governments agreed in the Palza Accord to force the overvalued US dollar to fall, raising the undervalued Japanese yen, thus slowing Japanese export. As the US dollar fell in value, Hong Kong and other Asian economies that are pegged to the US dollar experienced long periods of low or negative local interest rates. The Japanese Ministry of Finance responded to the G7 attack on the yen by lowering Japanese interest rates to keep the economy afloat and to slow the fall of the US dollar. By 1988, despite an overheated economy, Japan yielded to heavy U.S. political pressure to continue to keep Japanese interest rates low, in order to slow the contraction of the U.S. economy and the drastic fall of the US dollar. Low Japanese interest rates and an overvalued yen fueled financial bubbles throughout Asia that translated into systemic currency risks for the region, including Hong Kong which acted as an unregulated center for low-cost, easy Japanese loans. Even Japanese borrowers came to Hong Kong for yen loans.
To increase competitiveness and growth, both the Japanese and the Hong Kong governments emphasized capital intensive physical infrastructure investments at the expense of social infrastructure, with distorted and inefficient stimulative impacts on their economies. Starting in 1993, Japan spent in four years US$480 billion (70 trillion yen at prevailing exchange rates) worth of stimulative packages, with another US$115 billion package announced in April 1998. For growth, both Japan and other Asian economies rely heavily on external conditions that are beyond their control, depending heavily on the US consumer market and placing high hopes on China as a future market, as well as the emerging markets in Southeast Asia. The Japanese economy is managed by entrenched bureaucracies that jealously guard their prerogatives. In recent years, Japan has experienced a declining sense of public spirit and civic morals, brought about by waves of political, bureaucratic and business scandals. Japan is saddled with a political landscape that is hostile to the sitting administration, complicating economic policy formulation.
Japan has a serious bad debt burden (US$600 billion), carried over by banks in a binge of reckless lending during the bubble economy of the 1980s. The Nikkei 225 stock index rose six fold in a decade (from 6,550 in 1980 to 38,916 by the end of 1989). Deflated in the early 1990s, investor reckoning dragged down the stock market by over 60% from its peak in 1989 and property prices by 80%. Japanese banks never made proper provisions for the consequences of bad debt, keeping them on their balance sheets, hoping the economy would recover in time to allow the debts to be repaid in full or a resurgence of asset inflation to lessen the pressure. Typically, the managers of the Japanese economy engaged in denial, wishfully thinking that masking the symptoms would cure the fatal cancer. As the GDP contracts, the bad debt problem looms greater. To date, the government has spent 30 trillion yen (US$235 billion) to prevent the banking system from collapse. As a painless solution, it opted for the "convoy system", the practice of forcing healthy banks to rescue ailing banks by merging. The festering economic malaise has gone on for over eight years domestically and brought to a head by the Asian financial crises that began in July, 1997, the underlying conditions for which Japanese banks kelp created. The resultant credit squeeze caused bankruptcies losses to reach 14 trillion yen (US$115 billion) in 1997. Corporate failures in May, 1998 rose 37.5% from a year ago (to 1,791 filings, highest in 14 years, since 1984). Industrial production in April dropped 6% from the previous year, causing corporate profits to drop 25%. The precipitous collapse of the yen in the second quarter of 1998, (falling 15%, or 50% from its peak in 1995) rattled an Asia already in financial crisis, by threatening to trigger a new round of currency devaluation, including relatively insulated China. A falling yen threatens the stability of the banking system as it erodes its capital base. Many Japanese banks book their outstanding loans in dollars, some up to one third of their lending total. As the yen falls against the dollar, the yen value of dollar loans increases, pushing the yen capital of most banks towards falling below the 8% capital to loan ratio required by sound banking standards set by Bank of International Settlement. This causes Japanese banks to cut new lending or to roll over outstanding loans. As a major creditor nation, such actions by Japanese banks create new stress in the world economy that has yet to play itself out completely.
The accumulated deficit run up by the central and local governments of Japan during the post bubble years exceeded the size of the GDP, and when pension liabilities were added, the deficit doubled. Debt service now takes 22% of the national budget, more than education, defense and pension combined. A subsequent 75 trillion yen (US$600 billion) public spending program between 1992 and 1995 created some growth in the construction sector but failed to boost the economy generally. Along with fiscal measures, Japanese leaders made proposals to streamline government, change archaic business practices, reform education, reduce welfare expenditures, and deregulating financial services with a "big bang". While each of these changes is desirable for long term development, together, it was too ambitious a program to be carried out all at once, given Japan's political heritage and social convention.
Reform is seldom an engine of growth and never a timely cure for emergencies. Instead of concentrating on making the economy rolling, bureaucrats in government ministries devote most of their energy thinking up ever more ingenious ways of pandering to official directives while at the same time ensuring that their own official turf is not reorganized out of existence, thus stopping the economy in its tracks. Japan's banking crises greatly reduced the impact of any macroeconomics policy to stimulate demand. Regardless of demand in the economy, Japan is structurally condemned to no growth for the foreseeable future. Even if Japan does all that Washington wants it to: spurring demand with monetary and fiscal policy, cleaning up the banking system and vigorously pursuing systemic reform, its estimated contribution to stability in the global economy is overstated. U.S. export to Japan is a mere 1% of its GDP, to all Asia 2.4%. Rising European economies are filling in the Asian gap in world demand. Asian crises are keeping the Fed from raising U.S. interest rate which otherwise should be rising. Japan needs looser monetary policy while America needs tighter, either movement would further weaken the yen. The Fed cannot postpone hiking US interest for long, and must by more if it acts later.
The dissolution of the Soviet Union marked the transition of a bipolar world into a multipolar world. In the bipolar political world, trade was primarily a Western regime. The world was a sphere of contention between the two super powers that did not trade and aid was the exclusive tool of ideological competition and economic development . In a multipolar world, trade has become global, replacing aid as the recognized tool of economic development. American planners see world trade and globalization as a vehicle to a new world order under U.S. tutelage in which market capitalism and Western democratic principles rule. China sees foreign trade as means to achieving world power status along mercantilist paths. These two separate and different objects will inevitably clash. The U.S. see bilateral trade as a privilege to be granted to countries which subscribe to American values and in concert with American national interests. China see bilateral trade with richer nations as a moral obligation of rich nations to equalize historical economic injustice. Security threats faced by China in a multi-polar world have not diminished. The main threat has shifted now to the form of ethnic separatism, mainly orchestrated by U.S. interest in the name of freedom, human rights and democracy. Increasingly, China recognizes economic development as a key tool in combating ethnic separatism. Historically, a prosperous China attracts fringe ethnic group to join the center for obvious benefits, and a poor center feeds centrifugal forces toward separatism.
China started to lower its interest rate in 1996, after 3 years of rising rates, to combat inflation. By October of 1997, a total of 3.58 points were cut on bank deposits rates and 4.45 points on loan rates in three cuts in 22 months. Still, the real interest rate- the nominal rate minus inflation, continued to rise. While consumer price increase in 1997 was 5.5 points lower than the previous year, it still went up 2.8%. The People's Bank of China acknowledged that although the nominal rate for one year deposits is 5.67%, the real rate is around 7 %, and the 8.64% one year lending rate is a heavy burden for corporate borrowers. Industrial output slowed to 8% year on year in the first two months of 1998. Output of state owned enterprises growth rate slowed to only 3.6%. Thus deflation became a priority concern for policy makers. On December 5, the PBOC cut another .25% on key rates.
Cutting interest rates is a classic policy option to kick start the economy, but it threatens the exchange rate of the yuan. Since further cuts in the yuan interest rate beyond the narrow difference between yuan and US dollar rates will lead to massive shifts of yuan holding s into U.S. dollars. The same danger exist if U.S. interest rate rises. Such a shift could trigger the devaluation of the yuan despite official policy to avoid devaluation. This leaves China with the alternative option of increasing liquidity, thus leading to higher inflation and higher rates down the road. U.S. current account deficit is expected to top US$230 billion in 1998. IMF warned that with the dollar currently 15-20% above its medium term trading range, there is a real danger of a correction and possibly sharp fall in the value of the US. Dollar and of S government bonds and stock prices. Asset market inflation in U.S. and the EU may not be sustainable.
Ever since the U.S. abandoned the Bretton Woods international monetary agreement in August 1971, the global monetary system has been plagued with a leadership vacuum. Countries that have been hit with currency runs began to believe that the promise of market capitalism has been a cruel joke to rob them of their wealth and dignity. In the absence of a stable, equitable international monetary order consistent with open global markets, the U.S. continues to push for globalization. The prevailing free-for-all approach to currency relations engenders only monetary nationalism and ultimately fosters a protectionist backlash in all countries. The defeat of President Clinton's attempt to gain fast track trade authority and the gaining momentum of trade protectionists in the U.S. Congress are ominous signs for free traders. The current currency carnage rages on with disastrous economic and political consequences. Would socialism be ready to take up the challenge?
Henry C.K. Liu