Outlook: Japan faces dilemma over currency

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Just as everyone thinks the Asian crisis is beginning to ebb, it seems repeatedly to flow with renewed strength once more. China's implied threat to devalue the renminbi if the yen continues its fall, marks a new and potentially frightening turn of events. If China enters the game of competitive devaluation which has beset the region, then Hong Kong's dollar peg - a haven of strength throughout the crisis - cannot survive, notwithstanding the former colony's massive reserves of foreign currency. Its economy is just too linked in to that of China to suffer such a competitive disadvantage without massive recessionary consequences.

And if Hong Kong abandons the peg, then its safe haven status and importance as a business centre will be gone for good. No wonder the markets were so rattled by Dai Xianglong's carefully chosen words. China's central bank governor seemed to be threatening Hong Kong with a demise even more complete than the red army would be capable of.

Most currency analysts agree that the yen is now almost certainly undervalued against the dollar after the steep decline of the last two years, but that doesn't necessarily mean the trend will be reversed.

With the Japanese domestic economy mired in a deflationary recession, buoyant exports supported by a weak currency have become one of the few bright spots in an otherwise pitiless landscape. The Japanese authorities have no incentive to support the yen. Nor could they through the traditional mechanism of interest rates, for the Japanese domestic economy needs an increase in rates like a hole in the head.

Japan's crisis is a very different one from that which besets the former tiger economies of the region, but the two have become fatally linked. Japan's own economic paralysis is in serious danger of deepening the separate crisis that exists elsewhere. As ever, the solution can only come from Japan, the economic powerhouse of the region. However, other than persevere with economic reform, the benefits of which will take many years to show through, it is hard to see what else the Japanese government can do.

Even if the public finances could take it, tax cuts in Japan in present circumstances are a zero sum game. The extra spending power goes not into consumption but into savings. Some ingenious alternative proposals for refloating the economy have been proposed, such as Paul Krugman's idea that the Bank of Japan should simply print more money and then, rather in the nature of UN aid, air dump it on the Japanese population.

In most circumstances such a policy would be tantamount to debasing the coinage; its effect would be highly inflationary. Since Japan's problem is one of deflation, then this doesn't amount to a difficulty. However, it is easy to understand why this policy has rarely been used before, even in deflationary conditions, and the chances of Japan adopting such a radical approach are pretty much zero. At this juncture, it is still hard to see how South East Asia is going to find a way out of its economic gloom.