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Can Abenomics avoid triggering currency war?

Japanese Prime Minister Shinzo Abe’s economic agenda — dubbed “Abenomics” — seems to be working for his country.

Japanese Prime Minister Shinzo Abe’s economic agenda — dubbed “Abenomics” — seems to be working for his country.

Expansionary monetary policy is expected to inject liquidity into the Japanese economy until inflation hits the Bank of Japan’s 2 per cent target, while expansionary fiscal policy is expected to continue until economic recovery takes hold.

As a result, consumer and investor confidence is returning. The Japanese stock market has soared more than 40 per cent since November last year, when it became clear that Mr Abe would form the next government, and exports and growth are also picking up.

With a large output gap and low inflationary pressure, expansionary policies show great potential for reviving economic activity.

GOOD OR BAD FOR THE WORLD?

But other countries — including neighbouring Asian economies — fear that Japan is devaluing the yen to bolster exports and growth at their expense. Some have accused Japan of fuelling a global “currency war”.

Anticipation of aggressive monetary expansion has sharply weakened the yen, which has fallen by almost 20 per cent against the dollar in just over four months.

Of course, Japan’s escape from its 15-year deflationary trap and two decades of economic stagnation would be good for the world.

Japan remains the world’s third-largest economy, the fourth-largest trader, and the third-largest export market for neighbouring China and South Korea, which thus stand to benefit if “Abenomics” revitalises Japanese domestic demand.

More broadly, given Europe’s slide into recession and only a slow rise in world trade volume, renewed growth and stronger import demand in Japan would support global recovery.

The question now is whether Abenomics can achieve its goals without destabilising the world economy, especially neighbouring Asian economies.

Doing so requires Japanese policy makers to focus on more sustainable growth, while averting a vicious cycle of competitive devaluation and protectionism with Japan’s trade partners.

In particular, expansionary monetary and fiscal policies — which are helpful in the short term — must be accompanied by fundamental structural reforms.

STRUCTURAL REFORM IS KEY

Japan’s deflation and economic stagnation over the last two decades stemmed largely from a dysfunctional financial system and a lack of private demand. The collapse of asset bubbles in the 1990s left Japan’s financial system and private sector saddled with a huge debt overhang.

Recovery began only after the balance-sheet weaknesses in the financial, household, and corporate sectors were addressed. Sustainable growth requires sustained private-sector demand.

Monetary easing and fiscal stimulus, combined with structural measures to restore private firms to financial health, would stimulate household expenditure and business investment. Indeed, the impact of real exchange-rate depreciation on growth is likely to be short-lived unless increased corporate profits in the export sector lead to higher household consumption and investment.

And yet, risks to financial and fiscal stability could arise if higher inflation and currency depreciation were to spoil investors’ appetite for Japanese government bonds, thereby pushing up nominal interest rates.

That is why the success of “Abenomics” hinges not on the short-term stimulus provided by aggressive monetary expansion and fiscal policies — but on a programme of structural reform that increases competition and innovation, and that combats the adverse effects of an ageing population.

DANGER OF A CURRENCY WAR

Japan, of course, is not alone in using exchange-rate policies to keep exports competitive. Many emerging economies’ authorities intervene in currency markets to prevent exchange-rate appreciation and a loss of export competitiveness.

But, if Japan starts to intervene directly in global currency markets to ensure a weaker yen, neighbouring competitors will respond in kind. The danger of a currency war and protectionism should not be underestimated.

In South Korea, the government and business leaders worry that a stronger won, which recently rose to its highest level against the yen since August 2011, will hurt key export sectors, including automobiles, machinery, and electronics.

One report by a Korean research institute shows that the Korean economy will slip into recession if the yen-dollar exchange rate nears 118, its average level back in 2007.

Moreover, unlimited quantitative easing by the Bank of Japan, the Federal Reserve, and the European Central Bank also increases the risk of volatile capital flows and asset bubbles in Asian emerging economies. Chinese policymakers have raised serious concerns about the growing risks of inflation and property bubbles.

This delicate situation could escalate into further currency intervention, trade protectionism, and capital controls. Beggar-thy-neighbour policies could lower total trade volume — a zero-sum game from which no one would benefit.

After all, Japanese exports rely on emerging and developing markets, with East Asia alone accounting for nearly half of Japan’s foreign sales.

The regional economy would benefit from closer coordination of exchange-rate and monetary policies.

Mechanisms like the G-20 and ASEAN+3 (ASEAN, with China, Japan and South Korea) should be used more actively for policy dialogue and surveillance.

East Asian economies could then, over time, cooperate to enhance regional exchange-rate stability, thereby creating a more conducive environment for intra-regional trade.

Japan’s economy is moving at last, which bodes well for Asia and the world. But, despite its new vigour, the benefits of recovery could prove to be short-lived unless a sustainable and cooperative growth path is found.

ABOUT THE AUTHOR:

Lee Jong Wha, Professor of Economics at Korea University, served as Chief Economist and Head of the Office of Regional Economic Integration at the Asian Development Bank and was a senior adviser for international economic affairs to former President Lee Myung Bak of South Korea.

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