Japan may in the end follow its own advice to China, by implementing capital controls.
What is now essentially a currency war in which China, Japan and others fight over the limited supply of external demand may eventually cause dislocations that make highly unorthodox steps like capital controls palatable.
Japan on Friday announced negative interest rates, a move clearly calculated to drive down the value of the yen and raise the price of financial assets. While the move is justified by the Bank of Japan’s fight against deflation, the underlying cause of the new policy is the tidal wave of capital coming out of China, driving down the yuan and hurting Japan and its Asian trading partners.
Witness the extraordinary scene of BOJ governor Haruhiko Kuroda advocating at Davos that, for China, “capital controls could be useful to manage the exchange rate, as well as the domestic monetary policy, in a consistent and appropriate way.”
For a paid-up member of the developed market global central banking elite to advocate capital controls is a bit like a minister advising a parishioner to do a deal, temporary of course, with the devil to plug a cash-flow gap. The International Monetary Fund and others have become less doctrinaire about the use of capital controls, gates against the free flow of money in and out of an economy, but Kuroda’s advocacy of stronger capital controls is a measure of the seriousness of the situation. China is burning rapidly through its reserves, but weakness in the yuan is self-perpetuating and damaging for Japan, among others.
Japan’s move to negative rates is unlikely to spark a revival in bank lending; instead it will give banks and others an incentive to sell their yen bonds and buy overseas assets, thereby driving down the value of the yen. Right now the BOJ is buying bonds faster than the government is issuing them, becoming the nation’s de facto financier of first and last resort.
To be sure, that state of affairs can long continue, but the distortions that negative interest rates introduce, or make worse, in the financial system may ultimately put Japan in a corner where capital controls seem attractive.
Carl Weinberg, economist of High Frequency Economics, points out that the fall in interest rates will cause huge problems for Japanese banks, insurers and pension funds with very long-term liabilities, which will be unable to replace existing bonds as they mature with ones that yield enough to allow them to satisfy their obligations.
No exit
That leaves the Japanese with few natural buyers of government bonds other than the BOJ.
“This means the BoJ can never stop buying Japanese government bonds without defunding the government. There is no exit strategy from QE that does not wipe out the public finances,” Weinberg wrote in a note to clients.
“The only way this scheme can force money to stay in Japan and to go to work at negative interest rates is if the government imposes capital controls to throttle investment abroad. That may be next.”
There is, of course, the possibility that Japan’s economy recovers, sending interest rates higher and ultimately encouraging money to return home to fund what might be a slowly reducing need for finance. That’s the theory, but thus far the record of negative rates is not encouraging, even before we consider that Japan, with a dwindling population and no appetite for immigration, faces very difficult issues in fostering growth and inflation. Surely it is also worth noting that the recent past is littered not just with failed Japanese initiatives to restore growth and inflation, but also with the losses of investors who bet the nation would face a capital crisis.
China’s own situation adds markedly to the complexity and difficulty of Japan’s.
China is exporting deflation through dropping demand and outbound capital. China might erect more gates to outbound capital, but can only do so by losing some of its ability to stimulate demand at home. Needless to say, Japan’s move makes a tit-for-tat response from China more likely.
Little wonder that people are now harking back to the Plaza Accord, a 1985 joint currency intervention by the U.S. and other industrial nations to depreciate the dollar against the yen and the German mark. Whether this would take the form of an agreed devaluation of the yuan, as advocated by Bank of America Merrill Lynch, or of the dollar, as outlined by Deutsche Bank, is unclear.
Suffice to say that stuff is getting weird, and the range of possible outcomes appears to get wider and wider.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
