Japan’s policy trajectory threatens to burst China’s asset bubbles. Japan has devalued the yen competitively: US and European real exchange rates are down some 10 per cent since 2009, courtesy of quantitative easing and the euro crises. Surprise interest rate cuts in a number of countries hint at dangerous imitation. China is the most exposed: following Japan’s devaluation (echoed in Korea and elsewhere), China’s overvaluation has now reached an estimated 33 per cent.
At just over Y100 to the dollar the yen is cheap enough to get Japan’s economy back to its trend level from 2.5 per cent below it, with growth of 3 per cent this year and perhaps 1 per cent in 2014, and to eliminate deflation. Sharp increases in import costs could raise CPI inflation to 2 per cent (the new long-run target) by year-end or early 2014, but domestic costs are now still falling. That may stop by the end of next year, but CPI inflation could also fall back to zero unless there is a further yen devaluation, perhaps to Y120 versus the dollar. Inflation of 2 per cent is unlikely to last with the measures adopted so far.
But there are large internal and external risks in further devaluation. If the authorities are content to look at CPI inflation reaching 2 per cent by late this year, and declare the policy a success, they will have achieved a lot, maybe as much as can be hoped for without drastic reforms of income distribution within Japan.
Further yen devaluation may just happen. Current zero interest rates may be unacceptable to investors with the principal sum no longer boosted in real terms by deflation. This risk exists even with mere elimination of deflation at the current exchange rate – especially given likely near-term positive CPI inflation. But a further yen slide would make it much more acute.
Last year’s Japanese budget deficit was 10 per cent of GDP and is being increased. The gross public sector debt is 240 per cent of GDP, net debt 135 per cent. Without deflation, the return on that debt at interest rates of well under 1 per cent is inadequate, for all except the Bank of Japan under QE. The long-feared inflationary downward spiral could ensue: ever-greater money creation would be needed to mop up all the debt and hold down bond yields.
The biggest external risk concerns China. Its real exchange rate has become overvalued. It is heavily exposed to developed world countries ratcheting down their real exchange rates. Since abandoning the fixed 8.28 yuan/dollar rate in 2005, China’s unit labour costs have been rising at 7 per cent a year, and its currency by 4 per cent, for a combined annual 11 per cent in dollars.
Overvaluation became a serious problem in 2011. Producer price inflation (PPI) of 7 per cent then matched unit labour costs (in yuan), but crumpled into 2-3 per cent producer price deflation over the past couple of years. April’s 2.6 per cent deflation has intensified from 1.6 per cent in February. Chinese businesses have to slash prices to keep a grip on their export markets. But unit labour costs are still rising at a 5 per cent rate, squeezing profit margins, and are up 20 per cent relative to the export competition since 2011.
Adding to this problem is the sudden, related, swing into high real interest rates. In mid-2011, the one-year lending rate from state-owned banks was 6.6 per cent, which combined with 7 per cent PPI to give a slightly negative real rate. But a flight of depositors from China’s banks has kept nominal interest rates high. The nominal interest rate is only down to 6 per cent now, but combined with PPI deflation, the real interest rate is close to 9 per cent. Such high real interest rates combined with squeezed profit margins have pushed China into a prolonged “investment-led” slowdown.
China’s extravagant post-crisis recovery splurge, with capital spending raised to 48 per cent of GDP, much of it debt-financed, has left it with high prices for real estate and industrial commodities. These assets with low-to-negative yield are also the most sensitive to interest and exchange rate changes. Whether or not Chinese real estate is in a bubble, high nominal and real interest rates make these asset prices vulnerable.
Premier Li Keqiang spoke recently of plans to remove controls on capital outflows. Any such action could release a wave of savings seeking real foreign assets. This would devalue the yuan and cushion the rebalancing of the economy away from excessive capital spending. But it would also drain away bank deposits, threatening a major domestic asset sell-off as well as bank insolvency.
China’s annual savings are $4.5tn, versus $2tn in the US; their flow is vital. Chinese assets are thus under threat both under current policies or the chief liberalising alternative. The stakes are high in a potential currency war.
Charles Dumas is chairman of Lombard Street Research