Xie Yaxuan/Wen All history is contemporary history, and all history is intellectual history.
On October 21, 2022, the yen fell to its weakest level since 1990 at 151.9420. At 9 p.m. Beijing time on the 21st, the yen exchange rate began to strengthen rapidly, closing at 147.6505, and it was reported that this was caused by the Bank of Japan working overnight to intervene in foreign exchange.
Previously, Japan's Ministry of Finance and the Bank of Japan intervened in the foreign exchange market by buying yen and selling dollars on September 22. Affected by this, the yen against the dollar once rose to 139.9265 after touching 145.8945 yuan, with an intraday amplitude of more than 3.1%.
Majin Kanda, financial officer of the Japanese Ministry of Finance, said on the same day: "Excessive disorderly fluctuations in the exchange rate cannot be tolerated." This is Japan's first foreign exchange intervention to sell dollars in 24 years, in order to avoid an excessive weakening of the yen exchange rate. The last intervention to sell dollars was in June 1998, at the height of the Asian financial crisis. The most recent foreign exchange intervention occurred 11 years ago, in November 2011, but in the opposite direction, the operation was to buy US dollars and sell yen in order to avoid the yen exchange rate becoming too strong, and the governor of the Bank of Japan (the central bank of Japan, hereinafter referred to as "the Bank of Japan") at that time was Mr. Shirakawa Yoshiaki.
Chart: Japan's 10-year government bond rate was above 0.25% for the second consecutive trading day on October 20
Source: WIND, China Merchants Securities
First, the market seriously doubts whether the BOJ's foreign exchange intervention can be effective
The market does not buy this foreign exchange intervention. The day after the intervention, the yen settled at 143.3530, down 0.69% from the close of 142.3755 on October 22. Although the dollar index has recently retreated from a high of 114.7861 to 113.3095 on October 20, the yen weakened against the dollar to 151.9420, a historical low since 32 years in the second half of 1990. The market's doubts about the effectiveness of the intervention of the Japanese government and the central bank mainly focus on the following three points: First, is the size of Japan's foreign exchange reserves sufficient to meet the needs of intervention? Second, who is the main policy conflict between the Bank of Japan's loose monetary policy and exchange rate intervention? Third, the more fundamental question is that the pressure on the depreciation of the yen comes from the divergence of monetary policies between Japan and the United States. Should we wait for the Fed to ease or for the Bank of Japan to start normalizing monetary policy?
Chart: Japan's foreign exchange reserves experienced the largest decline in history in September 2022
Source: WIND, China Merchants Securities
To be clear, foreign exchange intervention is decided by the Ministry of Finance of Japan. According to Article 40, Paragraph 2 of the new Bank of Japan Law, the authority to intervene in the foreign exchange market in Japan belongs to the government, and the Bank of Japan is engaged in the trading of foreign currency assets for the purpose of stabilizing the exchange rate in its capacity as the executor of the Ministry of Finance (later the Ministry of Finance). In short, the Ministry of Finance is responsible for foreign exchange market intervention decisions, and the Bank of Japan is responsible for foreign exchange market intervention enforcement. Shirakawa said: "It should be 'government intervention in the foreign exchange market'. The Bank of Japan is only responsible for monitoring foreign exchange market movements on a daily basis and providing advice to the Ministry of Finance on foreign exchange market intervention. It is up to the Chancellor of the Exchequer to intervene or not, and at which exchange rate level". Therefore, when discussing the current yen issue, Finance Minister Shunichi Suzuki, Financial Officer Mato Kanda, and Bank of Japan Governor Haruhiko Kuroda are all key figures.
Is $1.4 trillion in foreign exchange reserves enough? This concern arises mainly for two reasons:
On the one hand, the current intervention is to stop the depreciation of the yen, requiring the interventionist to sell foreign exchange reserves. The reserves are getting smaller and smaller, and theoretically there is a possibility of exhaustion. Although the Ministry of Finance did not disclose the scale, media reported that the intervention on September 22 used 2,838.2 billion yen in reserves, a record high. The $1.4 trillion in foreign exchange reserves cannot be said to be insufficient, but after falling by $31 billion in August, foreign exchange reserves fell by a record $54 billion in September. This is completely different from the intervention situation under Shirakawa Masaaki in 2011, when in order to prevent the yen from appreciating, the intervener was required to buy foreign currency to increase his holdings of foreign exchange reserves, and theoretically there was no upper limit on the size of the reserves, and he could intervene indefinitely.
On the other hand, and more importantly, in the past 10 years, the Bank of Japan has continuously adopted unlimited monetary policy measures such as quantitative and qualitative easing and yield curve control to expand its balance sheet, and the ratio of foreign exchange reserve assets to the size of the central bank's balance sheet is not what it used to be. As of June 2022, the BOJ's balance sheet size exceeded 700 trillion yen, more than tripling from the beginning of Kuroda's presidency (April 2013) and far exceeding the effect of the early unconventional monetary policy period. The expansion of central bank balance sheets caused by quantitative easing during the Rapid Waters Era was only 44.8%, and the expansion of Shirakawa's comprehensive monetary easing (CME) period was only 53.2%. The ratio of Japan's foreign exchange reserve assets to the size of the BOJ's balance sheet fell from a peak of 1.06 in June 2007 to 0.84 when Governor Toshihiko Fukui left office in April 2008 and to 0.67 when Yoshiaki Shirakawa left office in March 2013. The acceleration of central bank balance sheet expansion since Kuroda took office, pushing the ratio down at a faster pace. As of June 2022, the ratio of Japan's foreign exchange reserves to the size of the central bank's balance sheet has fallen to 0.23. While Japan's foreign exchange reserves are growing steadily, they have shifted significantly compared to the faster expansion of domestic liquidity. To put it simply, in 2007, if the BOJ had a one-on-one draw with its market rivals, now it needs to be one against five, and the strength can be judged.
Chart: The ratio of Japan's foreign exchange reserves to the central bank's balance sheet continues to decline
Source: WIND, China Merchants Securities
The good news is that both theory and practice suggest that forex intervention works in the short term. Research on the effectiveness of foreign exchange interventions has a long history. In The Changing Fortunes, Volcker refers to the conclusion of the 1983 Justgenson Report that intervention works, which provides think tank and confidence support for the Plaza Accord. A July 2022 working paper by the International Monetary Fund (IMF) looked at foreign exchange interventions in 26 advanced and emerging economies between 1990 and 2018 and found that interventions aimed at reducing exchange rate distortions caused by long-term macroeconomic factors were unlikely to be effective. However, interventions can effectively correct short-term cyclical real exchange rate distortions, and the greater the distortion, the longer the duration of unilateral interventions, and the more significant the intervention effect. In addition, the study found that the intervention of selling foreign exchange (preventing the depreciation of the local currency) appears to be more effective than buying foreign exchange (preventing the appreciation of the local currency). In the relatively liquid foreign exchange market, the intervention effect is poor. With this research support, Japan's foreign exchange intervention may be useful in the short term and locally, at least as a "deterrent" effect.
Chart: The yen appreciated rapidly after the intervention in 1998
Source: Bank of Japan, China Merchants Securities
Kuroda is well aware of these issues. After graduating from the Faculty of Law at the University of Tokyo in 1967, Kuroda joined the Ministry of Finance (now the Ministry of Finance), where he was mainly responsible for national taxation and international finance. He served as Director General of the International Finance Bureau of the Ministry of Finance of Japan from 1997 to 1999 and Finance Officer of the Ministry of Finance from 1999 to 2003. Kuroda has "Mr. Yen" (Mr. Yen). Yen), known as Sakakibara Hideshi, is in close contact with the heads of financial and monetary authorities in various countries. Although Kuroda is an advocate of a free exchange rate system and is known as the godfather of money, he clearly understands that markets are not always rational. In 1998, the worst of the Asian financial crisis 24 years ago, Kuroda successfully directed the intervention with the Federal Reserve to stabilize the yen's exchange rate behind the scenes. During this period, there were 38 operations of selling US dollars to buy yen, and the maximum intervention amount at that time was 2,620.1 billion yen on April 10, 1998 (second only to September 22, 2022), and the total intervention amount was 5 trillion yen. Due to a combination of factors, the yen reversed after reaching a low of 147 in August 1998 and turned to rapid appreciation.
Figure: The Plaza Accord of 1985 is one of the few successful examples of international policy coordination
Source: WIND, China Merchants Securities
Intervention is not destined to be an end. A number of key Japanese figures expressed their views on the intervention itself (table below). The Prime Minister, the Finance Minister and the Financial Officer all emphasized that the goal of the intervention was to avoid excessive, violent and large fluctuations in the foreign exchange market. However, the financial minister emphasized that "no comment on the level of the yen exchange rate" shows that the intervention does not have such a specific price target as 150. Kuroda previously stressed that "the continuous depreciation of the yen makes it difficult for companies to formulate long-term development plans and increases the uncertainty of economic prospects, which is negative for the Japanese economy." But in response to market doubts, is the yen's exchange rate policy compatible with loose monetary policy? Kuroda's latest statement directly answers, "Japan is not suitable for raising interest rates," and his subtext is that easing must be carried out to the end, regardless of the yen's exchange rate.
Table: Statements of key figures on the yen exchange rate since October
Source: Cailian, WIND, China Merchants Securities
Second, there is a conflict between the objectives of the BOJ's foreign exchange intervention and loose monetary policy
The Bank of Japan's act of buying yen to intervene while buying government bonds and putting yen is tantamount to "left-right fighting." The metaphor for the image of monetary policy tightening is pumping and releasing water. The Bank of Japan's act of selling dollars to buy yen in the foreign exchange market is equivalent to "pumping" and recovering yen liquidity from the market; In order to maintain loose monetary policy and curb the 10-year treasury bond yield from breaking through the 0.25% ceiling, large-scale bond purchases are equivalent to "releasing water" and releasing yen liquidity into the market. Comparatively speaking, the scale and speed of water release are much larger than the scale and speed of pumping. If the Bank of Japan chooses between exchange rate policy and monetary policy, history and lessons tell us that Kuroda is most likely to choose to stick to loose monetary policy.
Table: Past Governors of the Bank of Japan
Source: Bank of Japan, China Merchants Securities
Modern research on the Great Depression shows that monetary policy is far more important than exchange rate policy. Conventional wisdom is that the phenomena of the Great Depression seem to indicate that exchange-rate policy matters: the later countries abandon the gold standard, the deeper their economies fall into depression and the slower their recovery. Traditional research suggests that this is because exchange rate policies, i.e., fixed exchange rates and excessively strong exchange rate levels, lead to a deepening and prolonged depression. However, the latest research by American international finance historian Eichengreen and others believes that the Great Depression was mainly due to the fact that countries did not implement a policy of greatly expanding domestic credit, and the gold standard and fixed exchange rate or exchange rate policy were the factors restricting monetary policy at that time. Therefore, monetary policy is more critical and important than exchange rate policy. As this year's Nobel laureate, Bernanke, celebrated Friedman's 90th birthday in 2002: "You were right about the Great Depression, and we [the Federal Reserve System] did it wrong."
Chart: Trade surplus and weak yen coexisted between 1978 and 1985
Source: WIND, China Merchants Securities
As an export-oriented country, Japan has a long history of attaching great importance to exchange rate policy. Due to the importance of exports to the economy, the long-standing belief that yen appreciation is evil has taken root. Based on the understanding of the situation before the opening of financial markets, old-school economists even believe that there is a decisive relationship between the yen exchange rate and the trade balance. For example, Mr. Isamu Miyazaki, a Japanese economist and former director of the Economic Planning Agency, wrote in "Records of Witnesses of Japan's Economic Policy": "Japan... The policy of expanding domestic demand is introduced in the hope of narrowing the trade deficit, and the exchange rate will naturally fall as the surplus shrinks." The reason why Koo Chaoming disagreed with the proposal of economists such as Krugman in the 90s to respond to recession through the depreciation of the yen is also because he believes that only trade-deficit countries can use exchange rate depreciation to cope with balance sheet recessions, such as South Korea, Thailand and Malaysia in the 1997 Asian financial crisis. Japan, as the largest trade surplus country at the time, could not do this, and the devaluation would bring strong opposition from trading partners represented by the United States. Interestingly, old-school economists apparently ignore the fact that Japan's large trade surplus with the United States coexisted with a weak yen in the period leading up to the Plaza Accord between 1980 and 1985.
Figure: Changes in the output gap as measured by the Bank of Japan
Source: Bank of Japan, China Merchants Securities
Avoiding the reversal of exchange rate policy and monetary policy is a major lesson of Japan's bubble crisis. Due to the excessive emphasis on exchange rate policy and the biased understanding of the determinants of exchange rate, the exchange rate policy objective overrides the monetary policy target, which has largely contributed to Japan's bubble economy. Shirakawa believes that after the Plaza Accord, "there was a strong demand from the export industry to prevent the yen from appreciating, and in the government's view, international policy coordination (including continued loose monetary policy) was needed to prevent the yen's appreciation."
He explained, "Japan has long adhered to an accommodative monetary policy due to excessive concerns about a recession caused by the appreciation of the yen. The lesson to be learned from the Japan-US trade friction is that proper management of monetary policy is essential. The purpose of monetary policy is to create a stable financial environment consistent with sustained economic growth, that is, price stability and a stable financial system, not to eliminate trade frictions and curb exchange rate appreciation. In this context, it is necessary to be vigilant about the widening of financial imbalances, such as rising asset prices and rising debt".
A typical example of this is 1987, when the Bank of Japan significantly raised the interest rate on loans to commercial banks. However, on October 19, 1987, the US stock market crashed (Black Monday), and in the face of events and pressure from the United States, Japan again compromised to set the discount rate at a low level of 2.5%. Mr. Wu Jinglian in September 2022, "What China Learns from the Lessons of the Japanese Economy?" The same view is held in the article. From a policy perspective, it is also possible to broadly divide the different views into two categories: one is that Japan's acceptance of the Plaza Accord and the consequent appreciation of the yen were the basic causes of Japan's economic downturn. Another view is that Japan's "lost twenty years" occurred five years after the Plaza Accord, interspersed by the rapid expansion of an asset bubble, which can only be attributed to the excessive reaction of the macro authorities to the appreciation of the yen. The implementation of extremely loose macroeconomic policies for a long period of time has led to a sharp rise in asset prices supported by high leverage and the formation of bubble economies. In their view, the subsequent bursting of the bubble and the resulting balance sheet crisis actually started here." Whether the lesson of Japan's bubble crisis is whether it is "allowing the yen to appreciate" (exchange rate policy) or whether "the authorities' attempt to maintain prosperity with extremely expansionary fiscal and monetary policies has pushed asset prices soaring, which ended in the inevitable bursting of the bubble and Japan's fall into a balance-sheet crisis" (monetary policy). Mr. Wu himself preferred the latter view and was explicitly agreed by Mr. Toyo Xingten, one of the main Japanese negotiators who was the director of the International Finance Bureau of the Ministry of Finance at the time of the Plaza Accord negotiations at a seminar in Tokyo, Japan, in 2008. Based on this, a basic policy lesson or corollary is that when the direction of exchange rate policy and monetary policy requirements is inconsistent, the priorities cannot be reversed, monetary policy should be the lead, and monetary policy cannot be controlled by exchange rate policy.
Figure: Japan's bubble economy in the 1980s was also the result of three phases of superposition
Source: Xiao Lisheng, Fan Xiaoyun, et al. "Asset Price Bubbles in China and Japan from the Financial Cycle"
Japan's bubble economy in the 1980s was also the result of three phases of superposition. As an aside, everyone will notice the extent to which Japan's asset price bubble inflated in the 1980s, and the increase and fall of asset prices were extremely rare, although the negative impact was equally far-reaching and rare. However, there are still different opinions about the reasons behind it. I believe that the reason why Japan's asset prices rose so much in the 1980s was the result of the superposition of the domestic economic cycle, the domestic financial cycle, and the global financial cycle, and the subsequent research will be carried out accordingly.
Kuroda admits that monetary policy is the mainstay, and the exchange rate is not the policy target. Not surprisingly, Kuroda, who has a deep understanding of Japan's economy and history, told a press conference after the September 22 monetary policy meeting that Japan's monetary policy is not aimed at the exchange rate. "There are many factors that affect the exchange rate, and the reasons for the depreciation of the yen are both unilateral and speculative. The continued depreciation of the yen has made it difficult for companies to formulate long-term development plans and raised uncertainty about the economic outlook, which is negative for the Japanese economy. Kuroda also believes that it is necessary to pay full attention to the impact of financial and foreign exchange market movements on the Japanese economy and prices. At a press conference in Osaka City on September 26, Kuroda said, "[Intervention] is an appropriate measure to impose excessive fluctuations [in the yen exchange rate]."
A weak yen is in fact consistent with the goal of loose monetary policy. Kuroda's many years of experience in the Ministry of Finance and the Ministry of Finance have given him a deep understanding of the role of a weak yen in promoting the effects of the Bank of Japan's loose monetary policy and countering deflation. For example, in his speech to the Diet on March 25, 2022, Kuroda Haruhiko noted that "a weak yen is generally good for the economy and the Bank of Japan will continue to implement stimulus policies." Objectively speaking, the weakness of the yen is consistent with the goal of Kuroda's insistence on loose monetary policy, and it can even be said that it is the inevitable result of loose monetary policy.
Chart: The effective exchange rate of the yen is also at its lowest level since 1990
Source: WIND, China Merchants Securities
In summary, relying on foreign exchange market intervention and exchange rate fluctuations, Kuroda has maintained the effectiveness of monetary policy (mainly me). After the collapse of the Bretton Woods system, theoretical studies believed that flexible fluctuations in exchange rates would make the domestic economy completely unaffected by foreign conditions. That is, developed countries can maintain the effectiveness of monetary policy under the free flow of international capital by implementing floating exchange rates. But in fact, Eckengreen pointed out that 50 years of practice shows that the international diffusion effect of fixed exchange rates is indeed higher than that of floating exchange rates, but the isolation effect of exchange rate fluctuations is not as expected. A more extreme view comes from Helene Rey, professor of economics at London Business School, who simply argues in The Dilemma Not the Trilemma: The Global Financial Cycle and the Effectiveness of Monetary Policy that exchange rate fluctuations alone are not enough to achieve the effectiveness of monetary policy, but must be supplemented by regulation of international capital flows. Japan's current practice is a case study of this, and so far, Kuroda has managed to maintain a loose monetary policy different from that of the Federal Reserve under the conditions of free capital flow. But problems also arise, on the one hand, the rapid depreciation of the exchange rate has caused concern and worry. If the stance of loose monetary policy does not change, foreign exchange market intervention can be called a boiling soup at best, and investors seriously doubt the credibility of the Bank of Japan to stabilize the yen exchange rate through intervention. On the other hand, as of October 12, 2022, Japan's latest issuance of 10-year government bonds failed to be traded in Japanese mutual securities for four consecutive trading days, for the first time in history. Japan's 10-year government bond interest rate has repeatedly stood above the 0.25% range. With increasing doubts and financial market pressures, how long can such "monetary policy effectiveness" be maintained?
Chart: Behind the fluctuation of the yen exchange rate is the change in the direction of Japan's monetary policy divergence
Source: WIND, China Merchants Securities
Third, the dilemma faced by the BOJ lies fundamentally in the divergence of monetary policy between Japan and the United States
The root cause of the current weakening of the yen lies in the divergence of economic fundamentals and monetary policies in Japan and the United States. It is worth considering that in the nearly 15 years since 2008, the Bank of Japan has adopted ultra-loose monetary policy in both the "Comprehensive Easing Monetary Policy (CME)" promoted by Masaaki Shirakawa and the "Quantitative Easing (QQE)" pursued by Haruhiko Kuroda. During this period, the yen exchange rate experienced a period of appreciation from 2007 to 2012, as well as a depreciation phase from 2013 to 2014 and in 2021, especially since August 2021. If the Bank of Japan's loose monetary policy stance has not changed, the yen is still the same yen, what is changing behind the exchange rate against the dollar from a significant appreciation to a sharp depreciation? Shirakawa pointed out that "there is a relatively high correlation between the two-year interest rate differential between the US and Japan government bonds and the exchange rate." "A slap does not sound", the exchange rate issue is naturally an international problem. The strength of the yen exchange rate is determined not only by Japan's economic fundamentals and monetary policy, but also by the divergence of economic fundamentals and monetary policy between Japan and the United States.
Chart: Japan-US interest rate differentials are highly correlated with the yen exchange rate
Source: WIND, China Merchants Securities
From 2007 to 2012, Shirakawa faced shocks from the U.S. wide currency and the appreciation of the yen. Shirakawa paid particular attention to the impact of international factors on Japan's economic and financial environment, including monetary policy, concluding that "in practice, even with the implementation of a flexible exchange rate regime, the United States still exerts a decisive influence on the monetary policy stance of many countries (if it is inferred from this that Japan cannot maintain its monetary policy divergence with the United States, as discussed below)." The situation experienced by Shirakawa from 2007 to 2012 is typical. "During the global financial crisis, advanced economies actively lowered policy interest rates, but Japan had little room to lower interest rates, so interest rate spreads narrowed and the yen appreciated. Because the yield curve of Japanese government bonds is more constant than in other countries, the policy tools are insufficient to resist the forces of yen appreciation." Since the second half of 2006, as the Federal Reserve has entered a stage of easing monetary policy, US bond yields have fallen even more, and the passive narrowing of the US-Japan interest rate differential has brought about a rapid appreciation of the yen. The yen fell from a high of over 120 against the dollar in 2007 to an all-time low of 75.72 at the end of October 2011. The appreciation of the yen has intensified the pressure on export enterprises and domestic deflationary pressure, and the appreciation of the yen has been listed as the first of the "six hardships" by enterprises. Calls within the ruling party and export companies to curb the yen's appreciation are growing. In order to curb the yen's appreciation, the Bank of Japan added 30 trillion yen in open market operations at the end of August 2010 to increase monetary policy easing. On the other hand, it intervenes in the yen exchange rate by entering the market many times. For example, after the Great Hanshin Earthquake in March 2011, the Japanese government bought US dollars on March 18 and sold yen on August 4 to intervene in the depreciation of 692.5 billion yen and 4,512.9 billion yen, respectively. From October 31, 2011 to November 4, 2011, the G7 issued a joint statement to intervene, and the Japanese government intervened for 9 trillion yen. At this stage, the scale of intervention to curb the appreciation of the yen was the largest in history, initially reversing the trend of yen appreciation.
Chart: The shift in the Fed's monetary policy spreads in May 2013 affected the yen exchange rate
Source: WIND, China Merchants Securities
However, what really turned the yen around in 2013 was the change in the Fed's monetary policy stance. Or rather, the real change comes from the convergence of the divergence of monetary policy between Japan and the United States. This is due to two points: First, Kuroda's quantitative and qualitative easing monetary policy (QQE). Due to his conservative attitude on monetary policy, Shirakawa, who grew up all the way from the Bank of Japan, was questioned by key Japanese government officials, including Prime Minister Shinzo Abe, and Abe said very directly: "I hope there is someone who agrees with our views on monetary policy." His successor, Haruhiko Kuroda, who has long worked in the Ministry of Finance, has a stronger execution on the path of loose monetary policy and faithfully practiced the "three arrows" of Abenomics. The second is the change in the Fed's monetary policy stance. IN MAY 2013, FED CHAIRMAN BERNANKE ANNOUNCED THAT HE WAS CONSIDERING TAPERING (TAPER) QUANTITATIVE EASING. Since then, the market's expectations for the Fed's marginal contraction of loose monetary policy have become stronger and stronger, the interest rate of US Treasury bonds has gradually climbed, and the interest rate differential between Japan and the United States has gradually widened. The yen gradually turned from strong to weak, weakening against the dollar from 2010 to 12 (75,90) to 2013-14 (90,120).
Chart: The Fed's interest rate cut in 1998 helped stabilize the yen
Source: WIND, China Merchants Securities
The effect of Japan's intervention in stabilizing the yen exchange rate in 1998 is also not unrelated to the adjustment of the Fed's monetary policy. Let's take a look at the intervention to deal with the depreciation of the yen, which is close to the current situation. Japan's foreign exchange market intervention to prevent the depreciation of the yen in June 1998 was able to achieve obvious results first, because the joint intervention of Japan and the United States had a significant impact on market expectations, and second, because the Fed cut interest rates by 0.25 basis points three times in a row on September 29, October 15 and November 17, 1998, which brought about the convergence of monetary policy divergence. In particular, the October rate cut was a special cut by Fed Chairman Alan Greenspan between meetings using his chairman's prerogative in response to the Southeast Asian financial crisis and the Russian crisis. It can be said that the Fed's interest rate cut has narrowed the interest rate differential and monetary policy difference between Japan and the United States, and has played a significant role in stabilizing the yen exchange rate.
In summary, the convergence of the divergence of monetary policy between Japan and the United States is the premise for the stability of the yen exchange rate. The convergence of economic fundamentals and policy divergence in Japan and the United States is equivalent to drawing wages from the bottom, and before this situation, foreign exchange market intervention is to some extent to stop boiling. The convergence of monetary policy in Japan and the United States is either a loosening of the Fed's monetary policy stance, a tightening of the Bank of Japan's monetary policy stance, or both. Let's start with the Federal Reserve.
Chart: Wages in Japan have begun to recover
Source: Bank of Japan, China Merchants Securities
4. Where will the divergence of monetary policy between Japan and the United States go?
The Fed's current policy focus is on controlling inflation in the United States, and it is too early to talk about a policy inflection point. The August 2022 US inflation data exceeded expectations, making market investors more aware of the persistence of the current round of inflation in the United States. In his Jackson Hole speech, Fed Chairman Jerome Powell quoted former Chairman inflation crusader Volcker as saying to stay at it and fight inflation. While Fed Vice Chairman Brainard's September 30 speech highlighted concerns about international spillovers, financial vulnerabilities, and financial stability of monetary policy contraction in a high-inflation environment, she also stressed that "the focus of monetary policy is, of course, to restore price stability in a high-inflation environment." As mentioned earlier, in the face of the 1998 Southeast Asian and Russian financial crises, then-Federal Reserve Chairman Alan Greenspan once said that "this 'financial turmoil' is of such magnitude that the United States cannot maintain prosperity despite the enormous pressure on the world economy", thus cutting interest rates three times in a row. But it was also because Greenspan was worried that contagion channels such as the Quantum Fund could endanger U.S. financial markets so he decided to act. Until interest rate hikes and stagflation fears further dampen U.S. financial markets and investor confidence, it is difficult for the Fed to signal monetary policy easing. It is more likely that inflation will fall slowly, the Fed will need to move back to end the rate hike process, and it will take time for the monetary policy inflection point to appear.
Chart: Most countries around the world did not predict the arrival of this round of inflation
Source: Bank for International Settlements, China Merchants Securities
The global nature of this round of inflation may further delay the Fed's easing of monetary policy. The current US inflation has a strong background and the global factors behind it. Professor Ge Jianxiong once pointed out in his evaluation of the advantages and disadvantages of the canal that the Grand Canal (China) connects different river systems that were originally parallel to the east and west, which not only facilitates navigation, but also leads to the spread of flood and drought disasters across water systems, small tributaries silt up when water is scarce, and flood in multiple basins during floods. As with globalization, deflation and inflation are passed across the globe. Whether a country's price level is inflation or deflation, it is affected by both the fundamentals of its economy and global factors. Recent research by the European Central Bank found that after extracting the slow variables in the inflation trend, inflationary pressures in the eurozone are highly consistent with, or even greater than, the United States, highlighting the global nature of inflation. Based on the supply and demand analysis, the ECB emphasized that current inflation is driven by global factors, the integration of many large emerging market economies into global value chains before the pandemic, and the huge global excess savings and unusually strong global excess demand for many internationally traded goods and commodities have contributed to the upward pressure on prices worldwide. The ECB even believes that the transformation of US consumer preferences from services to physical goods after the epidemic has pushed up the current round of global and eurozone inflation. If global factors are indeed an important cause of current inflation, then this will undoubtedly further aggravate the difficulty of central banks, including the Federal Reserve, to complete the task of fighting inflation. Because central banks consider the fundamentals of their own economies when fighting inflation, it is politically incorrect to adopt excessive tightening policies at the expense of their own economies to fight inflation from the goal of global inflation. From a global perspective, central banks such as the Federal Reserve are pumping water, but at the same time, central banks are stepping up to release water, and the results can be imagined. In view of this, inflation expectations have begun to spiral out of control globally, signs of a wage-price spiral are becoming more and more obvious, and inflation momentum is spreading across many countries, which is likely to further delay the Fed's easing of monetary policy.
Chart: Japan's consumer price index (excluding fresh food) reached 2.8% in August
Source: Bank of Japan, China Merchants Securities
Kuroda would be unusually cautious about tightening monetary policy. Let's go back to the Bank of Japan. Investors familiar with Japan should speculate that Kuroda must be very cautious in taking measures to tighten monetary policy at this time. On the one hand, this is because the idea of deflation still has a profound impact. After the bubble crisis in the 1990s, Japan fell into a deflationary quagmire for a long time. In recent years, President Haruhiko Kuroda has been preaching "Fighting Deflation: Japan's Experience and Challenges" with the ambition of fighting deflation. "With a hammer in his hand, his eyes are full of nails." Kuroda would rather underestimate inflation than contract monetary policy early. On the other hand, the lesson of Yasushi Mieno, then governor of the Bank of Japan, who burst the bubble in 1989, is even more profound. Mie Noya has been growing up in the Bank of Japan, and since the 80s, he has been the vice president of the Bank of Japan, and belongs to the cadres trained by the Bank of Japan. In the late 80s, he dared to face the ballooning asset price bubble and publicly said, "Japan is like sitting on a dry firewood." At the beginning, all sectors of Japanese society regarded Mie Noyasu as the "Heisei Onihei" (ask the Fang family, "Onihei" was a ruthless special police officer in the Edo period) to control the bubble, and praised his methods. However, with the emergence of a series of economic difficulties after the bursting of the bubble, it was gradually regarded as the "evil official" that led to the economic collapse. It is recorded that when Yasushi Mie Noshi died, then governor of the Bank of Japan, Shirakawa Yoshiaki, only stated that "this is a great loss." But in fact, in his memoir "Turbulent Times," Shirakawa recounted his memories of writing speeches for President Mie many times as director of the Planning Division. It also records that when Mie Noyasu was seriously misunderstood by the outside world during Shirakawa's tenure, he sent a handwritten color paper letter, quoting Xunzi's famous saying, "A gentleman's learning is not for the sake of understanding, for poverty but not for poverty, worry but not for the sake of will, and knowing that misfortune and blessing will always begin without confusion", and encouraged Shirakawa. As Kuroda, who was born in the Ministry of Finance, he obviously wants to be a little less "bookish" and try to avoid repeating the mistakes of being a governor of the central bank.
Chart: Current inflation trends in Japan and the United States are in line with each other
Source: WIND, China Merchants Securities
"It's not the inflation we want". Although subjectively reluctant to contract monetary policy, the situation is stronger than people, and the key to the future may cause the Bank of Japan to change its monetary policy stance is the trend of inflation in Japan. On this point, Kuroda and Shirakawa have very different views. If Shirakawa follows his reasoning, Japan's inflation level will rise with the rise in global inflation. In November 2021, Shirakawa argued in a speech entitled "The 50th Anniversary of the Nixon Shock, Time to Explore a New Monetary Policy Framework" at the 3rd Bund Finance Summit, arguing that "the impact of the global output gap (rather than the domestic output gap) on inflation is increasing"; "Domestic monetary conditions are beginning to be determined by global monetary conditions, which in turn are increasingly influenced by the monetary policies of major countries, especially key countries." So far, Shirakawa's reasoning has been verified, and Japan's inflation level has risen from 0.5% at the beginning of the year to the latest 2.8% in August, exceeding the inflation target of 2%. But Kuroda first refuses to acknowledge the existence of inflation, and then stresses that "this is not the inflation we want," that is, inflation mainly caused by rising commodity prices has not yet led to an increase in Japan's service prices and wages, and the central bank does not need to respond. He expects inflation to fall back below the 2% target in 2023 and insists on not changing his monetary policy stance. However, a careful analysis of the minutes of the Bank of Japan's interest rate meeting so far this year clearly shows the change in the bank's view on the trend of inflation in Japan. In January 2022, the minutes observed a rise in inflation in Japan, but stressed that the risk of future price movements is "balanced", that is, there is no risk of continuous rise or continuous decline, which has changed significantly from the main fears of deflation in the past. On May 13, 2022, Kuroda reiterated in a speech to the House of Representatives and the Committee on Investigation of Domestic and International Situations that the Bank of Japan would not follow the Fed in tightening monetary policy. "Japan's economic situation is completely different from that of Europe and the United States, which have recovered from the pandemic and are suffering from higher inflation." Although the minutes of the June and July 2022 interest rate meetings had to follow the repeated rise in inflation exceeding expectations, they stressed that wages in Japan have not yet continued to rise, and Japan's labor market is still relatively "relaxed" unlike that in Europe and the United States. Japanese companies have long been accustomed to a deflationary environment, and their decision to raise prices is relatively prudent. It is important to note that the minutes of the September interest rate meeting released on October 3 still emphasize that Japan is trapped by years of deflation, so inflation expectations are far more stable than in Europe and the United States, and Japan's labor market is different from that of the United Kingdom and the United States. But to start the reminder: pay attention to the expansion of the phenomenon of corporate price increases, evaluate the imported inflation risks caused by the yen exchange rate level "modestly and without prejudice", and pay attention to the trend of rising wages caused by labor shortages. Despite Kuroda's reluctance to change his monetary policy stance until his term of office in April 2023 arrives, the latest minutes appear to have laid the groundwork for a change. The next interest rate meeting of the Bank of Japan is October 27-28, 2022.
Chart: Kuroda believes Japan's aggregate demand curve is different from other economies
Source: Bank of Japan, China Merchants Securities
What other tricks can Kuroda have before the policy divergence between Japan and the United States converges? Although the Bank of Japan does not have an absolute advantage in foreign exchange intervention, it is speculated that the experienced Kuroda may have the following three directions: First, adhere to a flexible exchange rate system. This is evident from the fact that the yen has fallen to a low of more than 150 since 1990. The more depreciated, the recovery can be faster and more powerful. Second, use large foreign exchange reserves. As mentioned above, the advantage of 1.4 trillion foreign exchange reserves has weakened, but it should not be underestimated. Kenny Rogoff believes that from the experience of Asia, it may not only be the "three-way dilemma", but also foreign exchange reserves are very important. If the capital market is free to flow and there are high foreign exchange reserves, exchange rate stability can be maintained through a more flexible exchange rate regime. Short-term intervention to maintain exchange rate stability remains a policy option. Third, coordinate joint intervention with developed countries led by the United States. The June 1998 intervention was a Japan-U.S. joint intervention, and in 2011, the G7 issued a joint statement. "One good man and three gangs", joint intervention in the foreign exchange market can achieve twice the result with half the effort. Without the cooperation of developed countries such as the United States, intervention is likely to backfire. For example, in June 1999, Sakakibara Britishi, then the finance officer of Japan's Ministry of Finance, planned to devalue the yen from 117 to 122 yen against the dollar by intervening in the foreign exchange market. Lawrence Summers, then U.S. Treasury Secretary, was furious and declared that he would not recognize the reasonableness of Japan's intervention in the foreign exchange market. As a result, by the end of the year, the yen had appreciated to about 100 yen against the dollar. However, the conditions for the successful achievement of the joint intervention agreement are demanding, requiring both the unity of interests of everyone and the sufficient appeal of the coordinator. As early as 2012, when Shinzo Abe decided to be the next governor of the Bank of Japan, he gave two requirements: one must be "a person who can practice bold monetary easing" and the other must be "capable of becoming an international financier." Governor Kuroda's ability to win Prime Minister Abe's favor as governor of the central bank for the second time in 15 years as a retired official of the Ministry of Finance is not unrelated to the deep connections he has established with heads of monetary authorities during his time at the International Finance Bureau and the Asian Development Bank, and is a possible selection for coordinating joint intervention between Europe and the United States at this time. But this is clearly not enough.
Chart: The success of the former king pound has been greatly reduced
Source: WIND, China Merchants Securities
There is no sign of joint intervention and policy coordination between Japan and the United States. On October 13, Japanese Finance Minister Shunichi Suzuki, who attended the G20 finance ministers and central bank governors' meeting, said that he explained the yen foreign exchange market and the Japanese economy to the G20, and that he did not hold bilateral talks with U.S. Treasury Secretary Janet Yellen. Japan's foreign exchange intervention has been explained to the United States and understood by the United States. Asked if there was a Plaza Accord 2.0, U.S. Treasury Secretary Yellen made clear that Washington had no intention of taking such a joint action, calling the overall strength of the dollar "a natural consequence of the different pace of monetary tightening in the United States and other countries." Joint intervention requires the Fed to dump dollars in the market and increase dollar liquidity, which is almost a pipe dream in the face of high domestic inflation.
The Plaza Accord is a thing of the past. There are striking coincidences in history, and the forces that pushed the dollar index back from its all-time high in early 1985 and brokered the Plaza Accord came from the United Kingdom. According to Paul Volcker in The Changing Fortunes, the pound pair "reached an unprecedented 1:1 level" against the dollar due to "extremely inappropriate comments made by Prime Minister Thatcher's press spokesman". "Margaret Thatcher immediately called President Reagan and urged the United States to intervene in support of the pound, while recommending a greater and broader intervention." "This is a request that cannot be refused". "Margaret Thatcher is America's staunchest ally in most of its actions in the world, and she herself has a close relationship with the President and a good relationship with many of us." Can we expect the UK to initiate the coordination of exchange rate policy again? After 37 years, the pound is indeed close to parity against the dollar again in 2022, but the former Prime Minister Truss is not Margaret Thatcher.
Chart: China-US interest rate differential is inverted
Source: WIND, China Merchants Securities
5. The Bank of Japan's monetary and exchange rate policy practices have brought us policy enlightenment
Close to Japan, exports contribute a high degree to China's economy, so people from all walks of life in the mainland also attach special importance to the RMB exchange rate policy and exchange rate level. The September 2022 inflation data released by the National Bureau of Statistics recently showed that PPI and core CPI both fell, which determined that domestic monetary policy still needs to maintain an accommodative stance. The divergence between China's monetary policy and the Fed's tightening monetary policy has not converged and continues to put pressure on the RMB exchange rate. In view of this, the problems facing Japan and its coping strategies can bring us some inspiration.
First, we should comprehensively and objectively view the weakening of the RMB exchange rate since April. On September 28, 2022, the RMB weakened against the US dollar to close at 7.2458, and the depreciation of the RMB exchange rate below 7.2 can be said to be the first time since the exchange rate reform in 1994. The RMB exchange rate depreciated by 13.9% from 6.3730 at the beginning of the year to the end of September, and although market investors can deal with it calmly, there is no lack of worry. From a horizontal point of view, the yen depreciated by 25.9% against the US dollar from 114.95 at the beginning of the year to the end of September, and the depreciation of developed country currencies such as the euro and the British pound was also comparable. The depreciation pressure encountered by the RMB and many currencies at the same time is not mainly caused by their respective domestic factors, but mainly from the impact of the strength of the external dollar. Longitudinally, the dollar index last reached 114 21 years ago in 2001, Japan last dumped its reserves to intervene in 1998, and the pound last approached parity 33 years ago in 1985. This shows that the current external shocks faced by national currencies have not been encountered for many years, and it should not be surprising that the RMB exchange rate has performed rarely since the exchange rate reform in 1994.
Chart: The effective RMB exchange rate has stronger economic significance
Source: WIND, China Merchants Securities
Second, the RMB exchange rate policy serves the domestic monetary policy objectives. At present, the different steps of the economic and policy cycles between China and the United States have led to divergence in interest rate trends between China and the United States, bringing about phased international capital outflow and RMB exchange rate depreciation pressure. In this case, is the exchange rate or interest rate guaranteed? Both theory and practice suggest that exchange rate policy should be subordinate to monetary policy, and exchange rate policy should be combined with loose monetary policy to deal with the risk of balance sheet recession and deflationary pressures. By enhancing exchange rate flexibility and counter-cyclical macroprudential measures to alleviate the pressure of exchange rate depreciation and international capital outflow, we will jointly maintain the effectiveness of monetary policy. Gu Chaoming's view that the trade balance determines the level of the exchange rate and the view that the exchange rate policy is subject to the United States and other trading partners are not desirable, and the exchange rate policy should also be centered on us, with the goal of maintaining the effectiveness of monetary policy.
The third is to pay attention to the effective exchange rate of RMB. From focusing on the bilateral exchange rate of the renminbi against the US dollar to focusing on the effective exchange rate level of the renminbi against the basket currency, that is, the renminbi, the latter is more representative and economically significant.
Chart: The decline in China's foreign exchange reserve balance since 2022 is mainly due to exchange rate translation
Source: WIND, China Merchants Securities
Fourth, ad hoc intervention should remain an alternative tool for central banks. If the RMB exchange rate fluctuates abnormally in the short term, the use of foreign exchange reserves to intervene should also become an alternative policy tool, which coincides with the general direction of "storing remittances for the people". So far, the People's Bank of China has still responded to the depreciation pressure of the RMB by macroprudential measures such as adjusting the reserve requirement ratio for foreign exchange deposits, and has not continued to intervene in the foreign exchange market, but this tool should still be a policy option.
Fifth, actively use measures such as macro-prudential and cross-border capital flow management. Macroprudentiality is regarded by the Organisation for Economic Co-operation and Development (OECD) as a "cornerstone" of resilience against external shocks and financial stability. In mid-2022, the IMF published a new edition of its Institutional Perspective to formally revise its institutional view on capital flows. "When capital flows out on a large scale, monetary policy alone is difficult to solve the problem. Because raising interest rates at this time may lead to a tightening of the domestic credit environment, affecting economic growth and aggravating capital outflows, while interest rate cuts may continue to promote the depreciation of the local currency, push up debt service costs, and increase debt risks. In the short term, macroeconomic adjustment cannot be relied on to solve the problem of capital flows, because macro policy adjustment involves a wide range of aspects, policy formulation is slow, and policy effects are slow. Therefore, temporary capital flow management (CFM) measures can be taken to prevent economic crises caused by capital outflows". Recalling that in the Asian financial crisis in 1998, when the yen encountered serious depreciation pressure, the RMB exchange rate also encountered severe challenges after the market-oriented exchange rate reform in 1994, when it was able to overcome the crisis by first relying on promising non-competitive devaluation to stabilize expectations, and second, relying on strict "general inspection of foreign exchange settlement and sale" to prevent capital flight.
Chart: Capital outflows from China's bond market also act as a buffer
If one of the characteristics of developed currencies is that when the interest rate on their government bonds falls, the exchange rate weakens; When the interest rate on Treasury bonds rises, the exchange rate strengthens. So looking at the recent currency performance, the US dollar and yen are still solid developed currencies, the RMB is taking on the status of more developed currencies, and the former king of the pound is becoming an emerging currency.
(The author is the deputy general manager of the strategic research department of China Merchants Securities)