Fw: [Longwaves Forum]remarks by AG on japan

["Gary Santos" <garysantos@xxxxxxxxxxxx>]

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Subject: [Longwaves Forum]remarks by AG on japan


>
> Remarks by Chairman Alan Greenspan
> Current account
> Before the Economic Club of New York, New York, New York
> March 2, 2004
>
> It has been a number of years since the foreign exchange rate of the
dollar
> has played so prominent a role in evaluations of economic activity.
>
> I have no intention today of discussing the foreign exchange policy of the
> United States. That is the province of the Secretary of the Treasury. Nor
do
> I intend to project exchange rates. My experience is that exchange markets
> have become so efficient that virtually all relevant information is
embedded
> almost instantaneously in exchange rates to the point that anticipating
> movements in major currencies is rarely possible. The exceptions to this
> conclusion are those few cases of successful speculation in which
> governments have tried and failed to support a particular exchange rate.
>
> Nonetheless, despite extensive efforts on the part of analysts, to my
> knowledge, no model projecting directional movements in exchange rates is
> significantly superior to tossing a coin. I am aware that of the thousands
> who try, some are quite successful. So are winners of coin-tossing
contests.
> The seeming ability of a number of banking organizations to make
consistent
> profits from foreign exchange trading likely derives not from their
insight
> into future rate changes but from market making.
>
> This may seem a rather surprising conclusion, given that so many
> commentators apparently believe that they know the real value of the
dollar
> must decline further because of the record current account deficit of the
> United States. It should be sobering to recall that three years ago
> --February 2001-- to be exact for similar reasons a vast majority of a
large
> panel of forecasters were projecting a lower dollar against the euro. In
the
> subsequent twelve months, the dollar rose nearly 6 percent against the
euro.
>
> Rather than engage in exchange rate forecasting, today I will discuss
> certain developments in foreign exchange markets, and in the international
> financial system in general, which bear on the ultimate outcome of our
> current account adjustment process. Before raising the broader issues of
> adjustment, I should like to address the actions of certain of the players
> in the exchange market that are likely to delay the adjustment process,
but
> only for a time.
>
> I refer to the heavy degree of intervention by East Asian monetary
> authorities, especially in Japan and China, and the apparent stepped up
> hedging of currency movements by exporters, especially in Europe. As all
of
> you who follow these markets are aware, since the start of 2002, the
> extraordinary purchases by Asian central banks and governments of dollar
> assets, largely those by Japan and China, have totaled almost $240
billion,
> all in an apparent attempt to prevent their currencies from rising against
> the dollar. In particular, total foreign exchange reserves for China
reached
> $420 billion in November of last year and for Japan more than $650 billion
> in December.
>
> The awesome size of Japan's accumulation results from persistent
> intervention to suppress what Japanese authorities have judged is a
> dollar-yen exchange rate that is out of line with fundamentals. One factor
> boosting the yen is a significant yen bias on the part of Japanese
> investors. This propensity, in my judgment, runs far beyond the normal
> tendency of investors worldwide to buy familiar domestic assets and eschew
> foreign-exchange risk.
>
> Nowhere else in the world will investors voluntarily purchase ten-year
> government obligations at an interest rate of 1 percent or less,
especially
> given a rate of increase in the outstanding supply of government debt that
> has generally been running at 9 percent over the past year. Not
> surprisingly, very few Japanese government bonds (JGBs) are held outside
of
> Japan.
>
> Aside from the holdings of the Bank of Japan, almost all JGBs are held by
> Japanese households, banks, insurance companies and the postal saving
> system. And none of them holds significant amounts of foreign assets; 99
> percent of household assets are in yen, and, including the postal saving
> system, about 91 percent of the assets of financial institutions are in
yen.
> Japanese nonfinancial corporations do hold a larger share of foreign
assets
> in their securities' portfolios, but the absolute amounts are small. The
> Japanese have made significant foreign direct investments, especially in
the
> United States, and the Ministry of Finance does, of course, hold large
> dollar balances as a consequence of exchange rate intervention. But the
> Japanese private sector, by and large, has exhibited limited interest in
> accumulating dollar or other foreign assets, removing what in other large
> trading economies would be a significant segment of demand for foreign
> assets.
>
> The degree of domestic currency bias in Japan, which far exceeds that of
its
> trading partners, may thus have contributed to a foreign exchange rate for
> the yen that appears to be elevated relative to the dollar and possibly
> other internationally traded currencies as well.1 Of course, this
preference
> for yen assets, while a persistent influence on the value of the yen, has
at
> times been overwhelmed by other factors.
>
> Granted the level of intervention pursued by the Japanese monetary
> authorities has influenced the market value of the yen, but the size of
the
> impact is difficult to judge. In any event, it must be presumed that the
> rate of accumulation of dollar assets by the Japanese government will have
> to slow at some point and eventually cease. For now, partially
unsterilized
> intervention is perceived as a means of expanding the monetary base of
> Japan, a basic element of monetary policy. (The same effect, of course, is
> available through the purchase of domestic assets.) In time, however, as
the
> present deflationary situation abates, the monetary consequences of
> continued intervention could become problematic. The current performance
of
> the Japanese economy suggests that we are getting closer to the point
where
> continued intervention at the present scale will no longer meet the
monetary
> policy needs of Japan.
>
> China is a similar story. In order to maintain the tight relationship with
> the dollar initiated in the 1990s, the Chinese central bank has chosen to
> purchase large quantities of U.S. Treasury securities with renminbi. What
is
> not clear is how much of the current upward pressure on the currency
results
> from underlying market forces, how much from capital inflows owing to
> speculation on potential revaluation, and how much from capital controls
> that suppress the demand of Chinese residents for dollars and other
> currencies.
>
> No one truly knows whether easing or ending capital controls would lessen
> pressure on the currency and, in the process, also eliminate inflows from
> speculation on a revaluation. Many in China, however, fear that an
immediate
> ending of controls could induce capital outflows large enough to
destabilize
> the nation's improving, but still fragile, banking system. Others believe
> that decontrol, but at a gradual pace, could conceivably avoid such an
> outcome.
>
> Chinese central bank purchases of dollars, unless offset, threaten an
excess
> of so-called high-powered money expansion and a consequent overheating of
> the Chinese economy. The Chinese central bank last year offset --that is,
> sterilized-- much of its heavy dollar purchases by reducing its loans to
> commercial banks, by selling bonds, and by increasing reserve
requirements.
>
> But the ratio of the money supply to the monetary base in China has been
> rising steadily for a number of years as financial efficiency improves.
Thus
> the modest rise that has occurred in currency and commercial bank reserves
> has been enough to support a twelve-month growth of the M2 money supply in
> the neighborhood of 20 percent through 2003 and a bit less so far this
year.
> Should this pattern continue, the central bank will be confronted with the
> choice of curtailing its purchases of dollar assets or facing an
overheated
> economy with the associated economic instabilities. Lesser dollar
purchases
> presumably would allow the renminbi, at least temporarily, to appreciate
> against the dollar.
>
> Other East Asian monetary authorities, in an endeavor to hold their
> currencies at a par with the yen and the renminbi, accumulated about $120
> billion in reserves in 2003 and appear to have continued that rate of
> intervention since.
>
> * * *
>
> There is a general view that this heavy intervention places upward
pressure
> on the euro. It is assumed that the dollar's trade-weighted exchange rate
> reflects its worldwide fundamentals, and therefore if the Asian currencies
> are being suppressed, the euro and other non-Asian currencies need to
> appreciate as an offset.
>
> But a more likely possibility is that Asian currency intervention has had
> little effect on other currencies and that the trade-weighted average of
the
> dollar is, thus, somewhat elevated relative to the rate that would have
> prevailed absent intervention. When Asian authorities intervene to ease
> their currencies against the dollar, they purchase dollar-denominated
assets
> from private sector portfolios. With fewer dollar assets in private hands,
> the natural inclination to rebalance portfolios will tend to buoy the
dollar
> even against currencies that are not used in intervention operations,
> including the euro. These transactions raise the dollar against, for
> example, the yen, lower the yen against the euro, and lower the euro
against
> the dollar. The strength of the euro against the dollar thus appears to be
> the consequence of forces unrelated to Asian intervention. As I will
explain
> later, this does not mean that when Asian intervention ceases the dollar
> will automatically fall because other influences on the dollar cannot be
> foreseen.
>
> Some have argued that purchases of U.S. Treasuries by Asian officials are
> holding down interest rates on these instruments, and therefore U.S.
> interest rates are likely to rise as intervention by Asian monetary
> authorities slows, ceases, or even turns to net sales. While there are
> obvious reasons to be concerned about such an outcome, the effect of a
> reduction in the scale of intervention, or even net sales, on U.S.
financial
> markets would likely be small. The reason is that central bank reserves
are
> heavily concentrated in short-term maturities; moreover, the overall
market
> in short-term dollar assets, combining both public and private
instruments,
> is huge relative to the size of asset holdings of Asian monetary
> authorities. And because these issues are short-term and hence capable of
> only limited price change, realized capital losses, if any, would be
small.
> Accordingly, any incentive for monetary authorities to sell dollars, in
> order to preserve market value, would be muted.
>
> * * *
>
> A different issue arises with the apparent level of hedging by exporters
in
> Europe and elsewhere. The effect, however, is the same as Asian official
> intervention: It slows the process of adjustment.
>
> Against a broad basket of currencies of our trading partners, the foreign
> exchange value of the U.S. dollar has declined about 12 percent from its
> peak in early 2002. Ordinarily, currency depreciation is accompanied by a
> rise in the dollar prices of our imported goods and services, because
> foreign exporters seek to avoid price declines in their own currencies,
> which would otherwise result from the fall in the foreign exchange value
of
> the dollar.
>
> Reflecting the swing from dollar appreciation to dollar depreciation, the
> dollar prices of goods and services imported into the United States have
> begun to rise after declining on balance for several years. But the
> turnaround to date has been moderate and far short of that implied by the
> exchange rate change. Apparently, foreign exporters have been willing to
> absorb some of the price decline measured in their own currencies and the
> consequent squeeze on profit margins it entails in order to hold market
> share. In fact, given that the nearly 9 percent rise in dollar prices of
> goods imported from western Europe since the start of 2002 has been far
> short of the rise in the euro, profit margins of euro-area exporters to
the
> United States may well have turned negative.
>
> Nonetheless, euro-area exports to the United States, when expressed in
> euros, have slowed only modestly. A possible reason is that European
> exporters' incentives to sell to the United States were diminished
> significantly less than indicated by the dollar price and exchange rate
> movements owing to accelerated short forward positions against the dollar
in
> foreign exchange markets. A marked increase in foreign exchange derivative
> trading, especially in dollar-euro, according to the Bank for
International
> Settlements, is consistent with increased hedging of exports to the United
> States and to other markets that use currencies tied to the U.S. dollar.2
>
> However, most contracts are short-term because long-term hedging is
> expensive. Thus, although hedging may delay, and perhaps even smooth out,
> the adjustment, it cannot eliminate, without prohibitive cost, the
> consequences of exchange rate change. Accordingly, the currency
depreciation
> that we have experienced of late should eventually help to contain our
> current account deficit as foreign producers export less to the United
> States. On the other side of the ledger, the current account should
improve
> as U.S. firms find the export market more receptive. But in the process,
> dollar prices of imports will surely rise.
>
> * * *
>
> When the temporary forestalling of the U.S. balance of payments adjustment
> process comes to an end, does that suggest a steepening of the decline in
> the dollar's exchange rate?
>
> As I pointed out in the beginning, the most sophisticated analytical
> techniques have been unable to profitably project the exchange rates of
> major currencies. Yet, most commentators argue that because the current
> account deficit must eventually narrow, the price-adjusted value of the
> dollar must accordingly decline. But how can exchange rates and the
current
> account be systematically related, if exchange rates are inherently
> unpredictable? The answer is that the point at which the U.S. current
> account deficit will be forced to narrow is itself inherently difficult to
> predict. The current account reflects the myriad forces that bring our
> transactions with foreign economies into balance at our borders, of which
> exchange rates are only one. But those forces that, in the end, are
> reflected in a current account surplus or deficit are both domestic and
> foreign. Indeed, our current account balance can be shown to be exactly
> equal to the difference between domestic saving and domestic investment.
In
> fact, it is often instructive in longer-term analysis to view our current
> account in terms of its domestic counterparts.
>
> As I pointed out in a speech last November,3 virtually all of our trading
> partners share our inclination to invest a disproportionate percentage of
> domestic savings in domestic capital assets, irrespective of their
> differential rates of return. People seem to prefer to invest in familiar
> local businesses even where currency and country risks do not exist. For
the
> United States, studies have shown that individual investors and even
> professional money managers have a slight preference for investments in
> their own communities and states. Trust, so crucial an aspect of
investing,
> is most likely to be fostered by the familiarity of local communities.
>
> As a consequence, "home bias" will likely continue to constrain the
movement
> of world savings into its optimum use as capital investment, thus limiting
> the internationalization of financial intermediation and hence the growth
of
> external assets and liabilities and the dispersion of world current
account
> balances that such growth implies.
>
> Nonetheless, during the past decade, home bias has apparently declined
> significantly. For most of the earlier post World War II era, the
> correlation between domestic saving rates and domestic investment rates
> across the world's major economies, a conventional measure of home bias,
was
> exceptionally high.4 For the member countries of the Organization for
> Economic Cooperation and Development (OECD) , the GDP-weighted correlation
> coefficient was 0.97 in 1970. However, it fell from 0.96 in 1992 to less
> than 0.8 in 2002. For OECD countries excluding the United States, the
recent
> decline is even more pronounced. These declines, not surprisingly, mirror
> the rise in the differences between saving and investment or,
equivalently,
> of the dispersion of current account balances over the same years.
>
> The decline in home bias probably reflects an increased international
> tendency for financial systems to be more transparent, open, and
supportive
> of strong investor protection.5 Moreover, vast improvements in information
> and communication technologies have broadened investors' vision to the
point
> that foreign investment appears less exotic and risky. Accordingly, the
> trend of declining home bias and expanding international financial
> intermediation will likely continue. This process has enabled the United
> States to incur and finance a much larger current account deficit than
would
> have been feasible in earlier decades. It is quite difficult to
contemplate
> foreign savings in an amount equivalent to 5 percent of U.S. GDP being
> transferred to the United States two or three decades ago.
>
> * * *
>
> It is unclear whether the burden of servicing our growing external
> liabilities or the rising weight of U.S. assets in global portfolios will
> impose the greater restraint on current account dispersion over the longer
> term. Either way, when that point arrives, will the process of reining in
> our current account deficit be benign to the economies of the United
States
> and the world?
>
> According to a Federal Reserve staff study, current account deficits that
> emerged among developed countries since 1980 have risen as high as
> double-digit percentages of GDP before markets enforced a reversal.6 The
> median high has been about 5 percent of GDP.
>
> Complicating the evaluation of the timing of a turnaround is that deficit
> countries, both developed and emerging, borrow in international markets
> largely in dollars rather than in their domestic currency. The United
States
> has been rare in its ability to finance its external deficit in a reserve
> currency. This ability has presumably enlarged the capability of the
United
> States relative to most of our trading partners to incur foreign debt.
>
> Besides experiences with the current account deficits of other countries,
> there are few useful guideposts of how high our country's net foreign
> liabilities can mount. The foreign accumulation of U.S. assets would
likely
> slow if dollar assets, irrespective of their competitive return, came to
> occupy too large a share of the world's portfolio of store of value
assets.
> In these circumstances, investors would seek greater diversification in
> non-dollar assets. At the end of 2002, U.S. dollars accounted for about 65
> percent of the foreign exchange reserves of foreign monetary authorities,
> with the euro second at 19 percent. Approximately half of private
> cross-border holdings were denominated in dollars, with one-third in
euros.
>
> * * *
>
> More important than the way that the adjustment of the U.S. current
account
> deficit will be initiated is the effect of the adjustment on both our
> economy and the economies of our trading partners. The history of such
> adjustments has been mixed. According to the aforementioned Federal
Reserve
> study of current account corrections in developed countries, although the
> large majority of episodes were characterized by some significant slowing
of
> economic growth, most economies managed the adjustment without crisis. The
> institutional strengths of many of these developed economies --rule of
law,
> transparency, and investor and property protection-- likely helped to
> minimize disruptions associated with current account adjustments. The
United
> Kingdom, however, had significant adjustment difficulties in its early
> postwar years, as did, more recently, Mexico, Thailand, Korea, Russia,
> Brazil, and Argentina, to name just a few.
>
> Can market forces incrementally defuse a worrisome buildup in a nation's
> current account deficit and net external debt before a crisis more
abruptly
> does so? The answer seems to lie with the degree of flexibility in both
> domestic and international markets. In domestic economies that approach
full
> flexibility, imbalances are likely to be adjusted well before they become
> potentially destabilizing. In a similarly flexible world economy, as debt
> projections rise, product and equity prices, interest rates, and exchange
> rates could change, presumably to reestablish global balance.
>
> The experience over the past two centuries of trade and finance among the
> individual states that make up the United States comes close to that
> paradigm of flexibility even though exchange rates among the states have
> been fixed. Although we have scant data on cross-border transactions among
> the separate states, anecdotal evidence suggests that over the decades
> significant apparent imbalances have been resolved without precipitating
> interstate balance of payments crises. The dispersion of unemployment
rates
> among the states, one measure of imbalances, spikes during periods of
> economic stress but rapidly returns to modest levels, reflecting a high
> degree of adjustment flexibility. That flexibility is even more apparent
in
> regional money markets, where interest rates that presumably reflect
> differential imbalances in states' current accounts and hence cross-border
> borrowing requirements have, in recent years, exhibited very little
> interstate dispersion. This observation suggests either negligible
> cross-state-border imbalances, an unlikely occurrence given the pattern of
> state unemployment dispersion, or more likely very rapid financial
> adjustments.
>
> * * *
>
> We may not be able to usefully determine at what point foreign
accumulation
> of net claims on the United States will slow or even reverse, but it is
> evident that the greater the degree of international flexibility, the less
> the risk of a crisis.7 The experience of the United States over the past
> three years is illustrative. The apparent ability of our economy to
> withstand a number of severe shocks since mid 2000, with only a small
> decline in real GDP, attests to the marked increase in our economy's
> flexibility over the past quarter century.8
>
> * * *
>
> In evaluating the nature of the adjustment process, we need to ask whether
> there is something special in the dollar being the world's primary reserve
> currency. With so few historical examples of dominant world reserve
> currencies, we are understandably inclined to look to the experiences of
the
> dollar's immediate predecessor. At the height of sterling's role as the
> world's currency more than a century ago, Great Britain had net external
> assets amounting to some 150 percent of its annual GDP, most of which were
> lost in World Wars I and II. Britain in the early post World War II period
> was hobbled with periodic sterling crises when much of the remnants of
> Empire endeavored to disengage themselves from heavy reliance on holding
> sterling assets as central bank reserves and private stores of value. The
> experience of Britain's then extensively regulated economy, harboring many
> wartime controls well beyond the end of hostilities, provides testimony to
> the costs of structural rigidity in times of crisis.
>
> * * *
>
> Should globalization be allowed to proceed and thereby create an ever more
> flexible international financial system, history suggests that the odds
are
> favorable that current imbalances will be defused with little disruption
to
> the economy or financial markets.
>
> But there are other outcomes that are less benign, and we must endeavor to
> limit the likelihood of these outcomes. One avenue by which to lessen the
> risk of a more difficult adjustment is for us to restore fiscal
discipline.
> The rise in national saving that would accompany a reduction in the
federal
> budget deficit will alleviate some of the burden of adjustment that would
> otherwise be required of the private sector through movements in asset
> prices.
>
> Even more worrisome than the lack of fiscal restraint are the clouds of
> emerging protectionism that have become increasingly visible on today's
> horizon. Over the years, protected interests have often endeavored to stop
> in its tracks the process of unsettling economic change. Pitted against
the
> powerful forces of market competition, virtually all such efforts have
> failed. The costs of any new such protectionist initiatives, in the
context
> of wide current account imbalances, could significantly erode the
> flexibility of the global economy. Consequently, it is imperative that
> creeping protectionism be thwarted and reversed.
>
> Footnotes
>
> 1. The yen bias certainly existed in earlier decades, but it has become
more
> evident as Japanese growth slowed.  Return to text
>
> 2. That many exports even from Europe are priced in dollars is a trading
> convention. It does not affect the costs in domestic currencies that
> exporters incur.  Return to text
>
> 3. Alan Greenspan, speech at the 21st Annual Monetary Conference,
> cosponsored by the Cato Institute and the Economist, Washington, D.C.,
> November 20, 2003.  Return to text
>
> 4. See Martin Feldstein and Charles Horioka, "Domestic Saving and
> International Capital Flows," The Economic Journal, June 1980, 314-29.
> Return to text
>
> 5. Research indicates that home bias in investment toward a foreign
country
> is likely to be diminished to the extent that the country's financial
system
> offers transparency, accessibility, and investor safeguards. See Alan
> Ahearne, William Griever, and Frank Warnock, "Information Costs and Home
> Bias: An Analysis of U.S. Holdings of Foreign Equities," Journal of
> International Economics, March 2004, pages 313 36.  Return to text
>
> 6. Caroline Freund, "Current Account Adjustment in Industrialized
> Countries," Board of Governors of the Federal Reserve System,
International
> Finance Discussion Paper No. 692, December 2000.  Return to text
>
> 7. Although increased flexibility apparently promotes resolution of
current
> account imbalances without significant disruption, it may also allow
larger
> deficits to emerge before markets are required to address them.  Return to
> text
>
> 8. See Alan Greenspan, remarks before a symposium sponsored by the Federal
> Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002.
Return
> to text
>
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