Essay

ASIA’S FINE BALANCE

Koizumi’s re-election will help the global economy, and calm relations with China

DONALD COXE October 3 2005
Essay

ASIA’S FINE BALANCE

Koizumi’s re-election will help the global economy, and calm relations with China

DONALD COXE October 3 2005

ASIA’S FINE BALANCE

Essay

DONALD COXE

Koizumi’s re-election will help the global economy, and calm relations with China

JUNICHIRO KOIZUMI’S smashing election victory is good news for the Japanese economy and great news for Japanese stocks.

It should also be good news for the global bond market, because it will tend to reinforce the world’s most crucial financial partnership, the arrangement between China and Japan that pegs their currencies to each other and to the American dollar. Without that under-

standing, the U.S. dollar’s value would be far lower, U.S. long-term interest rates would be far higher, and U.S. home prices would be in big trouble. Given the influence of the U.S. market on Canadian rates, the impact on interest rates and house prices here would be quite similar. How this situation developed is a tale worth telling.

First, the election, which gives Koizumi an unprecedented mandate for reform for what could be his last year in office. Remarkably, he devastated the opposition by convincing voters that his Liberal Democratic Party

was the force for restructuring the nation’s sclerotic politics and economy. The LDP, which has ruled Japan for all but 11 months since Douglas MacArthur imposed democracy on the conquered nation, has been as liberal and democratic as the Holy Roman Empire was holy and Roman. Through government control of the US$ 3-trillion postal savings system, the gerontocrats who have chosen LDP premiers have had a seemingly bottomless well of funds to buy the seemingly endless

Koizumi convinced voters that he can reform Japan’s sclerotic politics

flow of government bonds that have financed the seemingly endless array of unproductive projects and payoffs. And that system has been a major factor in the seemingly permanent Japanese economic torpor, which spawned and maintained the seemingly endless spiral of Japanese deflation.

The Bank of Japan responded to the malaise with the monetary equivalent of all-out war—zero interest rates. Free lending should, according to economic theory, lead to excessive credit expansion, which should trigger inflation. But not when your banking system is still in purgatory for its sins during the asset-based lending binge of the 1980s, and has been cutting back its loan portfolio for 90 straight months. (It was headline news last month that the banks had actually increased their loans modesdy.)

Koizumi expects to shake up the system by reining in the non-market-based lending of the postal system. If he succeeds, the world’s second-largest economy could once again be an engine of global growth, rather than a millstone.

Although Japan-bashing has been in vogue for years, there is one important way that Japan has been providing powerful stimulus to the global economy. Koizumi, now seen as the ultimate in open politicking, has been, since 2001, one of the partners in what could be called the world’s biggest back-room deal.

Seven years ago this month, the global financial system was in crisis. Russia had defaulted on its debts, and Long-Term Capital Management, a huge hedge fund, was collapsing. Canadians may recall that this rogue fund boasted the cachet of having among its founders not one, but two Nobel Prizewinning economists, including Canadianborn Myron Scholes. It would turn out that their investment expertise was no better than that of most economists, who are, in general, poor portfolio strategists.

While the Federal Reserve was trying to figure out how to manage the Long-Term Capital crisis, a syndicate of 300 global banks was completing its restructuring of Indonesia’s foreign corporate debts. Like most of mainland Asia, Indonesia had been devastated by the collapse of the emerging nations’ currencies that had begun the day Hong Kong was swallowed by China. The only currency that

had not been devalued was China’s renminbi. At that point, the region’s bankers were struggling to avert a crisis threatening to destroy all the region’s “tiger” economies, and they needed China to hold firm. Indonesia’s rupiah was one of the last currencies to stabilize—the necessary precondition to refinancing its external debts, which were heavily denominated in American dollars.

Just as the bankers were about to ink the deal, the head of the syndicate was called by an official of the Bank of China. China was about to devalue its renminbi, he said. The banker was stunned. If the renminbi fell, a new, and worse, currency crisis would erupt. Indonesia, one of the frailest of the new Asian economies, would collapse, which would mean that the struggling democracy in the world’s largest Muslim nation would surely give way to dictatorship.

Why devalue now? Because, answered the official, Japan has carried out a stealth devaluation of its yen against the backdrop of the currency collapses across the region. China had held its currency firm in order to provide an umbrella for the new economies of Asia, but Japan’s devaluation of the yen, from 110 to the U.S. dollar to beyond 145, had given Japan a competitive advantage against China. Beijing warned Tokyo of the consequences of its ill-advised currency policy, but the Japanese promised only that they would study the matter in committee meetings and policy reviews—a standard stonewalling technique.

Unless Japan revalued the yen upward, China would drive the renminbi down.

The panicky bankers immediately agreed to call Tokyo. They convinced the Bank of Japan and the powerful Ministry of Finance that China wasn’t bluffing. The yen suddenly leapt by 15 per cent, one of the most spectacular revaluations of a major currency in decades. The crisis was over. A new Asian economic boom was under way.

That banker-brokered “deal” was the basis for the China/Japan undeclared partnership that has (l) maintained their currencies’ relationship to the American dollar; (2) provided the umbrella for the other Asian economies’ currencies and financial markets;

(3) prevented a global financial crisis when the American dollar rather suddenly entered a major bear market in 2002; (4) contributed to keeping U.S. bond yield low, even when the Fed is raising interest rates.

How have Beijing and Tokyo achieved such sustained stability? By ensuring that their currencies’ balance, with each other and with the American dollar, stay in line. That has been achieved through their astounding purchases of U.S. treasury and governmentbacked bonds to hold their currencies’ values down. Since 1998, they have bought roughly $ 1 trillion in U.S. Treasuries, which has helped to prevent the fast-rising U.S. trade deficit from producing a collapse of the American dollar.

This has also, indirectly, kept U.S. interest rates at low levels, sparking a housing boom that has more recently become a housing bubble. With the U.S. personal savings rate down near a previously unimaginable low of zero, and the U.S. economy one of the world’s strongest, with the Fed raising its rate from one per cent to 3.75 per cent, and with energy prices soaring, the yield on the 10-year Treasury note, which is used for setting mortgage rates, should have leapt. Instead, it has fallen. Alan Greenspan calls that “a conundrum.” Beijing and Tokyo call that a great vendor financing program that keeps their export industries humming.

Koizumi knows how this unofficial partnership works. In the middle of the election campaign, he bowed to Chinese demands, cancelling a planned visit to the Shinto warriors’ shrine that houses remains of Japanese soldiers who committed atrocities in China. This helped restrain anti-Japanese sentiment and maintain the region’s fine balance.

How this unique backroom cabal evolves will be one of the most important financial stories of the coming year. If you’re a homeowner, root for the Hu-Koizumi entente. If you’re a cash-rich homebuyer, you might desire a new Sino-Japanese flap.

Just as long as it isn’t too big. I¡I¡1

Chicago-based Donald Coxe is Global Portfolio Strategist, BMO Financial Group. dcoxe@macleans.ca

KOIZUMI aims to

make the world’s secondlargest economy an engine of growth again, instead of a millstone