In my previous article, Why the rising interest rate cannot go further than the current consensus, I have explained that instead of raising interest rate Japan is using their foreign exchange reserve to ease the strong USD by selling their USD into exchange rate market.
Source: Investing.com
Why is this happening? Can they not simply raise interest rate to prevent depreciation of their currency, yen?
To understand what is happening, we need to understand the structure of the Japanese economy and Japanese politics.
1) Japanese economy dependence on exports/energy imports
In general, depreciation of currency is known to benefit a country’s exports but leads to higher goods price as the price of imported goods increases.
This is precisely what is happening to Japan: while the Japanese exporting companies are benefiting from currency depreciation, import price—especially energy—is soaring.
Why does Japanese policy makers like this situation?
1. It is a good opportunity for companies to make profit from exports
2. It creates incentives for companies who have gone out of Japan to come back to domestic market, as they can now benefit from weaker yen
3. The increased price and quantity of energy imports is a good excuse to restart the Fukushima nuclear power plant, which has been shutdown since 2011 Tohoku earthquake and tsunami in Japan
4. Price level is increasing, which has been one of the core objectives of the Japanese government in the last few decades
2) Unchanging behavior of Japanese household assets
Japan has been swamped by persistent deflation since its bubble burst in the late 1980s. Under deflationary environment, in which price falls, currency strengths and the value of assets remain stagnant, people delay spending their money (because price tomorrow will be cheaper than today) and hold onto cash (because asset values do not appreciate, hence no reason to invest).
As a result, Japanese households hold more cash and deposits than the rest of the world (more than 50% compared to 13% US and 34% Europe, as per image below)
Source: Flow of Funds- Overview of Japan, the United States, and the Euro area, Bank of Japan, August 2019
Notes: (1) “Others” is the residual which is the remaining after deducting “Currency and deposits,” “Debt securities,” “Investment trusts,” “Equity,” and “Insurance, pension and standardized guarantees” from total financial assets
You can find my article on asset portfolio and pension funds of countries.
This is precisely why the deceased Ex-Prime Minister, Shizo Abe, tried unlimited quantitative easing and kept interest rate to virtually zero to effect changes in the behaviors of Japanese, and incentivize them to spend their cash.
For policy makers and politicians, decreasing purchasing power of the yen is a great opportunity to change the psychology of the Japanese people, in that it signals that perennial deflation is going away and that Japanese consumers will have to change their perception and behaviors under rising inflation environment to survive.
3) Indifference of Japanese to politics
However, inflation entails pains, which could lead to political discontent for the incumbent party and as a result, potentially regime change. This is precisely what is happening to many countries in the world, where the incumbent parties are facing harsh criticisms under difficult economic circumstance.
If regime change is imminent, then politicians will have to change their policy to assuage economic pain.
However, Japanese politicians do not need to take into consideration political unpopularity arising from sticking to zero interest rate, because Japan has been a de-facto one party ruling country except few years in its history since the World War II.
The Liberal Democratic Party (LDP) has been in power almost continuously since its foundation in 1955—a period called the 1955 System—except between 1993 and 1994, and again from 2009 to 2012.
Under such political circumstance, the incumbent ruling party has much breathing room in sticking to unpopular policy.
Conclusion
The Japanese government and bank of Japan are maintaining the current zero interest rate in spite of the rest of the world’s interest hike, because Japan knows that this could be a catalyst for effecting behavior change of Japanese people and would like to take advantage of depreciating yen to for their corporations, while political cost is very low.
This article is also published in Macrotrend
