Emerging markets at risk from a gigantic bubble

From :FT

By orchestrating a massive appreciation of the yen in the mid 1980s, the US condemned Japan to decades of stagnation and ended the challenge to its own economic hegemony. Effectively, Japan was forced to commit financial hara-kiri.

This theory, once confined to Japan’s nationalistic fringe, is now being used by the Chinese authorities to justify their resistance to a substantial revaluation of the renminbi. By so doing they are misdiagnosing Japan’s woes and misperceiving the true threat to their own economy. The threat to China does not lie in an appreciating currency, but elsewhere.

Here’s what happened in the case of Japan. In the Plaza Accord of 1985 the G7 attempted to address global imbalances – worrying then, but small beer by today’s standards – by “encouraging” significant changes in currency parities. They got what they wanted. The yen took off and never looked back.

Japanese policymakers accepted the loss of competitiveness not because they were submissive, but because they were brimming with self-confidence. They believed their economy would survive any downturn with little damage, and they were right: the recession of 1986 was short and shallow.

Furthermore they saw a strong yen as a useful weapon in a world in which Japan’s trading partners were imposing quotas on its most successful companies. Again they were right. The all-powerful yen allowed Japanese auto makers to build up manufacturing capacity inside key Western markets.

They also believed it was high time to shift the Japanese economy from exports to consumption, and that a stronger yen would raise the purchasing power of households. Here, though, they were wrong.

The spending spree of the late 1980s – when Japanese salarymen sprinkled gold-flakes on their noodles and secretaries stayed in the same upmarket Hawaiian resorts as American chief executives – is now a distant memory.

What got in the way was one of history’s worst doses of bubble trouble. For a crucial thirty months after the mild recession was over, the authorities allowed credit growth to rip and real estate and stock prices to soar.

Why would they do such a thing? Because of those fatal words that lie behind every bubble: “this time it’s different.” They genuinely believed what pundits, academics and opinion-leaders everywhere were saying – that Japanese industrial might was unstoppable, that Japan was destined to become the world’s largest economy.

So in a sense Japan did commit financial suicide – not by allowing the extraordinary rise in the yen, but by allowing an even more extraordinary rise in asset prices. By the end of 1989 Tokyo accounted for more than half of the world’s stock market capitalisation and the grounds of the Imperial Palace alone were reportedly worth more than the entire state of California.

The inevitable bust took down the banking system and set off a deflationary dynamic from which Japan has yet to recover.

This didn’t have to happen. We know this because the Plaza Accord targeted two countries with bulging current account surpluses. The other was pre-unification Germany.

Between September 1985, when the G7 met at the Plaza Hotel, and December 1990, when the Nikkei Index peaked out, both the yen and the mark rose roughly 40 per cent against the dollar. But in stark contrast to the Japanese experience, there was no German bubble. While the Nikkei was trebling, the Dax rose by a cumulative 50 per cent – less than most major markets. German house prices gently declined.

The message is clear. It wasn’t the rise in the yen which sunk Japan, but the response, which was an egregious policy mistake. So if you really wanted to sabotage the rise of China, the best way would be to facilitate a gigantic asset bubble.

In present circumstances, that would probably be best accomplished by leaving the renminbi where it is. This would lock high-growth China into the super-low interest rates appropriate for the weak US economy, force savers out of cash and into the housing market, and ensure credit grows much more than gross domestic product – the perfect mix for bubble trouble.

The degree of euphoria surrounding some emerging economies is already troubling. The Indian and Indonesian stock markets are trading at price earnings ratios of over 40 times, based on ten-year average earnings. You would surely need a hundred years of fortitude to buy Mexico’s recently-issued 100-year bond at a yield of 5.6 per cent. Bubble and bust in China, on which the world is now so dependent for growth and optimism, would likely tank the commodities markets, set off a second round of deflation, and end the emerging markets boom in the most spectacular way possible.

Peter Tasker is a Tokyo-based analyst with Arcus Research

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