Tuesday, 19 February 2013

On Japan, Abenomics and currency wars

Welcome to helicopter money.

Last week, I discussed the controversies about crisis central banking that underpin the ongoing currency war debates at the University of Boston. What makes the currency war discussion interesting is that it signals the increased irrelevance of cherised ideas of central bank independence or smooth monetary cooperation in the international arena. Instead, this is the era of conflicts and contestation for central banks, at both national and global levels.

On the national scene, most central banks have purchased private assets and government bonds, simulatenously abandoning the pre-crisis commitment to political neutrality (a la Alesina, where coordination is suboptimal because it undermines fiscal discipline) and market neutrality (where the central bank only intervened on one market segment, the unsecured interbank market, to enforce interest rate decisions). These decisions have been controversial particularly in the Eurozone, given the political difficulties of going beyond formal mandates during crisis times.

However, central banks learnt from the Japanese experience with QE during 2001-2006 that aggressive balance sheet expansion matters as much as risk spreads.Paradoxically, Japan interpreted its own experience differently: before Abe, Bank of Japan was far less aggressive in expanding its balance sheet compared to the US and UK, so that its balance sheet at the end of 2011 had not reached its first QE volumes.

Abe has clearly set to overturn this and bring Bank of Japan's balance sheet growth in line with counterparties in high-income countries. With Abenomics, Japan re-enters the currency wars not because of some misguided domestic politicians (as many argue) but because Japan cannot afford to stay out.  The reason: exchange rates. The expansion in the balance sheet of the Bank of Japan has been accompanied by increasing exchange rate appreciation driven by safe heaven effects during the Eurozone crisis.

Moreover, aggressive QE elsewhere has seen other currencies replacing the Japanese yen as key funding currency for carry-trades. Indeed, according to the Bank of Japan, throughout the early 2000s, the JPY played an important role in cross-currency yield pursuit and in funding the shadow banking sector growth in the US:

In the lead-­‐up to the credit crisis of 2007/8, purchases of mortgage assets and related securities by hedge funds and their intermediaries was financed (at least  in part) by money that was ultimately borrowed in Japan. With the burstig of  the credit bubble and the gathering pace of the deleveraging, the hedge funds  and their intermediaries have  had  to  unwind  such  bets  by  selling  mortgage  assets and repaying their Japanese creditors. Thus, we saw in the early stages of the crisis the conjunction of a  fall in asset prices and a fall  in the US dollar. (Hattori  and Shin, 2008:23)

Carry-trades depreciate funding currencies while they last, and appreciate them when they unwind. Japan experienced both dynamics before and immediately after Lehman. It has re-entered currency wars because the spillovers from other countries' QE does not only affect emerging markets (as Brazil complains) but also high income pairs. With globalized finance, Bank of Japan has no alternative but to follow the balance sheet policies deployed aggresively elsewhere.
Full text of presentation here .

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