The Silent Run on the Yen

BOULDER – Nearly three decades ago, as a visiting professor at Konan University in Kobe, Japan, I learned to live in a cash society. Rather than open a checking account – and maintain the required minimum balance of $1,000 – I did what Japanese did: carry large amounts of yen and pay for everything in cash. At the time, Japanese were very frugal, and low interest rates compelled many to hold their savings in cash in safe-deposit boxes. Recently, however, Japanese spending habits have changed significantly.

The Japanese are adjusting to a depreciating currency, with the value of the yen having fallen 16% over the last year, to ¥100 to the dollar. This trend is set to continue, given that the Bank of Japan (BOJ) has unleashed the world’s most aggressive quantitative easing (QE) program, which entails pumping ¥7 trillion ($73 billion) into the economy monthly.

The BOJ hopes that the measures will lower interest rates and kick-start Japan’s long-stagnant economy. But, rather than helping the BOJ to reach its 2% inflation target in two years, QE is causing interest rates on government bonds to increase sharply, thereby pushing up commercial lending rates for individuals and corporations. As a result, Japan’s commercial banks, hypersensitive to the risk and uncertainty associated with interest-rate fluctuations, have not responded to QE by increasing their lending activity.

Instead, Japan is experiencing a silent run on the yen. With the BOJ absorbing 70% of newly issued government bonds, Japanese investors are seeking higher yields in other markets, including the United States and emerging economies. Japanese insurance companies, for example, have shifted a significant share of their portfolios into foreign bonds.

Meanwhile, investment in Japan’s economy has been tepid at best. Last quarter, corporate investment fell 0.7% – the fifth consecutive quarter of decline. While currency depreciation has created opportunities for Japanese exporters, the combination of increasing import costs and rising interest rates creates a weak incentive for domestic investment and capital formation. An advisory panel to Japan’s finance minister recently warned that rising interest rates could exacerbate government deficits, and recommended that the government undertake serious fiscal reforms to avoid further rises in yields.

QE may well turn out to be just as disappointing in Japan as it has been in the US. In fact, although GDP growth remains sluggish and unemployment is still well above the target rate, the US Federal Reserve may soon terminate its purchases of Treasuries and mortgage-backed securities, effectively admitting that QE has failed and may now be counterproductive.

Against this backdrop, some in Japan and the US have discussed pursuing “overt finance,” by which the central bank prints money that is credited directly to the government to finance public expenditure without issuing new debt. Fed Chairman Ben Bernanke has suggested that such “helicopter money” would be a viable tool for the BOJ and other central banks to use to fight deflation – a statement that earned him the moniker “Helicopter Ben.”

If the BOJ resorts to helicopter money, Japan is in for a wild ride. The last time a developed-country central bank financed government expenditure directly was in Germany in the 1920’s. The Weimar Republic had incurred huge deficits, owing in part to meet reparations payments mandated by the Treaty of Versailles, but it was unable to borrow, so the central bank printed money. Within a few years, the Deutschemark’s value had plummeted, leading to hyperinflation and economic stagnation.

Given this experience, it is not surprising that German Finance Minister Wolfgang Schäuble has criticized advanced-country central banks’ expansionary monetary policies, arguing that QE is prompting investors to make bad decisions. As they speculate in riskier assets and accumulate more debt, the risk of an asset bubble grows. Even a small decrease in bond and equity prices could force investors to sell securities in order to raise cash to meet margin requirements. But Schäuble’s calls for developed countries to cooperate to curtail the amount of liquidity flooding international financial markets have largely fallen on deaf ears.

To be sure, the BOJ’s policy will not trigger hyperinflation in Japan. But the silent run on the yen could easily lead to a speculative attack, like that which struck Japan’s neighbors during the Asian financial crisis in the 1990’s. Japan escaped contagion, even serving as a haven from financial turmoil elsewhere in Asia, owing to its large reserves and stable currency.

But today Japan is more vulnerable. It has one of the largest public debt/GDP ratios among OECD countries, and its low rates of investment and capital formation, together with sluggish GDP growth, have made it less attractive to foreign investment.

Moreover, Japan’s trade balance is now in deficit, and, rather than boosting exports, as intended, QE in Japan has led some Asian countries to depreciate their own currencies. Competitive currency devaluation further increases the risk of a speculative attack. (It would be ironic if such an attack led to contagion and financial crisis in other Asian countries.)

I often wonder how Japanese are responding to QE. I would guess that they are no longer holding large quantities of yen, and that they have become less frugal and more willing to invest in risky assets. Prime Minister Shinzo Abe and the BOJ should find out. Only by understanding QE’s impact can Japan’s leaders prevent unintended consequences.