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The Fed’s QE Operations and the Dollar
November 28, 2008

By Stephen Jen & Spyros Andreopoulos | London

Summary and Conclusions

The Fed has commenced QE (quantitative easing).  In this note, we review the concept of QE and analyse the likely impact of this extraordinary operation on the dollar.  The upshot is that, since monetary policy, including QE, is a ‘nominal’ operation, the operation itself should not have significant implications for the real value of the dollar.  The nominal dollar value should, thus, only be affected if QE alters the outlook of inflation in the US over the medium term.  Also, whether QE by the Fed should erode the value of the dollar should be assessed relative to what other central banks do.  To the extent that the ECB and the BoE also conduct QE – which is the case – the impact of QE on the dollar is not necessarily negative. 

Having said this, though QE per se should affect the dollar through relative inflation as well as inflation expectations, the underlying structural problems that forced the Fed to conduct QE in the first place should alter the fundamental value of the dollar, relative to those of other currencies.  The parlous state of the US financial system should, in theory, be reflected in a lower value of the dollar, had it not been for its hegemonic reserve currency status propping the dollar up during this deleveraging phase.  The bloated fiscal deficits (which we assume will exceed those of the G7 countries) will further weigh on the intrinsic value of the dollar.

In sum, whether QE by the Fed is negative for the dollar depends on the inflation outlook of the US and the resulting inflation expectations.  But at a fundamental level, the dollar’s intrinsic value has indeed deteriorated with its severely weakened financial sector.  We maintain our core view that the dollar should continue to appreciate as the world slows – which we assume will last until next summer – but could give back some of the gains when deleveraging stops and the recovery phase for the US economy proves to be more protracted and treacherous than for other economies.  The size and vigour of the dollar rally against the majors in the next six months or so are also likely to be more tempered than we have had in mind, in light of the deteriorating fundamentals in the US.  Our call on EM currencies remains unchanged. 

Background Discussion on QE

As inflation falls, and the unemployment rate rises, the Fed is likely to embark on QE to sustain monetary stimulus even when the FFR approaches zero.  Broadly speaking, central banks can ease by either altering the price of money (i.e., interest rates) or the quantity of money.  While policy orthodoxy these days is focused on the former lever, when short-term nominal interest rates approach zero as inflation falls, central banks could in principle use quantitative channels through which to impart monetary stimulus.  Since it is the real interest rate that affects economic activities, the zero bound on nominal interest rates exposes an economy with deflation to persistently positive real interest rates.  This was the situation faced by Japan in 2000, that interest rates were cut to zero but there was still not enough demand for money for monetary policy to work.  That was an old-fashioned case of a ‘liquidity trap’.

However, for the US, Europe and the UK, the current situation is somewhat different.  Interest rates are still above zero.  The problem monetary authorities face is not quite deflation and inadequate demand for money (i.e., a deficient aggregate demand problem) – though this problem could emerge if demand slows further.  Rather, monetary policies lack traction mainly because there is no longer a smooth transmission mechanism from the short-term policy interest rates to broader monetary aggregates, credit and aggregate demand.  As a result, Japan had QE with ZIRP, but in the US, Euroland and the UK, there is QE without ZIRP.  

There are essentially three broad channels through which a central bank can conduct unconventional monetary easing. First, a central bank could ‘do things’ (i.e., through communications or QE) to foster the expectation that short-term interest rates will stay low for an extended period of time.  Indeed, this was the primary aim of the BoJ during its QE episode between March 2001 and March 2006. The FOMC statement in August 2003 which stated for the first time that “policy accommodation can be maintained for a considerable period” is another example of this type of commitment to monetary easing.   Second, a central bank could increase the size of its balance sheet to foster an expectation on the future path of inflation. (Currently, the Fed’s balance sheet is around US$2 trillion, up from US$900 billion in August.)  The intuition of this ‘money printing’ method of QE is obvious.  Third, a central bank could alter the composition of its balance sheet.  Assuming that investors treat different assets as not perfect substitutes, central banks’ purchase operations of selected assets could materially alter their prices.  The best example is long-term US Treasuries.  In theory, the Fed could purchase large amounts of Treasuries to cap the yields, just as the BoJ did through its rinban operations during the QE period.   These three different methods of QE are conceptually distinct but operationally fungible.  As the US economy slows further, we expect that the Fed will put all three methods of unconventional easing into practice.

The Fed began expanding its balance sheet in September.  It may be useful to consider two motivations for QE by the Fed.  The first is to take on market securities in an attempt to ‘jump-start’ the banking system; the second is to take on some of the intermediation duties that the private sector has refused to conduct.  We looked at how the expansion in the Fed’s balance sheet compares with the experience of the BoJ during the QE period that spanned from March 2001 to March 2006, during which time the BoJ’s balance sheet expanded from around 13% of GDP to about 22% (we measure the balance sheet by the monetary base for both countries).  Due to fundamental differences in the financial systems of the two countries, the Fed’s balance sheet has historically been substantially smaller than that of the BoJ – it averaged around 6% of GDP prior to this crisis.  By October, however, the Fed’s balance sheet had been expanded to more than 8% of GDP – a 35% increase.  

To properly assess the impact of ‘money printing’ by the Fed on inflation, it is important to track the evolution of broader monetary aggregates, and observe how the ‘money multiplier’ – the ratio between broad money and the Fed’s balance sheet – changes over time.  We looked at the trajectories for M2 of Japan and the US.  During Japan’s QE period, its M2 expanded from around 125% of GDP to more than 140%.  In the US, M2 has expanded from 53% to 57% of GDP since September. While the latter is a sharp surge, M2/GDP is not substantially higher than it was during 2003, when the Fed drove the FFR towards 1.00%.  Indeed, most of the surge in the figure comes from the anticipated sharp drop in 4Q nominal GDP. To summarise, while base money has increased dramatically (by 34% since August), M2 has grown by only 2.7%. 

The reason for this, of course, is that the ‘money multiplier’ (MM) has collapsed, reflecting a severe breakdown in the ability and the willingness of the bank and non-bank entities in the US to intermediate capital to the extent they had done prior to the crisis.  The collapse in the US MM is significantly more severe than in the case of Japan, during which time Japan’s MM fell from around 10 times  the size of the BoJ’s balance sheet to around 6.5 times (a fall of 35%).  In the US in the last two months, we have seen the US MM falling from more than 9 to around 7 (down 22%). 

Will QE by the Fed Weaken the Dollar?

Our short answer is ‘no’.  But whether this answer is right depends on a number of assumptions.  (1) Deflationary pressures cannot be dismissed so easily in this cycle.  Analysts can have their views on the inflation/deflation debate; however, to us, the fact that, with half a dozen ‘nuclear options’, the world’s policymakers have not yet succeeded at halting or containing the crisis worries us.  It is, to us, very difficult to argue convincingly that ‘it’ won’t happen in the US or elsewhere in the world (see Vice Chairman Don Kohn’s speech last week).  While the probability of this risk of sustained deflation is not high, it may be too high for comfort.  Though the Fed did act much sooner than the BoJ, the underlying problem is arguably more serious and the financial crisis has severely shocked the ‘money multiplier’, forcing the Fed to intermediate on behalf of the private sector.  In short, we fear deflation now more than we fear inflation tomorrow, because we simply have no confidence that this will merely be a ‘deflation scare’. 

Our guess is that the Fed and other developed country central banks have a similar asymmetry in fear of the two tail risks: this risk-management approach to monetary easing indeed reflects the asymmetry. (EM central banks have lingering concerns about inflation.)  In a way, investors realise this and are betting on the G7 central bankers to overwhelm and neutralise the left tail risk, leaving the risk of the G7 ‘overdoing’ (i.e., over-easing) it more prominent than the G7 failing to re-ignite their economies.  In other words, the greater the fears of deflation, the more will be done by central banks to avoid that scenario and, as a result, the higher the risk of inflation in the out-years, or so it is thought.  (Ironically, it was this stance the Fed had in 2001-03 that arguably sowed the seed for the ensuing credit bubble.)  Having said this, this thought process is logical but very subjective, with no clear right answer, in our view.  But tactically, we believe it is wise to bet that the deflation scare will be more powerful a market force as the global economy falters and as central banks fight the ‘icing problem’.  Whether there will be inflation is a debate for another day, probably three months from now, and it will probably not be reflected in market pricing, we suspect.  

Whether the dollar depreciates depends on whether investors believe that there will be runaway inflation in the US over the medium term.  Our view is that the Fed will most likely have time to retract on QE in time to keep a lid on inflation.  Without inflation, the dollar cannot be weakened by nominal operations, ceteris paribus.  Our guess is that, while dealing with a liquidity trap is difficult, removing stimulus when macro conditions normalise should not be a major problem for the Fed.   But this discussion also highlights the importance of the Fed having a credible ‘exit strategy’ for its QE operations. This is essentially the view of Minneapolis Fed President Gary Stern. 

Further, while many are focused on this question of QE by the Fed and the dollar, we argue that the ECB will likely be forced down the same path soon.  The European and the UK banking systems are just as unwilling to intermediate capital as the American banking system.  The ECB and the BoE, therefore, will likely be forced to do some of the intermediation on behalf of the private sector, just as the Fed has been forced to do.  So if the Fed, the ECB and the BoE adopt QE, what is the net result on EUR/USD or cable?  We think it is very unclear that EUR or GBP will necessarily rally, as is presumed by some investors when they think about the Fed.

Ironically, the tug of war between deflation and inflation fears indicates a reverse Dollar Smile mechanism of sorts. Recall that our Dollar Smile framework suggests that the dollar rallies when the US economy is stronger or weaker than the rest of the world. In the intermediate state, which we call the gutter, the dollar is weak. In the deflation versus inflation debate, on the other hand, both these extremes imply a weak dollar, while the intermediate state would foster dollar strength.

The USD’s Fundamental Value Undermined?

While the Fed’s QE operations affect the nominal value of the dollar through inflation, the severe deterioration in the US financial system must have had an impact on the intrinsic value of the dollar.  We stress again that exchange rates are a relative concept, so we need to be sensitive to how much structural damage the financial systems of other developed countries may have sustained.  This also includes the fiscal burden that these countries have to take on because of this damage. Notwithstanding all the problems in the US banking system, the size of banks’ balance sheet is much smaller in the US than in many other countries.  For example, total bank liabilities are around 650% of GDP for Switzerland, 430% for the UK, 320% for the Euroland, 150% for Japan and 85% for the US.  Investors should keep this fact in mind. 

In any case, as a rough guesstimate of how the USD major index may be affected by the breakages in the US financial system and the remedial policy actions, we simulated, using our multilateral USD index fair value framework, how the major USD index might be affected by prospective changes in relative productivity, relative terms of trade, relative fiscal positions and the US NFA (net foreign asset) position.   Our simulations are centred on the last two variables, as we believe that it is difficult to draw a clear link between the banking sector and relative productivity and the terms of trade. 

It looks likely, based on recent developments, that the relative US fiscal position may deteriorate by 2% of GDP, and its NFA position may also deteriorate by 3% of GDP (the US C/A deficit is expected to shrink but will still be large).  This scenario maps to a 5.3% depreciation in the fair value of the major USD index, according to our valuation model (the impact of NFA is small due to the small magnitude of the estimated coefficient in our model). 

Bottom Line

There are two considerations in thinking about the impact of the Fed’s QE operations on the dollar.  First, QE per se can only affect the nominal value of the USD through relative inflation.  The greater the inflationary pressures generated by QE, the more the dollar could weaken.  Second, the underlying reasons why the Fed has been forced to undertake QE operations may undermine the intrinsic value of the dollar by 5-7%.  Thus, while we still expect the dollar to appreciate as the global economy falters, the size of the USD rally against the majors in the next six months will likely be more modest than we had thought.  Against the EM currencies, we continue to expect significant USD strength in the next six months.

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South Africa
It’s No Longer Just Inflation
November 28, 2008

By Michael Kafe, CFA & Andrea Masia | Johannesburg


South African bond yields have rallied by some 180-250bp over the past month. This follows a 15% retracement in USDZAR, a 17% fall in the international price of oil, anecdotal evidence of weak demand pressures globally and what appears to be a fundamental decision by local asset managers to insulate their portfolios by switching out of equities into fixed income instruments, as the local equity markets plummeted to levels not reported since the end of 2006. And while the FRA curve is now pricing in as much as 450bp of easing over the next 12 months, the South African Reserve Bank’s (SARB) policy repo rate remains firmly unchanged at 12%. The sharp rally in the domestic fixed income markets has now driven a huge wedge between the policy rate and money market rates. We believe that the increased dislocation between market and policy rates is approaching a critical juncture in terms of the effectiveness of the monetary policy transmission mechanism with regard to financial markets. We therefore believe that the SARB may be willing to close the gap earlier than we had previously expected.

SARB to maintain financial system’s stability “at all costs”. Market conviction about the need for rate cuts appears to be reaching a stage where the money market curve may simply invert even further if the SARB were to raise interest rates. Put differently, we are becoming increasingly concerned that the policy repo rate may be so far removed from market rates that it loses its relevance as a signaling instrument. Under these circumstances, the SARB may want to minimize the potential risk of a breakdown in the relationship between financial markets and monetary policy by giving financial stability pre-eminence over straight-jacket inflation targeting. It could do this by realigning the repo rate, to some extent, with market rates despite the inflation outlook remaining somewhat clouded (i.e., a tactical rate move). That the SARB may be willing to do this may – with the benefit of hindsight – have already been hinted at by the governor at a University of Pretoria dinner on October 16, 2008 when he mentioned that “everyone has left ideology at the door…the key issue …is to maintain stability of the financial system at all costs”. And the SARB is not alone. Over the past month, in the interests of financial market stability, more than 15 other central banks have had to engineer monetary easing.

As things stand now, we believe that the SARB will adopt a middle-of-the-road approach, where it indeed brings the easing cycle forward, but resists the temptation to cut rates as aggressively as the market expects (i.e., cuts by only 50bp at each MPC meeting, beginning from February 2009). That way, it would still preserve some reputation as a credible inflation targeter that will not be dictated to by the markets, while contemporaneously avoiding a potentially chaotic disruption to the financial system and, as a corollary, the real economy.

An improving inflation profile allows the SARB to bring policy easing forward. Since the October MPC meeting, international oil prices have fallen by a substantial 39%, fully offsetting the 5% depreciation of the nominal effective exchange rate of the rand. In fact, local oil prices are now set to fall by roughly 160c/l in December (30c/l more than our earlier forecast of 130c/l). As we highlighted in recent research (see South Africa Chartbook: November – Macro Cracks Widening, October 30, 2008 and South Africa: Further Growth Downgrades, November 14, 2008), our forecasts show that, with oil prices at US$50/bbl, CPI could, on a pure technical basis, dip below the upper end of the 3-6% inflation target band in August 2009, as base effects from this year’s surge in oil prices kick in.

Up until now, we have regarded, and continue to regard, the potential dip below 6% next year as a technical blip that will fall out of the wash by 4Q09. We regard the sustained decline that we expect after 2Q10 as the relevant area of the inflation trajectory that should guide policy. However, given continued downside inflation surprises globally, and the fact that domestic demand conditions have remained weak, we now believe it is conceivable that the SARB regards the return above target in 4Q09 to 2Q10 as the technical blip, while focusing on August 2009 as the re-entry point for inflation. In fact, were the SARB to keep oil prices flat around the US$50/bbl level throughout 2009/10 (rather than the futures curve or some other oil price profile that anticipates a rise in oil prices after 1H09, as global growth recovers), it may in fact present an inflation profile that has CPI returning to target sustainably as early as 1Q10, with an end-2010 point forecast of some 5.2%Y. Under such a scenario, one could justify an interest rate cut in 1H09, and not 2H09 as we had earlier forecast.

But conceding that rate cuts could come in earlier than we had expected is not entirely impossible because of the dislocation between money market and policy rates. The fact that we had underestimated the rate of decline in oil prices in the past two months and overestimated the strength of both local and external demand conditions also had a role to play. 

Looking ahead, we now believe that policy easing will start as early as February 2009, although December 2008 cannot be ruled out completely. On the whole, however, we continue to look for no more than 200bp of cuts in 2009/10. In “South Africa: October MPC Outlook”, EM Economist, October 3, 2008, we established that, since the introduction of inflation targeting, the SARB has never initiated an easing cycle until targeted inflation is no more than three months away from returning to the target band. In that piece, we also argued that the change from an annual average target to “a continuous target of 3-6%” suggests that the monetary authorities may be willing to tolerate a maximum lead time of 6-8 months under the current regime. Thus, if the SARB indeed regards the August 2009 dip in CPI as its re-entry point, then policy easing should begin in February 2009.

We do not expect a rate cut in December 2008, for two reasons: First, the December 11, 2008 MPC meeting will be held just two days after the 4Q08 Quarterly Bulletin is published; monthly data from the South African Revenue Services suggest that South Africa must have posted a record trade deficit in 3Q08, contributing to a current account deficit that is likely to have rebounded to some 8.5% of GDP that quarter. Clearly, the MPC risks sending out the wrong message to investors if it cuts interest rates just two days after publishing such a deterioration in the current account deficit. This is especially so after the 3Q08 supply-side GDP data released earlier this week showed that the key export revenue-generating sectors, such as mining and manufacturing (which together account for more than 80% of total exports), are contracting sharply; meanwhile, the heavy users of imported capital, such as transport & communications, construction and personal services, continue to post positive growth rates. Second, a rate cut in December is doubtful, as data on the new inflation basket will only be released by Statistics South Africa in late February 2009. In our opinion, the SARB is unlikely to initiate wholesale policy relaxation when it does not even know what the impact of the re-weighting and re-basing of the new basket will be.

While it may be in the interest of financial stability to bring the easing cycle forward, we would have serious reservations about such a move. First is the currency: with the current account deficit likely to be deteriorating in 2009 and the global liquidity squeeze likely to continue well into 1H09, we believe that the rand is likely to continue to trade on the back-foot in the coming months, posing upside risks to the inflation trajectory. Second, although futures curves are arguably a poor predictor of future spot prices, the fact that the oil futures curve has now swung from backwardation into increasingly steeper contango over the past quarter suggests that there could be some upside pressure on oil prices in 2H09. Were this to happen, it is entirely conceivable that CPI stays above target for much longer than currently estimated. In fact, the lower oil prices fall during the rest of 2008 and early 2009, the more negative the base effects become in 2H09 and early 2010. This is an important development that could present challenges to the inflation-targeting framework over the course of 2009/10.

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How Japan Got Financial Reform Right
November 28, 2008

By Robert Alan Feldman, Ph.D. | Tokyo

A Brief History: Japan’s Three False Starts

Japan’s path to successful financial sector reform was characterized by three false starts from 1992-99. Various parts of the eventual success cumulated through these three false starts. In 2002-04, the reform process finally succeeded.

The first false start came from 1992 through early 1994. As growth collapsed in 1992-93, the Bank of Japan (BoJ) cut rates. In addition, there were large fiscal expansions, first by the Miyazawa Cabinet (mostly spending) and then by the succeeding Hosokawa Cabinet (mostly tax cuts). Structural weaknesses in the financial system and the corporate sector and a sharp bout of yen strength in 1993-94 (in part due to the loss of confidence in the US) ended the hopes for a quick revival from the collapse of the equity bubble.

Notably minor in the policies of this period were microeconomic and political reforms. The Mayekawa Reports (deregulation blueprints from the 1980s) were largely left on the shelf. The Structural Impediments Initiative (SII) was negotiated with the US, and proved popular with the Japanese public. However, SII remained mostly a tool to contain American protectionism. (SII did, however, serve as a blueprint, with ideas for later reform.) Most disappointing was the failure of election district reform under reformist PM Kaifu of the long-ruling Liberal Democratic Party (LDP), who resigned when this initiative died. Election district reform, which partly corrected the over-representation of rural areas and shifted Japan away from the multi-seat district system that over-represented small parties, would have to wait until 1994, and only be implemented in the 1996 election.

During this period, substantial worries about the financial system emerged. As the stock market tumbled, the capitalization of banks was questioned. (Unlike most other industrial countries, commercial banks in Japan are permitted to hold equities. Moreover, under the initial implementation of the BIS bank capital rules, 45% of the unrealized gains on stock holdings could be included in Tier II capital.)  As bankruptcies mounted, fears emerged about the level of bad loans and confidence eroded. A first attempt at resolution was made with the creation of the Cooperative Credit Purchase Corporation (CCPC), but the latter was not actively used. Moreover, by realizing gains on long-held assets, financial institutions were able to withstand market pressures.

The second false start came from mid-1995 through mid-1996, when a blockbuster fiscal package, more aggressive rate cuts by the BoJ and important deregulation in the telecom sector under PM Murayama temporarily stoked public works and business investment. (Murayama was a Socialist, but the fiscal package was designed largely by the LDP, which had formed a coalition of convenience with the Socialists in order to return to power after the loss to PM Hosokawa’s Japan New Party in the 1993 general election.) The equity market recovered temporarily, but the bond market was not fooled. Despite the GDP revival, both nominal and real bond yields fell. When PM Hashimoto took over in January 1996, the market saw fiscal austerity coming. The combination of spending cuts, tax hikes and the Asian Financial Crisis in mid-1997 ended Japan’s second try at revival.

Financial system worries deepened substantially during this period. The problems of housing loan companies (jusen) were highlighted, as their bad loans emerged. Private sector banks were held responsible for pushing bad projects onto the jusen, which had received a great deal of their financing from agricultural-related institutions. Despite harsh public opposition, the Diet voted in early 1996 to make capital injections into the jusen companies. A Housing Loan Administration Corporation was formed under the Deposit Insurance Corporation (DIC) in 1996, to dispose of bad assets of the jusen. In addition, as concerns over the financial system spread, the DIC expanded its deposit insurance program.

Nevertheless, this second period did see interesting steps forward. In the corporate area, one crucial reform was the amendment of the Anti-Monopoly Law to allow holding companies. This change paved the way for the corporate M&A boom that helped improve efficiency so much in the 2000-05 period. In government, a reorganization of ministries and creation of the Council on Economic and Fiscal Policy (to be the highest body for making and integrating economic policy across ministries) occurred. These changes smoothed the decision process for reform significantly, and prepared the ground for PM Koizumi to act.

The third false start came in 1997-99. The banking panic of 1997 triggered another massive fiscal package under PM Obuchi, this time focused on government guarantees for small business borrowing, starting at JPY15 trillion (about 3% of GDP) and growing to JPY20 trillion. Other measures in financial reform included support for money market transactions, which had frozen after the failure of Sanyo Securities in early November. The failures of Hokkaido Takushoku Bank and Yamaichi Securities in late November also triggered a major rethink of financial crisis management methods.

As part of measures to stabilize financial markets, the BoJ launched a major expansion of base money and its balance sheet, with extra support in light of worries about the Y2K problem. Unfortunately, the linkage between monetary policy and nominal GDP had collapsed. The correlation between base money and nominal GDP continued to worsen, went negative, and remained so until early 2004. Moreover, the signal from quantitative policy and interest rate policy remained inconsistent. While pushing hard on quantity, the BoJ refrained from cutting rates until late 1998; only in March 1999 did the BoJ move to a ‘near-zero rate’ policy.

During this period, the global IT boom brought hopes that technological progress would rescue Japan from its financial and non-performing asset problems. These hopes were in vain. The global IT bubble collapsed from mid-2000, and the Obuchi spending and credit guarantees generated little permanent demand. The near doubling of TOPIX from mid-1998 to early 2000 was mostly gone by autumn 2001.

Despite the failure of the Obuchi-Mori macro policies, this period provided a foundation for future growth. The importance and power of structural reforms was recognized, and the very depth of the financial crisis prompted a deeper look at Japan’s structural woes. PM Obuchi commissioned the Economic Strategy Council (ESC) to write a new blueprint for Japanese growth strategy. A driving force behind the report was Heizo Takenaka, then a university professor with little clout in political circles. (The ESC report of February 1999 became the basis for both the LDP and the Democratic Party of Japan (DPJ) manifestos in the elections of the Koizumi period.) In the succeeding Mori Cabinet, Economics Minister Taiichi Sakaiya – a former MITI official with a strong bent toward structural reform – provided a more comprehensive forum to plan and execute the next phase of deregulation. Academics and think tankers began to have a real impact on policy. Moreover, the Mori government implemented the ‘e-Japan’ program, a highly successful push to increase broadband connectivity, and thus raise productivity.

The greatest area of failure during the Obuchi-Mori period was the lack of effective action on non-performing loans/assets. Despite the financial panic, measures avoided getting at the root of non-performing loan numbers and focused on capital injections to the banks with only weak accounting of bad loans. That said, at least a start was made:  the financial regulatory oversight function was separated from the Ministry of Finance, in light of the failure of the latter to prevent the crises. Work began immediately on increasing the staff and honing the inspection methods for the new oversight agency. In addition, a new agency to aid disposal of bad loans was formed, the Resolution and Collection Corporation (RCC). This institution merged the agency charged with resolving bad loans from the jusen and other resolution institutions, and then expanded activities as more assets needed action. However, this institution was also hobbled by the lack of pressure on banks to transfer non-performing assets into the RCC.

Interestingly, the Obuchi-Mori years saw less public opposition to the capital injections. Public support came for two reasons. First, the financial crisis convinced the public that support was needed. Second, the conditionality on the capital injections was severe. Not only did recipients of the public injections (in the form of preferred shares) have to pay significant dividends to the government, but cuts of total compensation (by 20-30% from peak levels) were forced on the institutions.

The Real Thing: Financial Reform in 2002-04

The BoJ’s ill-timed exit from the near-zero rate policy in August 2000, just as industrial production began to collapse, was eventually recognized as a mistake, as the economy weakened. Moreover, confidence fell further, as continued political scandals, stock market weakness and slow progress on financial sector reform brought the support rate of the Mori government to single-digit levels. The BoJ cut rates first on March 1, 2001 and then moved to ZIRP on March 22. Simultaneously, the BoJ announced the shift to quantitative easing, and committed to maintain extremely easy monetary conditions until core consumer price changes sustainably returned to positive territory.

Political events came to a head in April. As the Mori government lost popularity, the ruling Liberal Democrat Party faced a crisis. In a four-way battle for party leadership, maverick Junichiro Koizumi emerged victorious, on a platform of ‘structural reform’. Initially, there was deep skepticism on whether Koizumi could run an effective government, particularly in the face of strong internal opposition in the LDP to his platform – appealing though it was to the electorate. (His popularity rating initially reached 80%.) However, implementing policies took time to achieve, largely because keeping the LDP together required so much effort and compromise.

During the first period of the Koizumi government, 2001/4-2002/9, the metabolism of many economic reform policies accelerated, but financial reform continued at the same pace as in the Obuchi/Mori years. Markets remained skeptical of Japan’s economic future, because the internal fighting in the LDP had yet to be resolved. Koizumi had appointed Takenaka as his economics minister, and used the Council on Economic and Fiscal Policy to push the reform agenda. However, bureaucratic resistance continued, fueled by persistent rumors of attempts to dump PM Koizumi.

Conditions changed suddenly at end-September 2002. Koizumi sent a strong signal by reshuffling his Cabinet, in which Takenaka now doubled as financial affairs minister. Within a month, the ‘Takenaka Plan’ for clean-up of financial institutions was formulated, and aggressive actions began. In particular, the Financial Services Agency, now directly under Takenaka, revised its methods of checking the classification of bad loans by banks, and insisted on uniform treatment across banks. Moreover, Takenaka began to hold auditors legally liable for the corporate results that they authorized. The impact of these actions was to trigger further large write-offs of non-performing loans, and to force actual liquidations.

On fiscal policy, the government adopted a target of eliminating the deficit in the primary balance, then about 6% of GDP, by 2011. At first, PM Koizumi set a goal of reducing deficit bond issuance to below JPY30 trillion, but this target was not achievable due to the worsening economy. However, he stuck to the philosophy of reduced government spending, and cut public works from 6.5% of GDP when he took office by an average of 0.5pp of GDP every year during his tenure through 2006.

Nor was the structural policy agenda ignored, particularly the agenda on corporate governance. In light of the slow pace of corporate restructuring, particularly of large troubled borrowers, the government decided to create a new, private-sector staffed entity. The concept for the Industrial Revitalization Corporation of Japan (IRCJ) emerged in late 2002, and the entity began operations in May 2003. There was tacit encouragement from the FSA for financial institutions to take troubled borrowers to the IRCJ, which then used special powers to enforce cooperation among creditors, based on realistic revival plans. The IRCJ was a huge success. It completed its task and closed shop well before the five-year deadline, and even returned a small profit to the taxpayer.

Despite the more aggressive stance taken by PM Koizumi from autumn 2002, the equity market continued to fall until May 2003. The market needed incontrovertible proof that Koizumi and Takenaka were serious. That proof came when the government took harsh action on a large troubled bank. Takenaka and Koizumi ejected 140 senior managers as a condition for financial assistance, and confidence returned to the financial system. After the asset liquidations, the start of strict asset assessments and the actions taken against the management of the failed banks, the market had a clear reading. Once these policies were implemented, Japan entered its longest economic expansion in the post-war period.

One other part of the story, the importance of an expanding global economy, is often emphasized. However, while world recovery after the 9/11 incident was clearly helpful to Japan, the role of the global economy should not be exaggerated. Domestic demand, especially business investment, was the driver once policies began to gain traction in 2003. Indeed, from 2003-06, only 2.6pp of GDP growth came from net exports. Of the 5.9pp from domestic demand, fully 3.4pp came from business investment. In short, the data show that the structural reform policies, especially financial reform policies, were crucial in reviving growth.

What’s Different

Of course, not every aspect of the Japanese case is applicable in other nations. Indeed, there are several aspects that differ from the cases of other countries today, and so the Japan success model must be adapted to circumstances.

First, Japan’s financial crisis was local. The bad loans of Japanese institutions were almost wholly local, and the regulatory problems were as well. Japan did not need to coordinate closely with other countries in trying to solve the domestic financial problems. Today, the situation for other nations is quite global. Decisions in one country can affect other countries very quickly and severely, because of close electronic connections among markets. Hence, regulatory rule changes and resolution actions must consider effects on other countries.

Second, the yen exchange rate played a safety valve role in the Japan crisis. That is, Japan relied in part on exchange rate changes for economic support. Sweden was another country where exchange rates were quite crucial to recovery.  However, for the financial system crises today, the exchange rate is not a major safety valve (although exchange rates may move significantly), because reliance on exports for economic support is not viable for large countries or regions.

Third, global growth was strong during most of Japan’s crisis period. Hence, foreign demand supported the economy to an extent. More important, however, is that economic shocks from abroad were not as disruptive (with the exception of the Asian Crisis in 1997-98) as they are now. In the current turmoil, not only must countries worry about export demand, they must also worry about foreign financial system shocks and contagion.

Finally, Japan started her decade of financial troubles with an inadequate regulatory system, poor accounting and disclosure standards and low levels of corporate governance. Thus, Japan had to develop much regulatory infrastructure as the crisis evolved. Fortunately, the rest of the world already has a great deal of financial regulatory infrastructure.

From History to Roadmap

In our view, the similarities are more important than the differences. Thus, other countries have much to learn from Japan’s history of financial reform. Japan is NOT merely a source of warnings about mistakes to avoid. Rather, the wonder is that Japan actually did get the reform model right, in the end. It took enormous efforts and creativity over a decade to create infrastructure from scratch, to overcome political and bureaucratic infighting and to summon the political courage to take needed steps and to share the pain.

Japan’s bitter history of financial sector reform suggests a roadmap. In order to become a roadmap, however, Japan’s history must be converted into a model of financial reform. In our view, that model comprises five factors: 

1.         Economic strategy. The nation needs an approach to improving the supply side of the economy, be it through education, capital-deepening, technology or corporate reorganization. Strong corporate governance is a part of national economic strategy. The strategy must be formulated with global economic trends in mind.

2.         Safety net. Those hurt by economic reforms need assurances that they will not be abandoned. Such assurances must extend to a broad range of the populace. The problem is to give support without falling subject to moral hazard. Areas include deposit insurance, money market confidence, small business support, monetary policy and fiscal spending.

3.         Capital injections. Restoring confidence in financial institutions requires public capital injections in many cases. The difficulty is to enforce adequate conditionality on stockholders, employees and management while keeping taxpayers happy and keeping the operations of troubled institutions alive.

4.         Public support. When public money is involved, politics becomes involved too; hence public support for the economic strategy, the fairness of the safety net and the conditionality on capital injections are all essential to achieve public support.

5.         Strict asset assessment. Confidence in the financial system cannot return unless depositors and investors believe that asset valuations are correct. Oversight agencies must be sufficiently staffed with expert personnel, and must coordinate closely across bureaucratic lines and across international borders. There must be clear, public standards for asset valuations, and clear rules for how to deal with deviations.

The key point is that ALL five of the factors above were necessary to fix the financial sector problem. In Japan’s initial phase, only canonical fiscal policy and politically convenient lending support were really tried in any major amounts. The second phase was largely the same, although some progress started on both the safety net and economic strategy. After the financial panic of 1997 occurred, the economic strategy (if not the ability to implement) became clearer, and the safety net was expanded. Capital injections began as well, but their main impact was stabilization, not recovery. Only in the 2002-04 phase, when public support and strict asset assessment were added, did the program become complete, and effective.

Japan in 2008: Backsliding

Japan’s history of financial reform has many lessons for other countries to learn. Unfortunately, Japan herself seems to have forgotten the lessons already. The economic strategy of the Koizumi years has been discarded by the ruling LDP, even though the party still uses the huge majority he won in the 2005 election. Moreover, there is no economic strategy proposal from both major parties, which remain in flux. Even a change of government is not likely to correct the lack of a stable economic strategy. Hence, the first condition for overcoming a financial system crisis is not met.

Japan’s safety net remains strong, with broad deposit insurance and very low interest rates. However, the moral hazard issues inherent in yet more expansions of safety net have been lost in the clamor for more support.

Capital injections are again under discussion, but Diet debate is bogged down in political gamesmanship, prior to the next general election (which must come by autumn 2009). There is no clear strategy on which regional financial institutions should get support, or on what conditions.

Public support for the Aso government is dropping, but the opposition party fares little better. The lack of a clear manifesto from the Democratic Party of Japan (DPJ) has hobbled attempts to establish policy credibility with the voters. Apart from problems in the individual parties, public confidence in the ability of political, bureaucratic and business leaders to lead the country remains low.

Finally, there have been some steps away from strict assessment of assets at financial institutions, particularly regional banks.

In light of these facts, foreign countries are not the only ones who need to review the Japanese model of financial sector reform.

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