Originally published in THE WALL STREET JOURNAL
September 24, 1999
Japans Yen for a Weak Currency
by Martin Feldstein
Board of Contributors
"There is no reason why the G-7 countries should participate in an exercise in yen devaluation that would inevitably raise dollar and euro interest rates and weaken its trade balance."
Japan has called for a coordinated currency intervention by the Group of Seven industrial countries to weaken the yen and thereby strengthen its economy. That proposal should be rejected as both unnecessary for its purpose and undesirable in its effects. Japan can always reduce the yen by itself if it really wants to and if the U.S. and other countries do not stand in the way. The real question the G-7 finance ministers should discuss when they meet in Washington this weekend is whether Japan should be permitted to depress the yen artificially in order to gain a trade advantage.
Japans desire for a weaker yen is understandable. Japanese leaders correctly fear that the 30% rise of the yen against the dollar over the past year will reduce the countrys exports and increase its imports. Although Japans trade surplus is currently very large, any significant reduction in it would threaten the economys fragile recovery. The recent two-quarter rise in gross domestic product provides only a feeble sign of hope. First-quarter growth was bought by massive government spending; second-quarter annualized growth was less than 1%. If the rising yen causes exports to fall by 10% and imports to rise by 10%, the effect would be to cut Japans GDP by more than 2%, turning a weak recovery into an outright downturn.
The yen has been rising despite an apparently strong interest-rate differential in favor of the dollar. Short term interest rates in Japan are virtually zero: The three month money market interest rate in Japan is less than 0.05% while the corresponding dollar interest rate is 5.3%. Why would any investor want to buy yen when the apparent return on dollars is so much greater?
The answer is that the expected return to a currency investment is not just the interest rate but also the anticipated appreciation of the currency. An investor will be better off holding yen deposits rather than dollar ones if the interest differential in the yen-dollar exchange rate strengthens over the year by more than the 5%. For example, someone who buys yen at 106 per dollar and expects to sell those yen a year from now at 100 per dollar would make a 6% profit on the transaction, more than enough to compensate for the interest difference.
But why would investors expect the yen to keep rising? For two related reasons. First, Japan has an enormous current-account surplus (3% of GDP) while the U.S. has an even more oversized current-account deficit (3.5% of GDP). This year, that deficit has forced foreign investors to accumulate dollar investments at a rate of about $250 billion, adding to the accumulated net foreign investment in the U.S. that now exceeds $1.5 trillion. The reluctance of global investors to go on accumulating dollar investments at such a pace, with the associated exchange-rate risk, means that the dollar must continue to fall if American goods are to be more competitive in world markets, slowing the rise of U.S. imports and increasing exports.
Second, inflation in Japan is now negative and particularly so for the products Japan exports. The yen must rise if those goods are not to become even more competitive and Japans trade surplus is not to widen further.
Japanese policy makers have been trying to strengthen domestic demand so that the economy can expand even if the rising yen reduces net exports. With short-term interest rates close to zero, there is little the central bank can do to stimulate demand. Instead, the government has dramatically increased its spending, provided capital to commercial banks, promoted bank mergers in order to facilitate the expansion of credit to business borrowers, and encouraged structural and corporate reforms. But its unlikely that these measures will accomplish very much, save to further balloon the deficit (now 10% of GDP) and cause the countrys unemployment rate to rise, as it has every year since 1991.
There are some constructive things Japan could do to stimulate domestic spending. Substantial reforms of land-use rules could encourage more house building. A shift from government infrastructure spending to personal tax cuts would also help. Sadly, there seems little prospect for such changes now.
Instead, attention in Tokyo is shifting to yen policy and net exports. Major Japanese industries say they need an exchange rate of 115 yen to the dollar in order to remain viable in global markets. The Japanese government has been intervening in the foreign-exchange market, selling yen in the hope of stopping its rise. Not surprisingly, such interventions have been overwhelmed by private transactions, leaving the underlying market trends unchanged.
Now the Japanese are calling for coordinated intervention by the G-7 countries. The Japanese hope that such a process will send a clear signal to the market that makes the yen stop rising and turn down, thus providing a few years breathing room for recovery. But the call is misplaced, because Japan is trying to drive down the value of its currency, not trying to reverse the decline of an overvalued one. Japan could simply announce that it wants an exchange rate of, say, 140 yen per dollar and is prepared to buy dollars for yen until it achieves that goal. Once markets saw that the Japanese were serious, the exchange rate would adjust and further dollar purchases would be largely unnecessary. The Japanese government could add that it recognizes that such an exchange rate cannot last indefinitely and that it expects to permit the yen to rise at, say, 8% a year, reaching 129 after one year, 119 after two years and so on until the currency reaches a level at which intervention is no longer needed,
Pay a Price
Keeping the yen undervalued in this way for five years would contribute substantially to a Japanese economic recovery. Exporters and companies that recapture domestic markets from import competition would see their sales rise and would respond by increasing employment and investment in new plant and equipment. Although Japan would pay a price by buying dollars that would later be worth much less, the higher interest rate on the dollar securities held by the Japanese government than on the Japanese securities held by foreigners would achieve an income shift in Japans favor. The stronger economy would reverse Japans current deflation, but the resulting inflation need not be large, especially if the creation of yen to buy dollars were limited by a rapid adjustment of exchange-rate expectations or was offset by the governments open-market purchase of the newly created yen.
Coordinated intervention would run counter to the interests of the U.S. and Europe. A weak yen would exacerbate the U.S. trade deficit and would jeopardize Europes nascent recovery. Even more significantly, the expectation that the yen-dollar rate would rise at 8% a year would cause investors to borrow dollars and invest in yen until the interest differential just balances the 8% expected rate of yen appreciation. Since Japanese interest rates cannot fall further, the adjustment of the interest differential would have to occur by an increase of the dollar interest rates to at least 8% from todays 5% level.
There is no reason why the G-7 countries should participate in an exercise in yendevaluation that would inevitably raise dollar and euro interest rates and weaken its trade balance. The key issue for the G-7 finance ministers is whether Japan should be free to pursue such a yen devaluation policy by itself or whether such a policy should be opposed on the grounds that it is an unacceptable interference with trade. If the ministers conclude that such exchange-rate intervention is unacceptable, the yen will continue to appreciate and the Japanese will have to seek to expand the economy through structural policies at home. In the long run, that may be for the best.
Mr. Feldstein, formerly chairman of the president's Council of Economic Advisers, is a professor of economics at Harvard University.