Thursday, October 30, 2008
Japan’s yen crisis – payback for the “carry trade” by Michael Hudson
Nowhere has this been more the case in Japan, whose economy has remained in the doldrums ever since its bubble burst in 1990. For seventeen years straight, quarter after quarter, Japanese land prices fell, and so did stock market prices – and hence, the collateral pledged as backing for loans. This quickly left Japan’s banks with negative equity. The Bank of Japan’s response was to devise a way for them to rebuild their balance sheets – to “earn their way” out of the bad loans they had made.
The policy was not to revive the faltering domestic market in Japan or its industrial corporations. From 1945 through 1985, Japanese had a model industrial banking system. But in 1985, U.S. diplomats asked Japan to please commit economic suicide. Angered by the striking success of Japanese industry, U.S. officials asked their compliant Japanese counterparts to raise the yen’s exchange rate so as to make its industrial exporters less competitive, and in due course to flood its own economy with credit so as to lower interest rates, thereby enabling the Federal Reserve to flood the U.S. market with enough cheap credit to give a patina of prosperity to the Reagan Administration. This policy – announced in the Plaza Accord of 1985 – led economist David Hale to joke that the Bank of Japan was acting as the Thirteenth Federal Reserve District and the Japanese government as the Republican Re-election Committee.
Japan flooded its economy with credit, lowering interest rates and fueling the world’s largest real estate bubble of the 1980s. The stock market also soared to reflect the rise in Japanese industrial sales and earnings. But after the bubble burst on December 31, 1989, the mortgage debts and stock that that Japanese banks held in their capital reserves fell short of the valuation needed to back their deposit liabilities. To help bail out the banks, Japan’s government urged them to engage in what has become known as the “carry trade”: lending freely created yen credits to foreign financial institutions at remarkably low rates, for these borrowers to convert into other currencies to buy bonds or other assets yielding a higher rate. If the domestic Japanese market lacked credit-worthy borrowers, let them lend to foreigners. As a new source of revenue for the banks in place of loans to domestic real estate and industry, low interest rates enabled them to flood the global economy with credit. This served global finance by providing speculators and “financial intermediaries” with an opportunity to get a free arbitrage ride.
Borrowing rates remained high within Japan itself. As veteran Japan watcher Richard Werner (author of Princes of the Yen) recently described the situation to me, “while Japanese small firms were killed by the continued refusal of banks to expand credit (and many a small firm president was killed by having to sell a kidney to the loan sharks he was forced to resort to), foreign speculators received ample yen funds for a pittance.” The silver lining to this credit creation was that Japanese exporters were aided as the conversion of yen into foreign currencies drove down the exchange rate. (Yen credit was “supplied” to global currency markets, and was spent to buy and hence bid up the price of euros, dollars, sterling and other currencies.)
So the yen remained depressed, helping Japanese sales of consumer goods, while foreign borrowers were enabled to ride their own wave of asset-price inflation. Speculators could borrow at only a few percentage points interest in Japan, and convert their debt into foreign currency and lend to equally desperate countries such as Iceland at up to 15 per cent.
Hundreds of billions of dollars, euros and sterling worth of yen were borrowed and duly converted into foreign currencies to lend out at a markup. Arbitrageurs made billions by acting as financial intermediaries making income on the margin between low yen-borrowing costs and high foreign-currency interest rates. As Ambrose Evans-Pritchard wrote over a year ago in the Financial Times, “the Bank of Japan held interest rates at zero for six years until July 2006 to stave off deflation. Even now, rates are still just 0.5 per cent. It also injected some $12bn liquidity every month by printing money to buy bonds. The net effect has been a massive leakage of money into the global economy. Faced with a pitiful yield at home, Japan's funds and thrifty grannies shoveled savings abroad. Banks, hedge funds, and the proverbial Mrs Watanabe, were all able to borrow for near nothing in Tokyo to snap up assets across the globe. BNP Paribas estimates this "carry trade" to be $1,200bn.”
All this was conditional on the ability of lenders to get a continued free ride. Now that the free lunch is over, Japan’s postindustrial mode of rescuing its banking sector is coming home to roost. It is doing so in a way that highlights the inherent conflict between finance capitalism and industrial capitalism. Whereas industrial expansion is supposed to keep going – and can continue to do so as long as markets keep pace with production – debt bubbles end, usually abruptly as we are seeing today. Now that Iceland has gone bust, Hungary looks like it is following suit.
As global currency markets no longer provide the easy pickings of the last decade, the yen carry trade is being wound down. This involves converting Icelandic currency, euros, sterling and other non-Japanese currencies back into yen to settle the debts owed to Japanese banks. This repayment – and hence re-conversion into yen – is pushing the yen’s price up. This threatens to make Japanese exports higher-priced in terms of dollars, euros and sterling. Last week, Sony forecast that its earnings will fall as a result, and other Japanese companies face a similar squeeze in sales, not only from rising yen/dollar prices but from the global slowdown resulting from two decades of pro-financial anti-labor economic policies.
Evans-Pritchard rightly accused the world’s central banks of having created this mess. “It was they – in effect governments – who intervened in countless complex ways to push down the price of global credit to levels that warped behavior, as the Bank for International Settlements (BIS) has repeatedly noted. By setting the price of money too low, they encouraged debt and punished savings. The markets have merely responded with their usual exuberance to this distorted signal. Private equity was tempted to launch a takeover blitz at a debt-to-cashflow ratio of 5.4 because debt was made so cheap. The US savings rate turned negative because interest rates were held below inflation.” He should better have said, asset-price inflation. Gains for wealth-holders at the top of the economic pyramid polarized economies. What was rising for the bottom 90 per cent was debt, not asset-price gains from easy money.
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Posted by nickglais at 2:34 PM