<b>A V Rajwade:</b> Learning from Japan

Japan is an interesting case study of the relationship between interest rates, exchange rates and inflation

In a somewhat surprising move, the Reserve Bank of India (RBI) increased repo and reverse repo rates by a 25 basis points in the face of continued rise in inflation, to stall “a potential possibility of heating up” (RBI Governor, The Indian Express, March 23). Such measures are expected to be important, not so much for their direct impact on price levels, as for “anchoring” inflation expectations.

Whatever the objective, the International Monetary Fund (IMF) economists recently took the heretical step of arguing that developed countries should aim at an inflation rate of 4 per cent rather than the more traditional 2 per cent, as the former would leave larger room for central banks to cut interest rates in times of need! Obviously, the IMF does not now seem to believe that very low inflation is necessarily virtuous. (Equally heretically, it even argued in favour of capital controls recently — clearly, the financial crisis does seem to have taught the IMF the need to look beyond the Chicago school theology.)

For students of macro-economy, Japan is an interesting case study in terms of the relationship between monetary and fiscal policies as well as inflation and exchange rates. Consider some numbers:

The Bank of Japan cut its interest rate from 8 per cent in 1991 to 0.5 per cent by 1995. Contrary to what most of the pundits argue, the exchange rate appreciated sharply during the period, at one time touching ¥80 per dollar. 
 

Since 1995, the monetary base has gone up 115 per cent, but the nominal GDP has fallen by 8 per cent despite real, if halting, GDP growth in many of the years. (Clearly, the assumption of a constant rate of money circulation is not valid in this case.) The economy continues to be in deflation even today. That this should occur over a 15-year period of practically zero interest rates and an extremely loose fiscal policy (with a fiscal deficit of 7.8 per cent of GDP in the current year), which has taken government debt to 200 per cent of GDP, seems to be completely contrary to what macro-economic theory suggests. (Milton Friedman of the Chicago school believed that inflation is always a monetary phenomenon.) 
 

It could be argued that the expectation of falling prices has become so firmly ingrained in the Japanese psyche, that the consumer keeps postponing purchases and the deflationary cycle perpetuates. But, this is not supported by the fact that every annual survey since 2004 has been showing that the Japanese people have consistently expected prices to go up in the following 12 months! (In other words, expectations seem to have little to do with outcomes.) In fact, household savings have dropped from 16 per cent of income to 3 per cent over the last quarter century, partly also because of an aging population. 
 

This year, maturing debt equivalent to only a little less than half the Japanese GDP would need to be refinanced — yet bond yields have been barely 0.15 per cent per annum for two years, going up to 2.1 per cent for the 20-year bond. But even at these low rates, the debt is so high that debt-servicing consumes 35 per cent of revenues. 
 

Despite the sharp fall of savings in the household sector and the huge negative savings of the public sector, the current account remains in surplus. The only possible conclusion is a sharp fall in private investment.

To my mind, the last point has a plausible explanation (to be sure, more creative and imaginative minds than mine would have plausible rationalisations for the others as well). Perhaps, the huge gyrations in the exchange rate explain the weak domestic investments — from ¥135 in 1991 to ¥80 in 1995 to ¥145 in 1998, only to appreciate to ¥111 in a few weeks. That the collapse of a hedge fund (Long-Term Capital Management) should change the exchange rate between the currencies of the two largest economies of the world by 30 per cent in a couple of weeks, is a telling commentary on market efficiency and the virtues of market-determined exchange rates. Which sane businessman would invest in an economy where there is such volatility in perhaps the single-most important price in a globalised world — namely the exchange rate? The surplus on current account seems to be more the result of a sharp fall in domestic investments than anything else. (Is this the case in China as well? — a point I will discuss next week). It is noteworthy that, after Sony, Toyota, et al became global brands in the last two decades, no new Japanese brand has come up.

Overall, the Japanese economy remains a riddle for the accepted tenets of macro-economic theory. Is it an exception to prove the rule, or do the tenets need review in a globalised economy?

Meanwhile, the Japanese experience should help sober us: Continued, fast growth is not a given and it can be dangerous to make such an assumption. After all, Japan was the most feared and competitive economy in the 1980s, before losing its way over the next two decades. Are we being over-optimistic, and taking 9 per cent per annum growth for granted, despite poor and worsening governance, increasing corruption, lack of infrastructure and an uncompetitive exchange rate?

avrajwade@gmail.com