The Bank of Japan threatens to start printing

Gavyn Davies on a financial system in crisis and how close it came to meltdown
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THE STATE of the Japanese economy inevitably dominated the G7 economic summit held in London this weekend. Inevitably, because the world's second largest economy - it accounts for almost two-thirds of Asian GDP - now clearly stands at a crossroads. For the first time ever, the Bank of Japan appears to be on the point of attacking the problem of deflation via the wholesale printing of money.

The latest Japanese crisis started in the spring of 1997 with the extraordinary decision to tighten fiscal policy by 2 per cent of GDP despite repeated warnings from the rest of the G8 that this could cause a slump. Although this fiscal tightening has now been belatedly reversed, the damage to confidence has not been repaired. The savings ratio is on a strongly rising trend, excess inventories are rocketing, the housing sector is in free- fall, and even exports are showing signs of flagging. The economy is now entirely dependent on the boost it is getting from the fiscal injection and the weakening in the yen against the dollar. Without these factors, which together will add about 2.5 per cent to output this year, GDP would have shrunk by almost 2 per cent in fiscal 1998.

As it is, the meagre growth rate of under 1 per cent this year may well be insufficient to head off the danger of outright deflation, which will mean that the Bank of Japan could soon be grappling with the problem of rising real interest rates, even though nominal interest rates are close to zero (and bond yields are at an all-time low, for any developed economy, of 1.3 per cent). That rarest and most difficult of all macro-economic phenomena - severe debt deflation, combined with a liquidity trap in the money markets which prevents interest rates from falling - is looming on the very near horizon.

What should be done about it? The classic policy prescription for such a situation is a direct fiscal stimulus via extra public spending, since it is difficult to stimulate private expenditure either through tax reductions or through easier monetary policy. In the context of the present Asian crisis, it is also seen by the Americans as very important for Japan to boost its growth rate by generating extra domestic demand, rather than by allowing its exchange rate to slip further. A renewed yen decline could easily tip the Chinese into a competitive devaluation strategy, which would trigger another bout of contagion throughout the emerging world. It would also worsen the burgeoning trade imbalance between Japan and the US. So further Japanese fiscal stimulus appears to make the most sense.

To some extent, this is exactly what the most recent Japanese economic package involves, which is why the US has become less strident in its criticism of the Hashimoto administration in recent weeks. However, the latest package has once again focused for political reasons on the inefficient and wasteful construction industry, which has so often in the past failed to trigger a multiplier response in the rest of the economy. Hence, international pressure is now on the Japanese authorities to introduce permanent income tax cuts, especially at the top end of the income scale, immediately after the Upper House elections in July. Mr Hashimoto has hinted that he is ready to do this, but the financing of these measures would disproportionately hit lower-paid workers. It will certainly be difficult for democratic politicians to introduce such regressive tax measures on the required scale, and the same applies to cuts in corporation tax.

This is where the Bank of Japan comes into the picture. Following recent scandals among public servants, a new board has been appointed at the central bank, and it appears to be more independent, and more willing to contemplate drastic action, than its immediate predecessors. Unlike the Ministry of Finance, it seems ready to live with a weaker yen if this should be necessary to head off the threat of deflation. Easier monetary policy will become inevitable if the economy and equity market fail to respond rapidly to the recent fiscal package.

Perhaps this might involve nothing more than a final cut in the Official Discount Rate from 0.5 per cent to 0.25 per cent or even zero. It is not clear that this would have much effect on the economy or on the yen. However, much more drastic action - the wholesale printing of money - is clearly being contemplated. So far, this has not quite been done, despite a 46 per cent increase in the liabilities on the Bank of Japan's balance sheet in the last 12 months. Of this, about 9 per cent has been due to a distortion relating to the bond repurchase agreements which the central bank has been using to inject liquidity into the money markets this year. Of the remaining 37 per cent, the vast majority reflects the central bank's emergency actions to deal with the credit crunch in the Tokyo money markets and thus head off an outright collapse in the financial system in the last few months.

Essentially, this is what has happened. Normally, private sector banks provide liquidity to each other in the money markets, with liquid institutions providing money to illiquid institutions for the price of a credit spread. With confidence in the financial system evaporating since last autumn, healthy banks have no longer been willing to fund ailing banks, almost at any price. This has put upward pressure on Tokyo interest rates as weak banks have desperately fought for credit lines. Without a huge injection of central bank liquidity - achieved through unprecedented purchases of long dated bonds from the private banks in exchange for cash or very short term bills - the banking system would probably have collapsed.

So far, this operation has simply prevented an increase in money market rates and has offset the shrinkage in the private interbank market. The central bank has become the counterparty to funding operations which normally would have been handled in the private sector. But it is too simplistic for the Bank of Japan to pretend, as it has been doing, that this operation is merely technical. In fact, it has provided the private sector banks with very short term dated bills worth about 4 per cent of GDP in exchange for much less liquid government bonds. This is very close to outright monetisation, and it has obviously pushed the yen lower, thus undermining the efforts of the Ministry of Finance to support the currency through foreign exchange intervention.

The next, and even more drastic, step would be for the central bank to inject cash into the banking system, instead of short dated bills. Some people on the board of the central bank have been arguing in public that this to be done. If it were done, the monetary base would explode as interest rates dropped to zero, and the yen would collapse. Great pressure would then be put on China and other emerging currencies to engage in a policy of competitive devaluation, and the Asian crisis would face a severe second leg.

No wonder the Americans are so anxious to persuade the Japanese authorities that the fiscal alternative - large and permanent cuts in marginal tax rates - should be adopted instead. But recent history suggests they may be disappointed.