US-Japan Exchange Rate Pact Could be Tempting

Revival of active currency policy may chime with Trump’s China objectives

By James McCormack

News that Japan has overtaken China as the top foreign holder of U.S. Treasury securities comes perhaps fortuitously as the incoming Trump administration girds for potential confrontation on economic and trade issues with Beijing. The development could play into a coordinated initiative that might help with Japan’s extended deflation battle and offer the U.S. a chance to tilt Asia’s regional economic balance in its preferred direction.

There are two reasons why the decline in China’s foreign reserves could be viewed positively by the U.S. Most obviously, as China gradually runs down its holdings of U.S. Treasuries to lean against yuan depreciation related to large capital outflows, it cedes symbolic leverage. The threat, empty as it may be in any meaningful way, of dumping Treasuries in response to provocative U.S. trade measures, diminishes proportionately with the stock held.

Second, despite President-elect Donald Trump’s rhetoric about China manipulating its currency to enhance its competitiveness at the expense of the U.S., steadily falling reserves are clear evidence of Beijing’s exchange rate policy doing the exact opposite. China may yet choose to allow a large devaluation, but it seems unlikely as the authorities are sensitive to the social consequences of higher inflation that would follow and it would almost certainly exacerbate the capital outflows they are currently trying to manage.

Japan has passively taken the lead in Treasury holdings by virtue of Chinese sales. But in its so far unsuccessful quest to generate a sustainable inflationary impulse, it may be time to consider additional bold measures to at least complement, if not partially displace, its purchases of its own government bonds and its yield curve management. An explicit policy of accumulating U.S. Treasuries could have several concurrent positive effects.

Along with higher U.S. interest rates consistent with expectations of fiscal reflation, one of the main global financial market consequences of the U.S. presidential election has been dollar appreciation. The Japanese yen is already down about 10%.

Channeling some Japanese base money expansion to the purchase of U.S. Treasuries should push the yen lower still. This would add inflationary pressure that has failed to take hold under policies that until now have primarily resulted in very low interest rates and ever-larger commercial bank reserve holdings with the Bank of Japan.

‘Zero-sum’ Solutions

From the BOJ’s perspective, the accumulation of U.S. Treasuries would reduce the overall credit risk on its balance sheet, which may be a consideration over time. Perhaps more importantly, it would also weaken the argument that the BOJ is engaged in debt monetization, a precursor to the risk of perceived fiscal dominance and diminished central bank policy independence. Additionally, a less active BOJ in the Japan government bond market might be welcomed by other buyers amid concerns about the growing difficulties of pricing credit in the country.

A compelling argument against any U.S.-Japan initiative to weaken the yen is the fact that active currency policies were discarded by advanced economies in the 1980s based on the understanding that they did not work and amounted to “zero-sum” solutions whereby one country’s comparative gains were matched fully by another’s losses.

Admittedly, it cannot be known if a prolonged period of yen depreciation would in fact raise Japanese inflation rates given the failure of so many other policies intended to achieve this outcome over the last 30 years. But Japan does appear to be running out of policy options and it was the 1985 Plaza Accord, designed conversely to strengthen the yen and weaken the dollar, which some commentators regard as the catalyst for the subsequent bursting of Japan’s property bubble and the onset of deflation.

As to the “zero-sum” issue, the new U.S. administration may take the view that its overall interests and, more specifically, its concerns regarding China’s growing regional economic dominance, are not badly served by the dollar strengthening against the yen if it contributes to an improvement in Japan’s economic prospects. Trump’s pledge to return manufacturing jobs to the U.S. would in theory be impeded by a weaker yen, but it is doubtful there have been meaningful job losses to Japan over the years.

An agreement between the U.S. and Japan to manage their exchange rate may seem a far-fetched idea, but so too did several now-standard monetary policy approaches to low inflation and weak economic growth before they were adopted. Moreover, investors need to be alert to the likelihood that recent unexpected political turns will be followed by economic policies which are equally unexpected or were previously put to bed. The return of a more aggressively protectionist approach to trade is one such policy and openly active exchange rate management, starting with the U.S. and Japan, may be another.

This article was first published exclusively in the Nikkei Asian Review.

James McCormack is global head of sovereign and supranational ratings at Fitch Ratings.