1. Introduction
In contemplating macroeconomic policies for Japan, it is not sufficient to examine the most likely scenario; it is necessary to study risk scenarios as well. Although chances of these risk scenarios materializing are low, if they were to materialize the adverse impact on the Japanese economy would be large. As a result, policy makers must take note of these risk scenarios. The risk management approach is thus indispensable in conducting macroeconomic policies. The focus of this study is external negative shocks originating in Asia, since the Japanese economy is now very closely linked to Asia through trade and investment and it would face serious consequences from a negative shock originating in the region.
The research project was primarily carried out by the following study group with the help of the following secretariat. The study group met five times between October 2007 and March 2008. The final report is comprised of eight chapters, six of which are written by the members of the study group separately and two by the secretariat.
| (Study Group) | |
|---|---|
| Masahiro Kawai | Dean, Asian Development Bank Institute |
| C. H. Kwan | Senior Fellow, Nomura Institute of Capital Market Research |
| Masaya Sakuragawa | Professor, Keio University (Deputy Director, Global Security Research Institute) |
| Shumpei Takemori | Professor, Keio University |
| Mitsuru Taniuchi | Professor, Waseda University |
| Shin-ichi Fukuda | Professor, Tokyo University |
| (Secretariat) | |
|---|---|
| Research fellows | |
| Mitsuo Hosen | Senior Research Fellow, Global Security Research Institute Keio University |
| Masaya Sakuragawa | Deputy Director, Global Security Research Institute Keio University |
| Asako Okamura | Research Associate, Global Security Research Institute Keio University |
| Administrators | |
| Yukari Kamakura | Chief Administrator, Global Security Research Institute |
| Hiroko Hanada | Global Security Research Institute |
| Takayuki Miyajima | Graduate Student, Economics Department, Keio University |
2. Summary
We must pay more attention to Chinese economic conditions at the current juncture than to the rest of Asia, such as Southeast Asian countries and Korea. First of all, stock prices and real estate prices in several large cities such as Beijing may have climbed too much and may collapse in the foreseeable future after a decline since the end of 2007. Secondly, the size of the Chinese economy is now much bigger than the rest of Asia. On the other hand, it is less likely that the Southeast Asian countries or Korea will be hit by currency and/or financial crises in the near future, since they have accumulated a large amount of foreign exchange reserves that can be utilized in case of crises. Furthermore, their currencies have become more flexible than ten years ago, and thus attacks on their currencies are less likely these days. Finally, the individual economic size of these countries is much smaller than China, and so the impact on Japan from an economic crisis in one of these countries would be limited.
(Development in the stock and real estate markets)
The Shanghai stock market index rose sharply from slightly less than 1,000 in June 2005 to 6,029 in October 2007, primarily due to excess liquidity associated with foreign exchange market intervention and the stock market reform that allowed non-circulation stocks, which are currently held by the government and publicly-owned enterprises, to be sold to the market. Since then, however, the index declined by approximately 30 percent by the end of February 2008, reflecting worsening economic conditions at home and abroad and deteriorating demand-supply conditions in the stock market.
We must pay close attention to the Chinese stock market for the following reasons. First, current stock prices can not be rationalized by current corporate profit levels, as the price/earnings ratio is still around 50, as of February 2008. Secondly, a huge amount of non-circulation stocks will be sold to the market until 2011, thus putting downward pressure on stock prices. Thirdly, monetary tightening to fight against inflation will have an adverse impact on stock prices.
The real estate market, which had been buoyant for some time, also recently entered into an adjustment phase. Real estate prices in several large cities such as Beijing have been declining since the end of 2007. This is at least partly attributable to the government’s policy measures announced in late 2007 to restrain speculative investment in the real estate market. It is yet to be seen whether real estate prices in those cities will further decline and, if so, by how much.
(The impact of a sharp drop in asset prices on the domestic economy)
According to several prominent economists in Beijing, the impact of a sharp drop in asset prices on the financial system in China would be very different between the stock market and the real estate market. It is prohibited to utilize credit from a bank to buy stocks in China, and thus the impact from a collapse of the stock market on the financial system would be limited. However, it is not prohibited to borrow money from a bank to buy real estate, and recently banks have expanded credit to the sector. If real estate prices collapse, the impact on the financial system will be substantial.
In the past, the Chinese government spent a large amount of money to resolve the non-performing loan problem of commercial banks. However, a further injection of public money may be difficult, since commercial banks recently have received a substantial amount of capital from foreign financial institutions..
On the macroeconomic front, a sharp decline in stock prices would lead to stagnant consumer spending and a slowdown in investment. Against the backdrop of a slowdown of the world economy, some observers argue the Chinese economy may reach a turning point even before the Olympic Games in August 2008.
(The impact of a bubble-burst in China on the Japanese economy)
What would be the impact on the Japanese economy if a bubble in the Chinese stock and/or real estate markets bursts? On the real side of the economy, Japan would suffer from a sharp decline in exports to China, due to deceleration of the Chinese economy. Japanese exports to China was some ¥10 trillion in 2006. If half of its exports to China were lost, the direct impact on its GDP would be ¥5 trillion, or 1 percent of GDP. The total impact on its GDP would be slightly higher, depending on the magnitude of the multiplier. More serious impacts could be felt on the financial front. If the Japanese economy is perceived by many market participants to be very much dependent on China, the Japanese stock market may have a difficult time due to a large amount of selling based on that perception. In that process, we would have to pay close attention not only to U.S. or European hedge funds but also to sovereign-wealth funds recently established by emerging countries and oil-producing countries. The worst scenario for Japan would be that the government bond market also would be seriously affected, in addition to the stock market. Since the debt/GDP ratio of Japan is exceptionally high compared with other countries, and some economists argue that the Japanese government bond market is in a bubble, it is conceivable that the market would be attacked. If government bond prices collapsed and interest rates jumped, a financial crisis as well as a fiscal crisis would arise because financial institutions own a large amount of government bonds.
There are several reasons why we believe the chances of Southeast Asian countries or Korea being hit by the same kind of crises as that in 1997-98 are limited: accumulation of foreign exchange reserves, a substantial reduction in debt to foreign banks and more flexible exchange rate regimes. Among these factors, the accumulation of foreign exchange reserves seems to have been playing the most important role in preventing crises in recent years.
During the Asian crisis, Thailand, Indonesia, Korea and other crisis-hit countries were faced with extremely serious liquidity shortage problems, since their foreign exchange reserves fell short of short-term external debt. Because of this harsh experience, many East Asian and other developing countries have tried to accumulate a large amount of foreign exchange reserves to minimize liquidity shortage risks. The accumulation has been further accelerated by their foreign exchange intervention to weaken their currencies and thus to strengthen competitiveness of their export products.
There are a couple of yardsticks regarding an appropriate level of foreign exchange reserves. One rule of thumb is that an amount equivalent to 3 to 6 months of imports is appropriate. Whatever yardsticks are utilized, however, the current levels of foreign exchange reserves in Asian developing countries seem to be excessive. They are, in a sense, paying insurance premiums by holding seemingly excessive foreign exchange reserves at normal times, because they know that, from their experience during the Asian crisis, economic and social costs will be enormous if they are hit by a crisis.
Holding excessive foreign exchange reserves has its demerits as well its merits. Before the Asian crisis, most Asian and other developing countries had current account deficits, but after the crisis they have worked hard to have current account surpluses and to accumulate foreign exchange reserves to safeguard themselves against crises. Most East Asian and other developing countries used to import capital, but they are now exporting capital, notably to the United States, and thus distorting global capital flows and exacerbating global imbalances. What is called the “global savings glut” is caused, to a large extent, by excess foreign exchange reserves held by developing countries.
Apart from this global problem, excess holding of foreign exchange reserves by developing countries has an adverse impact on their own macroeconomic performance in the long-run. An econometric study done by a member of the study group clearly demonstrates that an increase in reserves in developing countries tends to decrease consumption but to increase investment in the long-run. However, looking at data from East Asian countries in the last decade, investment has also declined, except for China. Thus the exceptionally rapid accumulation of foreign exchange reserves in Asian countries except for China seems to have depressed not only consumption but also investment.
What kind of policy measures are needed for developing Asian countries to minimize the risks of being hit by crises but not to rely too much on reserve accumulation? After the Asian crisis, a regional framework for financial and currency cooperation was developed. For example, the Chiang Mai Initiative, a regional financing arrangement, was established to ensure financial stability in the East Asian region. An economic and financial information sharing and monitoring system in East Asia has also been pursued in the context of the ASEAN + 3 framework. However, further efforts have yet to be made to strengthen the regional cooperation mechanism in the international financial area. To improve the soundness of the financial system in individual countries as well as to further develop and integrate the regional financial system, the following important issues need to be seriously examined: establishing a regional institution to pool foreign exchange reserves such as the Asian Monetary Fund, coordination of regional exchange rates and promoting Asian bond markets.
The reaction of East Asian countries, and Southeast Asian countries in particular, to the crisis in 1997-98 seems to have contributed to widening global imbalances. These countries have tried, most importantly, to improve their current accounts and thus to accumulate foreign exchange reserves in order not to be hit by a crisis again. Their current accounts, generally speaking, are in surplus now, while they were in deficit before the Asian crisis. Domestically, savings exceed investment now, while investment exceeded savings before the crisis. Domestic savings have not changed much, but investment has declined substantially since the crisis in these countries. This change in the savings-investment pattern in East Asian countries has created excess global savings and financed the widening U.S. current account deficit.
The reasons for the decline of investment in the crisis-hit countries are twofold. First, the corporate sector was faced with excess capacity which was caused by buoyant investment before the crisis, and it also had to restructure its business by repaying debt and closing non-profitable projects. Secondly, financial institutions were reluctant to extend credit to the corporate sector. All in all, both the non-financial corporate sector and the financial sector became extremely cautious of taking risks after the crisis, and thus business investment was depressed.
In the case of China, the domestic counterpart of a ballooning current account surplus is not depressed investment but increased savings. The investment ratio has increased since the beginning of the 2000s, but the savings ratio has increased even faster. The current high investment reflects overheating of the economy, which is partly attributable to excess liquidity caused by, among others, foreign exchange market interventions. State-owned enterprises do not have to pay dividends to the government, and so their high profits tend to be undistributed. This is another reason for high investment. On the other hand, household consumption is depressed due to anxiety about the future mainly caused by the underdeveloped social security system.
To reduce excess savings in ASEAN countries, it is desirable for them to stimulate investment rather than to reduce savings. For that purpose, it is important to implement basic policy measures that are conducive to attracting more FDI from abroad, strengthening the domestic banking system, developing domestic bond markets and strengthening corporate governance.
Policy prescriptions to reduce excess savings for China are different. Its investment ratio in recent years, 40 percent or even more, is exceptionally high both historically and internationally. It needs to slow down investment growth and spur household consumption. Stock market reform is conducive to that purpose. Currently no dividends are paid to owners of non-circulation stocks such as government agencies. If the stock market is reformed in such a way that dividends are paid to government agencies and other owners of those stocks, increased government revenue can be used to improve the social security system, which will then help spur household consumption. At the same time, business investment will be suppressed because more dividend payments will lead to less retained earnings. All non-circulation stocks are currently scheduled to be sold to the market by 2011. This reform process will also stimulate consumption and suppress business investment because more dividends will be paid by the corporate sector to households. Some economists also argue that the government can raise corporate taxes and use that tax income to improve the social security system, since the corporate sector is currently not paying enough taxes.
Appreciation of the renminbi will lessen China’s current account surplus and thus contribute to correcting global imbalances. However, the government seems not to allow substantial appreciation of the currency at the moment, fearing serious damage to the domestic economy. To change the government’s position and to make the renminbi’s exchange rate substantially more flexible, the following policy measures need to be taken: strengthening the banking system, reforming state-owned enterprises and relaxing capital controls, particularly those on outflows.
A large amount of capital inflow, which was recorded in East Asia before the crisis in 1997-98, turned into outflow after the crisis. However, the resurgence of capital inflow has recently been observed in several East Asian countries. Thailand and Vietnam are the most notable examples, but China and Korea are also recording capital inflow. This trend may have been accelerated by the subprime mortgage loan problem and associated economic stagnation in the U.S., since a shift from the U.S. dollar to Asian and other currencies may have taken place.
In many East Asian countries, the current account has been in surplus in recent years and so pressure has been put on their currencies to appreciate. However, governments have worked to prevent their currnencies from appreciating through foreign exchange market interventions. As a result, foreign exchange reserves have been accumulated and domestic liquidity has expanded. Inflow of capital in some of these countries has further exacerbated the problem. This may lead to overheating of domestic economies, asset market bubbles and inflation. That is to say, macroeconomic stability as well as financial market stability may be eroded. Furthermore, once capital inflow suddenly and abruptly turns into outflow, there will be the risk of a currency crisis. Thus it is extremely important for several East Asian countries to control capital inflow and to minimize risks associated with it. Based on recent capital inflow episodes in emerging countries since 1987, 16 percent of all episodes led to crises in one form or another, such as sharp currency depreciation, a sharp drop in output and a fiscal squeeze.
Orthodox policy measures to cope with a surge in capital inflow without risking macroeconomic and financial market stability are (1) improving exchange rate flexibility, (2) fiscal contraction and (3) strengthening prudential measures for financial institutions and financial sector reform. However, some of these measures may not easily be applied to East Asian countries. Policy makers in ASEAN countries, for example, may be against fiscal contraction, since they squeezed public sector investment after the Asian crisis. It can also be argued that suppressing public sector investment would not be acceptable because of its impact on the current account. Financial sector reform can not be implemented in the short-term, and it is not easy to strengthen prudential measures for financial institutions if the financial system is fragile from the outset.
What is left for East Asian countries as a realistic short-term possibility is improving exchange rate flexibility. However, one big problem here is the inflexible renminbi exchange rate. Even if more flexible exchange rates of their own are desirable for other East Asian developing countries than China, they can not accept stronger rates because their products would lose competitiveness against China due to the inflexible renminbi rate.
More substantial appreciation of the renminbi will not only make it easier for other East Asian countries to adopt more flexible exchange rate regimes but also benefit the Chinese economy itself, which is faced with inflation and asset market bubbles. Collective appreciation of regional currencies including China would be acceptable, and for that purpose coordinated policy dialogues among countries concerned and collective actions to adjust exchange rates against the U.S. dollar would be effective.
(Implication of the subprime mortgage loan problem for Asia)
Since the start of this research project in September 2007, the subprime mortgage loan problem has widened and deepened and turned into a financial crisis in the U.S., which is probably the most serious concern for the world economy at the moment. Asian developing countries have already felt the direct impact of the financial crisis in the U.S.: a surge in capital inflow caused by an economic slowdown and lower interest rates in the U.S. Capital inflow was already observed in several Asian countries even before the financial crisis took place in the U.S., and there was an upward pressure on their currencies. However, their governments intervened in the foreign exchange market to keep the exchange rates of their currencies low so that their products’ international competitiveness would not deteriorate. That, in turn, has created an excess liquidity problem in their domestic economies. The financial crisis in the U.S. is accelerating capital inflow to Asian developing countries from the U.S. and other developed countries and exacerbating the excess liquidity problem in some of these countries.
(The world economy after the subprime problem)
Important questions for Asia are how the world economy will evolve and how global imbalances will unwind after the subprime problem. The answers to these questions will very much influence Asian economies. There are two opposing scenarios about the future world economy: a pessimistic scenario by Prof. Rogoff of Harvard University and an optimistic scenario by Prof. Cabarello of MIT.
First of all, what is the cause of global excess savings and imbalances? According to Prof. Rogoff, developing countries should not import capital from abroad until infrastructure for receiving foreign investment such as investor protection is well established and fiscal discipline is clearly put in place, and so the U.S., which is creating excess capital demand, is responsible for global imbalances. In contrast, Prof. Cabarello argues that the lack of investment vehicles or opportunities in developing countries is responsible for global savings glut, low interest rates and so on.
The world economy has enjoyed high growth in recent years thanks to bubbles à la Tirole (1985): the IT bubble up till 2001, the housing market bubble afterwards and the current price hike of oil and other commodities. Ideally, investment vehicles will be developed in developing countries and global capital will flow into these countries. However, the development of investment vehicles is not an easy task, and therefore Prof. Cabarello would argue that the world economy will have to rely on bubbles à la Tirole to sustain high growth in the world economy in coming years. In contrast, Prof. Rogoff seems to argue for steady or slower growth of the world economy, because he seems to believe high economic growth dependent on bubbles à la Tirole is not sustainable. If Prof. Rogoff’s view is correct, the U.S. economic growth rate will slow down or turn negative and so will the growth rates of developing countries, albeit by less. The U.S. current account deficit will be reduced. In developing countries, current account surpluses will shrink because of a decline in exports and at the same time capital outflow will shrink due to a decline in excess savings. This is probably Prof. Rogoff’s view on the world economy in the years to come. If he is right, the U.S. economy may fall into a serious recession and the world economy as a whole may suffer from a slowdown for a relatively long time. A careful examination of this possibility is warranted. If this pessimistic scenario really materializes, each government will have to prepare a safety net to cope with economic, social and political problems caused by its economic slowdown. At the same time, a sharp rise in protectionism, which is aimed at capturing a larger portion of a smaller pie, will have to be carefully watched.