As the Fed raised interest rates by 75 basis points last Wednesday for the fourth time this year, financial markets are beginning to shake.  Basically, the interest rate hikes in response to higher inflation is a reversal of nearly two decades of generally declining global interest rates, higher asset bubbles and not surprisingly, anemic growth.  

The Bank for International Settlements (BIS) has just issued a paper looking at the policy implications of exchange rate swings.   The US dollar index has broadly appreciated 10% against the other currencies since the beginning of the year, 15.2% since its recent low in June 2021, and 46.8% since its 12 year low in August 2011.

The yen has dropped to its recent low of 150 against the dollar on 20 October and Mr. Yen (Professor Sakakibara, former Japanese Vice Minister for International Finance) hinted that yen may go to 170.  

The BIS attributes three factors to the appreciation in the dollar: (1) an improvement in US terms of trade with higher oil prices that impact on Europe and Japan as oil importers (concomitantly with US emerging as oil exporter); (2) divergence in monetary policy stance (interest rate differentials), as Fed is more aggressive in raising rates than European Central Bank (ECB) or Bank of Japan (BOJ); and (3) flight to quality due to war and fears of recessions.  

The Chinese have a saying that the bum pushes the brain – your point of view depends on where you sit.  Economists tend to look at prices (from supply and demand) and flows, which are changes in stock (or balance sheet) over time, because these are the most readily available numbers.  However, if you look at the earth from 30,000 feet up, you see broadly the stock position, whereas flows are micro-blip changes from that height. At ground level, you only see flows, because the big stocks do not appear to change that fast.  

Reality requires us to look at both stock and flows, which is why we must examine the balance sheet effect of price and flow changes.   The Japanese were the first to understand the process of aging and balance sheet effects.  After the 1980s asset bubble reversals (arising from the rapid appreciation of the Yen versus the dollar), Japan went through a balance sheet deflation, meaning that Japanese companies and households spent the next three decades rebuilding their balance sheets aid by near zero interest rates.  

What Japan did had world-shaking implications that many Western analysts ignored, mainly because it suited Wall Street.   With the big swings in the Yen rate, Japanese GDP in yen terms have been roughly flat but slightly growing, but in USD terms have declined from a peak of USD6.2 trillion in 2012 to $4.9 trillion at the end of 2021.  However, in terms of net international investment position (the amount of net foreign assets minus foreign liabilities), Japan has built up a formidable $3.6 trillion or 75.8% of GDP war chest, compared with only $0.8 trillion or 16.3% of GDP in 1999.  

In other words, in preparation for aging population plus slower domestic growth, Japan shifted her financial assets abroad on a massive scale, so that depreciation in Yen would mean higher income and wealth effect from foreign earnings.

The architect of this transformation is Governor Kuroda of the Bank of Japan.  Under his watch, BOJ today owns more than half of the Japanese government bonds (JGBs) continuing to buy JGBs to maintain a flat zero yield curve, under what is called yield curve control (YCC).  In effect, Japanese pension funds are protected from Japanese inflation and interest rate increases, since long-term bonds are shifted to BOJ balance sheet.  In terms of scale, BOJ holdings of JGBs is $3.6 trillion, almost identical to net Japanese surplus in foreign assets.

In September and October this year, the Japanese Ministry of Finance already spent Yen9.1 trillion ($61.9 billion) to slow Yen’s depreciation.  Expect more to come.  


How does USD strengthening impact on global balance sheets?  

The US net liability position has deteriorated to $18.1 trillion at the end of 2021, of which Japan alone accounted for 19.7% and East Asia surplus economies (Japan, China, Hong Kong, Taiwan and Singapore) accounted for 55.8%.  Europe as a whole is square, having a net investment liability of 2% of GDP in 2010 to currently negligible (0.2%) net liability.  The Northern European surpluses are cancelled by Southern European liabilities.    

As the BIS analysis shows, USD strengthening is generally bad for the world economy because higher USD interest rates tighten trade finance liquidity and impacts on financial stability on those sovereign and corporate borrowers in USD.  As dollar strengthens, whilst Euro and Japanese interest rates become cheap in relative terms, the carry trade will increase, meaning you borrow Euro and Yen to invest in dollar assets, paying cheaper interest rates and expecting the exchange rates to depreciate.  This accelerates USD strengthening until it’s time to take profits.  The carry trade was instrumental to financial accidents in both the 1997 and 2008 crashes. 

From a macro-perspective, the US economy is sitting pretty, with imports cheaper due to strong dollar, but how long can the dollar continue to strengthen?   The global rich class loves higher US dollars because it protects their interests, but worry that global liquidity tightening will result in a global deflation.  When it begins to weaken, expect no loyalty from the rich.  

This balance sheet view shows that exchange rate shifts reflect fundamental big picture structural changes. And the strength of the US dollar matters in the geopolitical power game.  

If the US uses this window of opportunity to do major reforms, the strength of the dollar would simply reinforce the view that America is back.  If the markets perceive that the macro-economic management is flawed, like what happened to sterling in September, then the markets can be brutal in punishing such mistakes.  

Which is why I am watching if and when BOJ monetary policy reverses course.   That is when small waves may signal tsunamis ahead.  

Contributed by 

Andrew Sheng