Japan sinks into recession – but there is more to the story than the mainstream narrative would care to admit
Last week (February 15, 2024), the Japanese Cabinet Office released the latest national accounts estimates…
I was running late yesterday and the blog post was already rather long so I left some matters concerning central banks for today. The question we address briefly today is what is the role of central banks in all these trade transactions. Does an export surplus country face an ever increasing money supply as central banks provide the counterparty service to traders who sell in a foreign currency but want their own currency (such as a manufacturer who incurs costs in say Yen but sales revenue in $AUD – as per our example yesterday)? There appears to be confusion on that front as well. So while I am not typically going to write a detailed blog post on a Wednesday, in the interests of continuity, here is Part 2 of the series on trade and currencies.
In this blog post – Do current account deficits matter? – I explained some of the central bank operations that occur in this regard.
One should immediately understand that under a flexible exchange rate system, monetary policy is freed from defending some fixed parity through ‘official intervention’ (buying and selling currencies in the foreign exchange market).
Under flexible exchange rates, the sovereign government can make use of this expanded policy space to pursue economic growth and rising living standards even if this means expansion of the current account deficit (CAD) and depreciation of the currency.
The foreign adjustment is then accomplished by the daily variations in the exchange rate.
Please read my blog – Gold standard and fixed exchange rates – myths that still prevail – for more discussion on the differences between monetary systems.
While there is no such thing as a balance of payments growth constraint in a flexible exchange economy in the same way as exists in a fixed exchange rate world, the external balance still has implications for foreign reserve holdings via the level of external debt held by the public and private sector.
Further, if the central bank is still engaging in official intervention in a flexible exchange rate regime then it is aiming to manipulate the currency value in some way. There is no other reason for such intervention.
Sterilisation enters the scene here as well. It is often erroneously thought that financial inflows (corresponding to the CAD) via the capital account of the Balance of Payments boost commercial bank reserves. Mainstream economists who operate within the defunct money multiplier paradigm think this might be inflationary because it will stimulate bank credit creation.
The flawed logic is – increased bank reserves -> increased capacity to lend -> increased credit -> excess aggregate demand -> inflation.
You might like to read the following blogs – Money multiplier and other myths – Building bank reserves will not expand credit and Building bank reserves is not inflationary – to understand why that is totally at odds with the way the credit creation system operates.
The mainstream claim is that the central bank can ‘sterilise’ (drain) this impact by selling government debt via open market operations. However, if there is excess capacity in the economy, the central bank might refrain from sterilising and allow aggregate demand to expand.
I showed yesterday that no such increase occurs from a macroeconomic perspective.
Think about what a CAD actually means. I always argue that it is essential to understand the relationship between the government and non-government sector first. A common retort is that this blurs the private domestic and foreign sectors. My comeback is that the transactions within the non-government sector are largely distributional (as I also showed yesterday), which doesn’t make them unimportant, but which means you don’t learn anything new about the process net financial asset creation.
In the case of CAD, what mostly happens is that local currency bank deposits held say by Australians are transferred into local currency bank deposits held by foreigners.
If the Australian and the foreigner use the same bank, then the reserves will not even move banks – a transfer occurs between the Australian’s account in say Sydney, to the foreigner’s account with the same bank in say Tokyo.
The point is that the AUD never leaves ‘Australia’ no matter who is holding it or where. The same goes for the USD and all the fiat currencies.
If the transactions span different banks, the central bank just debits and credits, respectively, the reserve accounts of the two banks and the reserves move.
What happens next depends on the approach the commercial banks take to the reserve positions. We know that excess reserves put downwards pressure on overnight interest rates and may compromise the rate targetted by the central bank.
The only way the central bank can maintain control over its target rate and curtail the interbank competition over reserve positions is to offer an interest-bearing financial asset to the banking system (government debt instrument) and thus drain the excess reserves.
So sterilisation in this case merely reflects the desire of the central bank to maintain a particular target interest rate and is not discretionary. The alternative is to offer a return on excess returns equivalent to the target rate.
An important point to understand is, to repeat, that in a trade transaction the sale currency never ‘leaves’ the country which is importing.
Sure enough, a foreign holder of a USD income stream can, ultimately, only realise these holdings by buying goods and services (or assets) denominated in US dollars.
Unless they enter the foreign exchange market, which we analysed yesterday.
During the fixed exchange rate period (Bretton Woods) between 1945 to 1971, the German Bundesbank, for example, regularly engaged in official intervention to keep the value of the Deutsche mark low so as to maintain the competitiveness of its industrial export sector.
It would accumulate foreign exchange reserves by selling the mark when there was excessive upward pressure on its exchange parity.
The Deutsche Mark was also often pushed up in value by speculators in the currency markets, who were betting that the US dollar, the Italian lira and the French franc were overvalued.
In these situations, the Bundesbank was forced to sell marks and buy other currencies (principally US dollars), which pushed more marks into circulation.
This was seen as placing a constraint on its capacity to achieve certain growth rates in the money supply and forced the Bank to engage in offsetting policy initiatives – that is, ‘sterilisation’ – which relates to the goal of insulating domestic monetary developments from those associated with the central bank’s defense of the exchange rate.
In this situation, for example, the Bundesbank could reduce the supply of loans it provides to banks in need of reserves to offset its sale of Deutsche marks in the international currency markets.
The problem for the Bundesbank was that this intervention came up against their obsession with inflation and so they were torn between maintaining as lower a mark value that was allowed under the Bretton Woods arrangements and maintaining a check on the flow of marks into the economy.
They often erred on the side of the latter concern and forced central banks in the US, France and Italy (among others) to take the burden of foreign exchange adjustment to maintain the parities.
This was a major reason the post-Bretton Woods European Monetary System arrangements did not promote currency stability.
Once Germany surrendered its currency and joined the Eurozone, the adjustments to maintain competitiveness had to come from manipulating domestic prices and wage costs because the Bundesbank no longer had direct control over the exchange rate.
Hence, in the early years of the EMU, we saw the draconian Hartz reforms introduced in Germany.
Now jump into the modern day and consider the case of two nations both with, ostensibly, floating exchange rates: China and Japan.
In yesterday’s example, I used the case of a Japanese car manufacturer offering their products for sale via a dealer network in Australia (which may or may not be owned by the car manufacturer) to Australian consumers.
The sale price was in $AUD yet the manufacturer invoiced the dealership in yen.
There were two options:
1. The car dealer after deducting their $AUD costs and markup would enter the foreign exchange market, exchange the left over $AUD sale price for yen, and arrange for those yen funds to be paid into the bank of the car manufacturer (which might be in Japan or somewhere else – but accounts in yen).
2. The car manufacturer decides to keep the sales revenue in $AUD either in a deposit account or in some other financial or real asset.
The second option might involve the car manufacturer re-investing its profits (as FDI) into a local assembly or design plant, for example.
In both cases, as they stand, the volume of yen and $AUD in the respective financial systems did not change, merely the ownership of those financial assets.
Now consider Option 1 in the context of a central bank that is actively engaged in currency manipulation – an accusation that has been levelled at various times against the Chinese government and its People’s Bank of China.
The central bank is unlikely to be the initial counterparty in the foreign exchange transaction between the car dealer and the initial holder of yen balances.
In this scenario though, the export surplus nation, under flexible exchange rates will be facing upward pressure on its exchange rate, which, other things equal, reduces its real exchange rate and hence its international competitiveness.
Why is that so?
Think about the operations of the foreign exchange market.
Exchange rates are determined by the supply of and the demand for currencies in the world foreign exchange markets, which could be the local bank foreign currency desk or elsewhere, like a train station kiosk in a city where travellers meet.
The supply of and demand for currencies are in turn linked to trade and capital flows between countries.
Consider the supply of Australian dollars to the foreign exchange market. When Australian residents buy foreign goods (imports), buy foreign assets or lend abroad, they need to purchase the relevant foreign currencies in which the transaction is denominated. To buy the currency they desire, they supply $AUDs in exchange.
Alternatively, on the demand side, when foreigners buy Australian goods and services (exports) and/or Australian financial assets they require $AUD. They purchase them in the forex market by supplying their own currency in exchange.
If there is an excess demand for $AUD then there is pressure for the $AUD to appreciate in price relative to other currencies.
If there is an excess supply of $AUD, the $AUD depreciates and one unit of foreign currency buys more $AUD, so the exchange rate increases.
These changes in the exchange rate work to resolve the supply and demand imbalance but with time lags.
In the case of an depreciation in the Australian dollar, the foreign price of Australian exports is now lower (less yen required to purchase a given $AUD priced good), and with export demand varying inversely with price (by assumption), the demand for exports and hence $AUD’s rises.
Assuming a fixed import price in the foreign currency, the $AUD price of imports rises whiich reduces the quantity demanded.
While most currencies float freely against each other, at times the central bank will enter the foreign exchange markets as a buyer or seller of the local currency as a means of influencing the parity determined in that market.
This is called Official intervention.
So for export surplus nations, the central bank may see it is in the interests of their industrial exporters to engage in some currency manipulation – that is, sell its currency into the foreign exchange markets and purchase targetted foreign currencies (perhaps to improve bi-lateral real exchange rates against major trading partners).
In doing so, the central bank will accumulate foreign reserves and the base money stock will rise. Mainstream economists claimed that would be inflationary because they erroneously believed in the operations of the money multiplier.
Please read my blog post – Money multiplier and other myths (April 21, 2009) – for more discussion on this point.
Consider the first graph which shows the foreign exchange reserves held by the The People’s Bank of China from January 2000 to April 2018 (the units are $USD millions).
Between 1950 and 1990, the average was $US14.4 million, after which the holdings steadily rose until the early 2000s, when the PBC started accumulating foreign reserves in large volumes.
More recently, it has been selling them off again.
The next graph shows China’s current account balance as a percent of GDP 1997 to 2017. In the lead up to the GFC, China’s current account surplus rose substantially only to return to levels below 2 per cent of GDP.
Relative to Germany, China does not have a large external surplus.
But prior to the crisis, the huge external surpluses were placing upward pressure on the Chinese currency as is shown in the next graph.
The following graph shows the movement in the Chinese yuan (to one US Dollar) from January 1985 to April 2018.
The 50 per cent devaluation in December 1993 is obvious. This was when China unified its dual exchange rate system and aligned its official and swap centre rates as part of its so-called take-up of the ‘socialist market economy’.
It devalued by 33 percent overnight to 8.7 to the dollar and then allowed the market to take the yuan further down.
In 2005, the PBC stated that it was shifting to a “a managed floating exchange rate based on market supply and demand with reference to a basket of currencies”.
This pushed the value up against the USD.
The flat section during the GFC followed the PBC pegging the currency against the USD to insulate the Chinese economy from the GFC.
This led to allegations that the PBC was manipulating the value of the yuan against the USD to favour China’s exporters.
There was no definitive conclusion though because there was widespread disagreement as to whether the yuan was overvalued or undervalued.
But, with international pressure rising, China entered a period of appreciation from 2010 came with the PBC announcing that it was ending the peg and allowing some ‘flexibility’ into the yuan.
In February 2012, the yuan appreciated to 6.2884 which was a record high level for the currency.
The value then eased only to begin a new phase of appreciation in 2017.
I put together the exchange rate time series with the build up of foreign exchange reserves at the PBC (using monthly data) to show you the relationship (if any).
During the GFC, when the PBC pegged the rate against the US dollar, the build up of foreign currency reserves accelerates.
Prior to that foreign exchange reserves were increasing significantly even though the yuan was appreciating. The point is that the Chinese government was containing that appreciation in some orderly way through official intervention.
Note that the depreciation that became in 2014 was accompanied by a sell off of foreign exchange reserves.
Finally, consider the next graph which shows the relationship between China’s current account balance and the stock of foreign reserves held by the PBC.
The lower part of the graph starts in 1997 and shows the rising current account surplus with a rising stock of foreign exchange reserves.
As the current account has returned to much lower values, the foreign exchange reserves continued to rise.
In other words, there is nothing unidirectional about this relationship. It all comes down to whether the central bank chooses to manipulate its currency in international markets or not.
Now consider Japan.
The first graph shows its current account balance as a percent of GDP from 1980 to 2017. It averaged 2.47 per cent over that period.
Relative to China, Japan runs a significantly larger external surplus.
Now here is a graph of foreign currency reserves (millions of yen) held at the Bank of Japan. The spike occurred during the GFC when the Bank was taking extraordinary steps to help its export sector.
There has been hardly any trend increase over the 20 odd years shown.
And as a percentage of total Bank of Japan assets, foreign currency reserves have been very stable and since the recovery period have been falling.
The point is that there is no consistent relationship between external surpluses and the holdings or changes in holdings of foreign exchange reserves at the central bank.
Clearly, if a central bank is engaging in currency manipulating to try to reduce the currency effects of current account surplus then it will be increasing the monetary base.
But Japan shows that that is not an inevitable outcome of external surpluses on the current account.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.