Currency Wars Risk Dangerous Escalation
Another volley of shots has been fired in the currency wars with the Bank of Japan raising its inflation target to 2% from 1% and committing to open-ended monetary easing next year, which is partly designed to weaken the JPY. This is likely to unleash a series of reactionary events from across the world.
The JPY rallied on the announcement – a case of buy on the rumour sell on the news and also it wasn't as strident as some in the markets had expected. However, the direction of travel is very clear.
It's a very worrying escalation in the currency wars to see the world's third largest economy so openly attempting to devalue its currency in the face of G20 commitments not to do so. Also, of concern is that the Bank of Japan has been 'bullied' into this position by the newly elected government of Prime Minister Shinzo Abe. It represents a further slide towards central banks becoming politicised and therefore less independent. In the long run that is likely to damage their credibility with the markets.
On top of that, the current BoJ governor Masaaki Shirakawa steps down in April and Abe has talked about finding a replacement who “fully understands that the Bank of Japan has a big role and a clear role in maximising jobs.” Rhetoric, which echoes the US Federal Reserve's commitment to target a US unemployment rate of 6.5%. That suggests that the next governor of the BoJ may well pursue its new mandate aggressively.
South Korea – the next domino?
Among the first dominoes to fall in this latest round of the currency wars could be South Korea, which has been sounding warnings that it will act to stem the rise of the KRW. It's notable that Japan and South Korea compete head on for export markets and JPY's recent depreciation is hurting the latter. If South Korea pursues a competitive devaluation the next ripple could come from China, which might look to weaken the Renmimbi in response. The latter would cause consternation in Washington where there would no doubt be talk of trade retaliation.
For those countries with an appreciating currency, particularly emerging market ones, the next favoured tool after monetary policy, is controls on the inward flow of hot money and both South Korea and Brazil have used them. These are likely to be discussed again.
The early beneficiaries of a 'quantitative easing' splurge are equities and commodity markets, which are being pushed higher on a tidal wave of liquidity even though actual fundamentals often do not justify their valuations. However, should the currency wars morph into trade wars where import barriers are enacted asset markets could quickly go into free-fall as investors ponder a re-run of the great depression.
With practically every country in the world wishing for a weaker currency the long-term beneficiary is likely to be gold as it looks like the only hard currency left in a world obsessed with currency debasement.
Hungary, a member of the EU, also seems to be shifting towards a politicised central bank with talk of a special alliance between state and bank and the prospect of a government minister becoming governor. Basically, nationalisation by the back door. And of course the government wants lower interest rates and a weaker exchange rate to boost economic growth.
The BoJ's reluctance is understandable
It's worth speculating over the BoJ's reluctance to spearhead Abe's economic policies. Reading through BoJ reports it is clear that it believes Japan's rapidly ageing population and rising dependency ratio are a key cause of the country's economic malaise. That means less consumer spending, less workers, less income taxes paid and more people drawing pensions. Household consumption makes up roughly 60% of Japan's economy so a structural decline in this area is bound to sap economic growth as pensioners tend to have less income than when they were working.
Take that logic a step further and implementing a more aggressive monetary policy probably won't change much in the real economy if there are few growth opportunities to invest in. But if Japan is not careful and get's the inflation it wishes for, it could actually damage what little consumer demand there is. Witness the UK's example where inflation is eroding consumer spending power year after year as it outpaces lacklustre wage growth. Although, that is also eroding the principal on the UK's pool of outstanding debt – a situation investors have so far decided to tolerate.
The other issue is infrastructure spending. Japan is already littered with white elephants from previous attempts to boost the economy. Doing it again will not reverse the structural decline in consumer spending and risks just adding more debt for future, but dwindling generations to pay. Exchange rates will be a major discussion point at the next G20 meeting on Feb 15-16.