Saturday, August 29, 2009

A yen for wisdom

An expert may have all the knowledge on any subject at his fingertips yet he may not have the wisdom. As a guide to tell a wise person and an expert apart, I've chosen an article, Japan's control on the yen, which appeared in the Think Asian column of the Malaysian newspaper, The Star on August 29, 2009. The author is Andrew Sheng, Adjunct Professor at the University of Malaya and Tsinghua University as well as a Director of Khazanah Nasional Berhad. He also sits on various prominent high-powered councils and boards. He sure is a heavyweight on his subject but his article is full of irrelevant arguments, or the proverbial trees instead of the insightful forest.

Let me summarise the pertinent points in his article. The article discusses why the Japanese yen fails to become a reserve currency. Several arguments, the trees, are advanced to support that contention. Among them are its volatility (unstable value), the low yield on yen denominated financial and real assets, and, lastly, the rise of the euro which adds another competing alternative to the yen.

Now, let's rise above the trees to see the forest. One point is enough to puncture holes in all of Mr. Sheng's arguments. For a currency to be a reserve currency, the currency's country must have a tremendous amount of current account deficits, i.e., it must be a global debtor, not just a debtor like most sub-Saharan countries. Only one country qualifies and it is the United States of America.

That is the crux of my argument. The detailed bits follow.

Of course, not every country can be a global debtor. For it to be a global debtor, it must be credible, not only economically but also militarily. In other words, it must earn its stripes. It is not an easy process because a country has to go through the mill. It must first be a creditor country, accumulating current account surpluses over the years. In fact, only in the 1980s did the US become a debtor nation. Thenceforth, its foreign debts could only move one way, that is upwards.

Since Japan is not a debtor country, there's not enough yen floating around for it to be adopted as a reserve currency. You may argue you can easily buy yen. True but for you to hold yen, you must give the Japanese something in exchange. The Japanese don't want your Malaysian ringgit or any other exotic currencies because they are not tradeable outside the countries' borders. They prefer the US dollar. Same goes for the EU. The more yen or euro you want to keep, the more US dollars the Japanese and Europeans must hold in return.

As for the volatility of the Japanese yen, it's not Japan's fault. Since many countries trade mostly with the US, they stabilise their currencies' exchange rates only with respect to the US dollar. Should there be a major fluctuation of these currencies vis-a-vis the US dollar, it's primarily due to a drop or a rise in their economic competitiveness relative to other countries exporting to the US. For example, the 1997 Asian financial crisis was precipitated by the rise of China which made all other East Asian countries non-competitive. Only when they devalued their currencies could they recover. George Soros wasn't the cause nor were capital controls a remedy.

The US does not have the luxury of setting its own exchange rate. It has to take whatever exchange rates set by the monetary authorities of other countries. When the Japanese ran huge trade surpluses with US in the early 1980s, the US had to bear on the Japanese through the 1985 Plaza Accord to get them to appreciate the yen vis-a-vis the US dollar. The yen doubled its value within three years. Gradually, the Japanese became non-competitive. Whatever it can produce, the Koreans and, eventually, the Chinese also can at much lower costs because of their cheaper currencies. With a population that's both declining and ageing faster than those of its competitors, Japan will be an economic basket case.

Since other countries do not target a specific exchange rate vis-a-vis the yen, the yen is bound to fluctuate (or more likely, appreciate) relative to their currencies. There is no benefit at all in borrowing money in yen even if no interest is charged; the borrowers will be hit by the increasing exchange rate.

The low yield on the Japanese assets are also beyond their control. Japan's economy has been in the rut ever since their bubaru keizai (bubble economy) burst in 1991. They tried various measures including zero interest rate policy but to no avail. Till today, policymakers can't figure out why Japan remains mired in a gloomy mindset for such a long time. Even when they had economic growth, the outlook wasn't cheerful. Actually, this phenomenon is a pernicious effect of globalisation. Similar situations can be found in resource rich countries, such as the major oil exporting countries. As it requires a lengthy explanation, I'll elaborate on this in a future post.

Finally, can the euro displace the yen? Actually, such a notion is implausible because neither can be reserve currencies. The euro's claim to reserve currency status is as much tied to Germany's current surplus as the yen is to Japan's. However both are only claims, not real entitlements. Neither has been a superpower and ever won't they be.

These arguments countering Mr. Sheng's assertions are intended to demonstrate how an eminent expert can suffer from blind spots. Being wise is not difficult; you need to build patterns in your thinking. Patterns include enduring laws which are simple yet escape the attention of experts. For example, one highly pertinent law is that the interest rate for a country cannot exceed its economic growth rate. Applying this to the Japanese case, we can naturally deduce that returns on yen denominated assets would be very low since Japan has been in recessionary mode for the past twenty years despite having intermittent growth. So to advise Japan to increase the yield on the yen denominated assets is indeed silly.

An expert may know all the tools of the trade but to know what tool to use and where to use it require wisdom.

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