A V Rajwade: Japanese monetary policy

WORLD MONEY

The Bank of Japan has signaled that inflation, rather than deflation, is now the main worry.

It has been a horrendous decade and a half for the miracle economy of the 1970s and 1980s. At the end of the 1980s, Japanese equity and real estate prices had reached absurd levels and were being rationalised "" low interest rates, the miracle economy, and so on. (To be sure, one can always rely on investment bankers to justify any prices.) The bubble burst in the early 1990s and, as if that shock was not strong enough, the exchange rate went to equally absurdly high levels (less than ¥80 to a dollar) in the middle of the 1990s. The result has been an economy swinging between slow growth and recession through much of the time "" since Japan remains the world's second largest economy, this has also had its impact on global growth.

As the asset price bubble collapsed, the banking system went into a mess, with mountains of bad debts: it had to be rescued at the cost of hundreds of billions of dollars by the government. This was accompanied by huge public investment, particularly in infrastructure, whether needed or not, just to create demand and employment. The fiscal deficit had crossed 8 per cent of GDP in 2002 "" it is down to about 6 per cent last year. The Central government debt is as high as 160 per cent of GDP, probably the highest ratio amongst the OECD countries. (The government expects to record a revenue surplus, that is, before interest, only "early next decade".)

The loose fiscal policy was accompanied by an equally loose monetary policy with the Bank of Japan moving away from the traditional interest rate targets to pumping liquidity in the banking system to persuade banks to increase lending. Interest rates remained at zero per cent for a long time. Remarkably, the huge fiscal and monetary excesses did not lead to any inflationary pressures, as orthodox economists would expect. Indeed, for much of the period since the turn of the century, core CPI, as also the broader measure, namely the GDP deflator, have been negative.

Helped by the fiscal and monetary policies and the consolidation and cleaning up of the banking system, the economy seems to be back on a sustainable growth curve for some time. Consider some pointers:

GDP growth was 3 per cent in fiscal 2005-06, and the International Monetary Fund (IMF) expects growth of 2.75 per cent this year and the next (to be sure, because of the negative GDP deflator, nominal GDP growth is much lower).

The growth has been driven by exports and corporate investment, as traditionally in Japan.

Corporate and bank profitability has been growing and the Nikkei index was at a five-year high at the end of the last fiscal year (still, it is only a little above 40 per cent of the absurd levels at the end of the 1980s).

Unemployment is at a seven-year low, and consumer confidence at a 15-year high. Women workers, whose jobs are the first casualty in an economic slowdown, are being re-hired.

Perhaps, most tellingly, golf-course fees have started going up.

As a result, the Bank of Japan has signaled that inflation, rather than deflation, is now the main worry: it has also signaled that it is moving away from targeting liquidity to interest rates.

While the bank has hastened to emphasise that this does not mean an immediate change in the zero-rate regime, financial markets are worried "" and so they should be, if only because there is an estimated $200 billion worth of "carry trade" riding on the ultra low yen interest rates. Not many who were market participants at that time would forget how the yen exchange rate jumped 21 per cent in a couple of days with the reversal of carry trades following the collapse of Long Term Capital Management. With years of negative inflation, the yen is perhaps undervalued as much as 20 per cent in real effective terms.

One fall-out of the collapse of the banking system has been a far stronger Financial Supervisory Authority (FSA) in Japan. It has been unusually active in the current year with punitive actions even against large players such as JP Morgan, Mizuho Bank, Sumitomo Mitsui Bank and so on. The latest big fish to be caught in the net (this time not by FSA, but by criminal investigators) has been Yoshiaki Murakami, a star, if controversial, fund manager. For some, he had come to signify a new, Anglo-Saxon-type player in Japanese financial markets. He has been accused of insider trading and indicted recently. There are calls for the resignation of the Bank of Japan governor because he had invested some personal savings in the fund managed by Murakami. The investment was done back in 1999, before Fukui became the governor "" but was continued thereafter as well. The scandal has erupted at an awkward time for the Bank of Japan, when it is in the midst of effecting a major policy change, from targeting liquidity to interest rates.

Email: avrco@vsnl.com