend that trade flows reflect comparative advantage and other “natural” market forces).  And where necessary, they must take offsetting policy measures to defend their own competitiveness and demand: perhaps by intervening similarly to suppress their own exchange rates, perhaps by using trade policy levers to moderate the resulting effects on trade flows, or perhaps by implementing alternative targeted measures (through fiscal policy or other means) to offset the impact of the suppressed foreign currency on industrial competitiveness.

These are tough, complicated policy issues, with no obvious or easy answers.  What is irrefutable, however, is that:

1. Japan’s export success reflects pro-active government policy, not a “natural” or market-determined competitiveness; and

2. The claim that central banks can do nothing about their exchange rates is nonsense.