August 2, 2022
KUALA LUMPUR – It never rains but it pours. Every day this summer we are bombarded by bad news — raging forest fires, the continuing Ukraine war, random shootings in different cities, a mutating omicron, monkeypox and rising debt distress all over.
The good news for some is that the United States dollar is stronger than ever. Or is that bad news for others? In the Bali G-20 Financial Ministers and Central Bank meeting held last week, there was concern that currency volatility could trigger more instability in the emerging markets.
The dollar is strong because the euro, yen and even the yuan are weakening. In times of global uncertainty, plus the fact that the US Federal Reserve is raising interest rates, makes the dollar attractive as a safe haven currency. The euro is understandably weak with the Ukraine war, shutdowns in gas and rising inflation, plus widening fiscal deficits. China has been affected by the omicron lockdowns.
Thus, the IMF chief economist has warned in his latest blog that the current outlook is looking pretty gloomy, if not grim. The Fund projected three years of slowing global growth from 6.1 percent in 2021, 3.2 percent this year and 2.9 percent next year.
The yen is down to 137 to the dollar, the lowest for 20 years, 16 percent lower than the beginning of the year. Three possible reasons are given for this decline: the oil shock from the Ukraine war, difference in Bank of Japan’s monetary policy stance; and possible return of Mrs. Watanabe. Let’s deal with the easier reasons first.
Japan is a major energy importer, so higher oil prices increase her trade deficit, meaning greater outflow of yen. But Japan runs an overall balance of payments surplus because of her net international investment position of $3.5 trillion, meaning she is one of the largest net lenders to the rest of the world. As the nation ages (with a median age of 48 years) earnings on her accumulated savings keep the balance of payments in surplus, so there should not be too much impact on the yen rate.
The second is the loosest monetary policy in reserve currency countries. Japan was the first to experiment with unconventional monetary policy and quantitative easing by announcing the zero interest policy in February 1999, when the country was going through the post-bubble recession. Aggressive monetary policy came in 2013 with the first arrow of “Abenomics,” the economic policies of recently assassinated former Prime Minister Shinzo Abe (1954-2022). The Bank of Japan promised to double the money supply and achieve the 2 percent inflation target, which enabled the yen to weaken from a high of 77 yen to the dollar to 101.8 yen within six months of the second Abe Cabinet (2012-2014). Since 2013, the Bank of Japan’s balance sheet has expanded from roughly 30 percent of GDP to currently 134 percent of GDP, compared with 30-40 percent range for the Fed and the People’s Bank of China balance sheets.
Now that the Fed has hiked Fed funds rate by another 75 basis points, the gap between US interest rates and European Central Bank and Bank of Japan rates is widening, enabling the return of interest rate arbitrage trading (borrow cheap yen or euro and invest in dollar assets). Traders are now more willing to short yen or euro and long dollar, betting that the dollar will go stronger. Note that the Fed funds rate is between 2.25-2.5 percent, whilst ECB interest rate was hiked this month to 0.5 percent per annum from zero, and BOJ is still minus 0.1 percent.
With US inflation at a high of 9.1 percent per annum, the real interest differential is still negative by over 6 percentage points, suggesting more room for interest rate hikes.
This raises the specter of the return of Mrs. Watanabe, the mythical Japanese housewife who used margin trading to earn higher interest rates to supplement household income. She would lose heavily if the yen appreciates sharply instead of continuing to depreciate.
Markets worry about Mrs. Watanabe because there is over a thousand trillion yen ($6 trillion) of Japanese household deposits earning no interest rates, and if a portion were used to speculate on FX, the markets would be in for another roller-coaster ride.
So far, Japanese inflation is still low compared with those in the US and Europe, so the BOJ has not acted to change its current monetary stance.
My book, “From Asian to Global Financial Crisis” (Cambridge University Press 2009) pointed out that depreciation of the yen caused Japanese banks in the 1990s to pull back on their dollar loans to East Asia, triggering off the dollar shortage. This time round, the Japanese banks are well capitalized, but the weakening yen and euro has always led to global liquidity tightening, causing FX losses for dollar borrowers, especially among emerging market (note debt distress in Sri Lanka).
With 30-year residential mortgages already costing 5.5 percent per annum, the US housing market is cooling off, and further hikes could trigger recession. As higher interest around the world reverse asset bubbles, we are caught between stagflation (high inflation and stagnant growth) and financial distress. Note that in every global financial crisis, there were major corporate or sovereign debt default except this last pandemic, when loose monetary and fiscal policies staved off mass borrower failures. But the period of postponing bankruptcies and low interest rates may well be over.
Thus, all eyes are now on what the major surplus countries like Japan will do. Will Japan continue to supply the rest of the world with savings? Will yen interest rate increases cause Japanese investors to seek safety back home in yen?
Those who have no yen for risk, hold on to your hats!