Resolving Shirakawa’s conundrum


The governor of the Bank of Japan, Masaaki Shirakawa, says he is confounded by the still very low level of Japanese government bond yields given the country’s elevated debt to GDP ratio of over 200 percent. Speaking on an IMF panel over the weekend, he offered a rather unintuitive explanation for the phenomenon:

It seems difficult to explain the case of Japan in light of conventional wisdom. One frequently offered explanation is that the ample domestic savings in Japan have absorbed the issuance of JGBs and the share of JGBs held by foreign investors is very small. But a more fundamental explanation is that the stability in the current bond yields reflects market participants’ expectations that fiscal soundness will be restored through structural reforms imposed in the economic and fiscal areas.

Most economists think Japanese yields are low because of continued expectations for deflation and weak economic growth. But for Shirakawa, it seems, it is public confidence in future fiscal restraint that is keeping bond yields low. Except he then contradicts this point by saying weak confidence in future fiscal reforms is also simultaneously undermining consumer spending:

At the moment, such expectations are not firmly backed by concrete reform plans. The public therefore restrains spending on concerns over future fiscal developments. This constitutes one factor behind sluggish economic growth and mild deflation. If this is indeed the case, the experience of Japan indicates a possibility that a cumulative increase in government debt combined with weak economic growth expectations might generate deflationary pressures.

Not so, argues Ugo Panizza, head of debt and finance analysis at the United Nations Conference on Trade and Development. He and co-author Andrea Presbitero find no causal link between high debt levels and weak economic growth.

IMF crisis funds: Why nobody really cares

With reporting from Steven C. Johnson and Nick Olivari

A lot of time and money is spent on high-profile multilateral gatherings like this weekend’s International Monetary Fund meeting in Washington. The central story this time is the Fund’s effort to raise more funds (no pun intended), which appears to have been successful as G20 nations committed more than $430 billion in new funds.

French Finance Minister François Baroin, speaking to reporters at a press briefing on the sidelines of the IMF meeting, greeted the news with optimism:

Clearly, the reinforcement of the IMF with more than $400 billion in new resources and its effects on confidence will contribute to financial stability in the euro zone.

Election fever hits the markets

We’re not talking about the U.S. presidential vote, though that does cast another layer of uncertainty over the outlook. Rather, investors are focused on even shorter-horizon events, as evidenced by this jam-packed electoral worry list from Marc Chandler, currency strategist at Brown Brothers Harriman:

This weekend’s first round of the French presidential election kicks of the quarter that will include:

*   Greek national elections, where polls warn that the current coalition government may not be returned, increasing the uncertainty.

Europe’s triple threat: bad banks, big debts, slow growth

The financial turmoil still dogging Europe is most often described as a debt crisis. But sovereign debt is only part of the problem, according to new research from Jay Shambaugh, economist at Georgetown’s McDonough School of Business. The other two prongs of what he describes as three coexisting crises are the region’s troubled banks and the prospect of an imminent recession.

These problems are mutually reinforcing, and require a more forceful policy response than the authorities have delivered to date. In particular, Shambaugh advocates using tax policy to lower labor costs, fiscal stimulus from those economies strong enough to afford it, and more aggressive action from the European Central Bank:

It is possible that coordinated shifts in payroll and consumption taxes could aid the painful process of internal devaluation. The EFSF could be used to capitalize banks and to help break the sovereign / bank link. Fiscal support in core countries could help spur growth.  Finally, the ECB could provide liquidity to sovereigns and increase nominal GDP growth as well as allow slightly faster inflation to facilitate deleveraging and relative price adjustments across regions.

Return of the currency wars

Maybe it never went away at all. But if the war was dormant, Brazilian President Dilma Rousseff certainly launched what appeared to be an opening salvo for a new round of battles – rhetorical ones for now.

Rousseff reached for some cataclysmic language to describe the recent appreciation of the real, which Brazil worries will crimp exports and hurt the domestic economy. The culprit, according to Rousseff, is an irresponsible “monetary tsunami” resulting from the ultra-loose monetary policies of rich nations like the United States.

Alonso Soto and Tiago Pariz offer some background in this Reuters article out of Brasilia:

China renminbi as reserve currency: yuan a bet?

China’s importance to the global economy makes it difficult to believe the role of the yuan in foreign exchange will not continue to expand. Will that dominance advance sufficiently to make the Chinese renminbi one of the world’s reserve currencies? A new study from the Brookings Institution suggests that in the long run, the ascendance of the yuan to reserve-currency standing is likely. It notes that of the six largest economies in the world, China is the only one whose currency does not have reserve status. But the road to getting there will be long and tortuous, the study warns, and there will be plenty of potholes.

Getting there will require overcoming two main challenges, according to Eswar Prasad and Lei Ye, who authored the report:

Sequencing of capital account opening with other policies, such as exchange rate flexibility and financial market development, to improve the cost/benefit trade-off.

Will U.S. criticism affect Japan’s FX stance?

Currency analysts are divided over whether U.S. criticism of Japan’s forex policy will change Tokyo’s currency stance. While some say it could raise the hurdle for further Japanese intervention, others think it might not have much impact. Rob Ryan, FX strategist at BNP Paribas in Singapore says the effect will be limited given uncertainty about the Japanese economy’s outlook and current levels of dollar/yen and cross/yen pairs.

“I think if they (Japanese authorities) feel they have to intervene, they will intervene,” Ryan says, adding that a dollar drop down to the “low 76s” might be enough to prompt further action from Japan.

The U.S. Treasury Department said in its semi-annual report on international exchange rate policies issued on Tuesday that the U.S. did not support Japan’s recent bouts of solo FX intervention, adding that they took place when volatility in dollar/yen was relatively low. USD/JPY was currently trading at Y77.98, not too far from a record low of Y75.311 hit on Oct. 31, when Japan conducted massive yen-selling intervention.

Without “bazooka,” Europe still vulnerable

This time it was going to be different. A make-or-break, comprehensive, grand, “bazooka” solution would draw a line under the euro zone debt crisis.

But the plan agreed by all EU states except Britain to pursue stricter budget rules and a stronger fiscal union did little to soothe bond markets. Ten-year Italian yields rose as far as 6.8 percent, prompting the European Central Bank to intervene in the secondary market, and German Bunds rose more than 100 ticks on the day.

Among the short-falls, the capacity of the euro zone’s bailout fund was capped and it was not granted a banking license. For now, this puts more pressure on the European Central Bank to help contain the crisis by stepping up bond-purchases. The bank however has repeatedly resisted a bigger crisis-fighting role and last week dampened expectations that it could ramp up a program which has tried to keep borrowing costs affordable. The legal basis of a new accord to enforce debt and deficit rules also still needs to be worked out.

Drop in Fed custody holdings reflects FX interventions

A sharp recent drop in the Fed’s holdings of U.S. Treasuries for foreign central banks probably reflects the effort by many developing economies to stem rapid declines in their currencies, not some frightening move by the likes of China out of U.S. bonds. That’s the argument put forth by Marc Chandler at Brown Brothers Harriman, who notes the pullback of recent weeks appears to have been the most dramatic since the Asian financial crisis of the late 1990s.

His reasoning makes sense: a September spike in the U.S. dollar was accompanied by steep plunges in the exchange rates of many emerging economies. Still, Chandler remains puzzled as to why the selling accelerated to a hefty $21 billion even as the dollar reversed course in the last week:

This is the seventh consecutive weekly decline and over this period, custody holdings have fallen an average of about $12-$12.5 billion a week, making this past week quite large relative to trend. It likely reflects foreign central banks’ selling of Treasuries to intervene to support their currencies rather than a dumping of Treasuries to diversify reserves or as a protest to such low interest rates.

Carstens says Mexican peso undervalued

Mexico Central Bank Governor Agustin Carstens spoke to Reuters Insider on the sidelines of this year’s IMF/G20 meetings. He said the peso, which like many other emerging market currencies has taken a drubbing with the dollar’s recent rally, is undervalued. But unlike in Brazil, where an even more volatile exchange rate has prompted the monetary authorities to step in, Carstens said Mexico does not see the need to intervene.

As long as the markets continue to work well, I think central bank intervention is not required. If we guide ourselves by fundamentals the peso should appreciate soon.

Asked about the path of monetary policy for Mexico, Carstens said he backs a “neutral” stance for now given all the uncertainty in the global economy. Until recently, analysts were betting the central bank would lower borrowing costs to offset the drag from a global economic slowdown. But the peso’s steep depreciation, with its potentially inflationary implications, has muddled the outlook for Mexican interest rates, currently at 4.5 percent. Mexico is struggling to recover from a deep recession in 2009, with growth seen below 4 percent this year, and is particularly vulnerable to lower U.S. demand.