Propped up, but not pulled to safety

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The Independent Online
THE EAST Asian story moves on. Each week there seems to be a new twist, something coming along which forces a reassessment of one's response to the two big questions: "will the regional decline continue?" and if so "how will the rest of the world be affected?".

The two main twists last week were the impact of the intervention in the foreign exchanges by the US authorities trying to check the fall of the yen, and the new US trade statistics showing that the weakness of the Asian economies was starting to hit the US trade position: the April deficit of $14.5bn was the largest ever. A word about each.

The conventional view of central bank intervention is that (a) it is most effective in the short run when it reinforces an existing trend, and (b) it is only effective in the long run when it is supported by other measures, be they fiscal, monetary or structural. Last week's intervention fulfilled the first criterion. The yen had been recovering and the fact that the US authorities were in the market as well as the Japanese came as a complete shock. The result was the classic "bears running for cover" story.

Whether the longer-term criterion for success will be fulfilled is another matter. We simply don't know. A typical view last week was one expressed by the HSBC economics team, which reckoned that policy change in Japan would remain ineffectual, and that while the intervention would put a temporary floor under the yen, it would eventually resume its downward movement. The target for the end of the year was 160 to the dollar, with a further fall to 170 in 1999.

That rather gloomy forecast was based on minus 1.7 per cent growth this year and minus 0.2 per cent growth next, ie two years of recession (see left-hand chart). Domestic demand would remain stagnant or falling and the economy would not be rescued by stronger export demand, as it was in 1997. Nor would Japan help the rest of the region by importing more: as the graph shows, HSBC is forecasting minus figures for imports through the next 18 months. It is not expected to increase its exports by much either, except to the US. Some 45 per cent of its exports go to the East Asian region and if demand there remains flat, it is more or less inevitable that its overall exports will remain flat too.

That gloomy outlook for Japan is towards the end of the range. By contrast HSBC is quite positive about China, which it thinks will emerge relatively unscathed. A very weak yen may make Japan more competitive vis-a-vis China, but it also cuts China's foreign debt servicing and import costs. Accordingly it reckons Chinese growth will end up at 6 per cent this year and 7 per cent next.

Again, we cannot really do more than make an educated guess at this stage, but what we do know is that pressure on the US trade account will rise. The right-hand chart shows what has been happening to the US trade deficit with both Japan and China since 1985. As you can see, in money terms not much has changed over the last 12 years as far as Japan is concerned. The very latest figures (I have taken the April numbers and annualised them) are shown in the blobs. These do suggest that the slight narrowing of the deficit with Japan in 1996 has reversed; the 1997 deficit was increasing and the latest April deficit was wider still.

But on a 10-year view, the more remarkable feature than the continuing deficit with Japan is the new one with China. True, the April figure is no worse than the average for last year, as you might expect since China, unlike Japan, has not devalued. But in political terms that is small comfort. After all Japan has been an ally of the US for the last half century; the relationship with China is quite different. A decade ago trade between the two was in balance. Now - well, you can see from the chart why the US Commerce Secretary William Daley is going with President Clinton to China this week to talk about the trade situation. It is hard to see the US tolerating a continuing deficit with China in the same way that it has allowed it to happen with Japan.

What next? Writing ahead of Saturday's G7 meeting in Tokyo, I think that as far as Japan is concerned the main thing to look for will not be policy initiatives but signs of a spontaneous recovery in both consumer and commercial confidence in Japan. It is rather unfashionable even to hint that policy decisions are not important, and of course I am not saying that. There are many measures, mostly structural, that need to be taken. Until they are, Japan will find it hard to sustain much of a recovery. Nevertheless, the rebuilding of confidence is not just a question of policy. It is also a question of familiarity with a new world.

Let me explain. The entire developed world is in the middle of a transition from inflation to deflation. The guiding principle that has governed all our working lives is that prices and wages tend to go up, with wages going up a little faster. That, in a world of inflation, is how we get a rise in our standard of living.

Here in Britain we are still in that world, as the prices and earnings figures last week demonstrated. Japan is not: the standard of living of ordinary people is rising, but it is rising more because of lower prices than higher wages. In theory it should not matter much which way we increase our standard of living - unless you believe that the money illusion is a powerful human response. But if you have debt it matters enormously, because you are paying off debt with more valuable money, not less valuable.

From a corporate point of view this can be a catastrophe: the company typically borrows a lot of money, invests it in expensive plant, finds that demand does not grow as rapidly as expected, and then finds that the real value of the debt increases as the general price level falls.

From an individual point of view, the position depends on whether you have borrowed too much. Those with debt are in the same position as the over-borrowed company. But those without can sit back, relax, save away and wait for prices to fall. The longer you wait, the better the deal you will get. Eventually you decide that you do not need to wait any longer and you spend the money, for eventually you adjust to the new relationship between prices and earnings. But there is a time-lag, and Japan is currently enduring that lag.

If this line of thinking is right, the problem of domestic demand in Japan - that if the government hands back money in tax cuts, the Japanese save it instead of spending it - is not just a response to job insecurity. It is partly that, but it is also a response to a world of falling prices. If the long-term trend of inflation elsewhere remains down, sooner or later the rest of the developed world will make this transition. It may well be that the rest of us will manage it more easily than Japan has done, thanks to lower corporate debt levels and more robust banking systems. But we will still have to face it some time. So as far as Japan is concerned, watch the change in policies, but also watch for any rebuilding of consumer confidence.

And the US trade deficit? It will widen, that we know. What we don't know is whether and when the US itself and the rest of the world start to become alarmed about it. The current popular view is that the attraction of the dollar as a safe haven will allow the US to run a deficit more or less indefinitely. It can certainly go on for a very long time, but eventually it will have to chopped back. Debts either have to be repaid, whittled down by inflation, or repudiated. If you exclude options two and three, only one is left. In any case, at some stage the US will no longer want to go on accepting a flood of Chinese imports.

To return to the questions at the beginning of this article, there is nothing in the last week's evidence that suggests the East Asian crisis is moving to any kind of resolution; there will be more bad news to come. And, yes, the crisis is now starting to have a significant impact on US trade, increasing an already large current account deficit.

None of that, in itself, is good news. But there is slightly better news in the fact that the US authorities are now publicly worried in a way that was not evident even a week ago. Being worried does not of itself solve anything; but until you are worried you do not begin to seek solutions. It is a start.

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