Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)
Phuah Eng Chye (31 July 2021)
Observers are revisiting the US confrontation with the then rising economic power, Japan. Huijian Wu notes “in 1985, Japan overtook the United States as the world’s largest creditor, and products made in Japan flooded the world. The frenzied expansion of Japanese capital caused Americans to exclaim Japan will take over America in peace! Many American manufacturing companies and congressmen began to…lobby the US government…devalue the dollar to save the depressed American manufacturing sector…In September 1985…the agreement was also known as the Plaza Accord. The agreement stipulated that the yen and the mark should appreciate significantly to recover the overvalued price of the dollar. After the signing of the Plaza Accord, the five countries intervened in the foreign exchange market and began to sell the US dollar, which in turn led to a selling frenzy among market investors, resulting in the continued sharp depreciation of the US dollar”. “In September 1985, the yen’s exchange rate fluctuated up and down from 250 yen to 1 dollar, and in less than three months after the Plaza Agreement came into effect, the yen rapidly appreciated to 200 yen to 1 dollar, an increase of 20%. At the end of 1986, it was 152 yen to the dollar, reaching a maximum of 120 yen to the dollar in 1987”.
Joshua Felman and Daniel Leigh notes that due to the exceptionally large yen appreciation, “Japan’s export and GDP growth essentially halted in the first half of 1986…the authorities were under considerable pressure to respond. They did so by introducing a sizable macroeconomic stimulus. Policy interest rates were reduced by about 3 percentage points…By 1987, Japan’s output was booming, but so were credit growth and asset prices, with stock and urban land prices tripling from 1985 to 1989. Then, in January 1990, the stock price bubble burst. Share prices lost a third of their value within a year, and two decades of dismal economic performance followed. Today, nominal stock and land prices are back at their early 1980s levels, one quarter to one-third of their previous peaks. The critical question is whether this sequence was inevitable. In other words, did the appreciation force Japan to introduce a powerful stimulus to sustain growth, which then triggered a bubble, which caused the Lost Decades when it collapsed?”
The Plaza Accord has been analysed from two perspectives. First, the lessons for China from the sharp yen appreciation and asset price bubbles that caused the Japanese economy to stumble. Second, the lessons for US on the managing of QE in relation to Japan’s Lost Decades or Japanification[1] risks. Some economists consider Japan’s economic problems were not the result of currency appreciation and QE, but was an outcome compounded by policy mishandling. Joshua Felman and Daniel Leigh argues “Japan’s experience shows that currency appreciation does not, in fact, inevitably lead to the lost decades. The appreciation did not inevitably require such a large macroeconomic stimulus. The stimulus did not inevitably lead to the bubble. Nor did the bubble’s collapse inevitably lead to the Lost Decades”. They point to the combination of late and inappropriate policy responses, financial deregulation and a build-up of leverage related to real estate as contributory factors.
Dissimilarities between the Plaza Accord and the US-China confrontation
On the surface, the situations appear similar. Huijian Wu points out China’s position as the largest exporter and holder of foreign exchange reserves “is partly similar to that of Japan in the mid-1980s…the Plaza Agreement of 1985 was a turning point…believe that the Plaza Accord was a big conspiracy laid by the US to bring down Japan. The US is now trying to use the same approach with China…Accuse China of not protecting intellectual property rights…accusing China of artificial manipulation of the RMB”.
However, there are extensive dissimilarities – starting with the nature of the bilateral relationship. Huijian Wu notes “Japan is dependent on the United States because of its comprehensive power. Japan is politically dependent on the US for protection, economically dependent on the US market, and financially unable to get rid of the US dollar. When the US could not win the game, they used off-field forces, such as foreign exchange, laws, standards, rules, etc. Hegemonic tactics were used to bring the Japanese to their knees”.
In contrast, China has an independent and inter-dependent relationship with the US. Huijian Wu points out “China has a population of 1.4 billion, and with a development perspective, the US will be more dependent on China. Politically and militarily independent of each other, China does not seek protection from the US. In terms of the US dollar, the RMB is at a disadvantage, but China has several trillion dollars in foreign exchange reserves…In the areas of diplomacy, resources, industrial infrastructure and scientific research, China has long pursued an independent and autonomous path of development and has accumulated a relatively complete system, which is relatively strong in coping with various unexpected risks”.
The landscape differences are even starker. Japan is relatively insular and the number of Japanese residing, working and studying abroad is small. Hence, the use of Japanese language and its cultural influence abroad is limited. In contrast, there is a large overseas Chinese population. Mandarin and several dialects are widely spoken around the world. China has a larger global platform than Japan. When Japan was the leading export nation, the other Asian economies and supply chains were relatively undeveloped…Japan was isolated and did not have an alternative to Western markets, particularly the US. Few foreign manufacturing plants were established in Japan. Foreign firms generally found it difficult to penetrate the Japanese market. Potential rewards from Japan’s domestic market were limited by the fact it was already a high-income economy and the Japanese were large savers.
Atter the Plaza Accord and yen appreciation stymied Japan’s advance, Japanese capital, technology and talent flowed to Korea, Taiwan and later to China. These economies were able to emulate Japan’s export-led model. Today, China is the dominant player in global supply chains. Many MNCs have located plants in China to cater to the domestic and export markets. Entry into China’s domestic markets is prized as China is still a middle-income country with enormous pent-up consumer demand. East Asia is already a vibrant economic region while China’s Belt and Road Initiative (BRI) is creating a growth corridor along Eurasia and Africa. China is well positioned to maintain an independent stance and, unlike Japan, is unlikely to cede commercial space to the US.
Japan’s biggest vulnerability is not trade. It remains a major exporter despite domestic economic setbacks. Its main weakness is in its financial sector. It did not handle pressures from currency appreciation and capital flows well as its capital markets and regulatory framework were under-developed then. The regulatory gaps meant currency appreciation could spill over to fuel equity and property price bubbles. When prices collapsed, many corporates were caught while banks were under-capitalised to withstand the shock. The Japanese domestic economy never fully recovered from private sector balance sheet retrenchment. Recovery has been impeded by the slow pace of structural reform and the resistance of legacy businesses to disruption.
It appears China has taken the lessons on financial regulation to heart. China has modelled its regulatory framework on global best practices such as the International Accounting Standards (IAS), International Organization of Securities Commissions (IOSCO) and Basel banking principles. China’s regulators are thus better prepared to handle crises. China’s regulators also appear more resilient to domestic and foreign industry lobbying and has the confidence to evolve its own legal and regulatory framework to suit their own circumstances. While it has not protected traditional intermediaries from fintech, it has also been taken stern actions to ensure the new business models are brought under strict regulatory oversight.
Revisiting the strong currency paradigm
One key question arising from Plaza Accord is whether China will be able to manage the pace and consequences of currency appreciation. Huijian Wu notes “the renminbi is not as developed as the Japanese yen, and Western financial oligarchs, including Soros, have no way to launch an attack on it”. Since the 1998 Asian financial crisis, China’s regulators have gained much experience with managing offshore speculative attacks on its currency. This provides insight as to why it still maintains tight capital controls and is keen to bring asset price bubbles under control.
Nonetheless, given the magnitude of US’s fiscal stimulus and QE, the pressures on the yuan can only continue to intensify. China seems comfortable with yuan appreciation but would want to avoid a sharp appreciation as they would not wish to repeat Japan’s experience with a strong yen; which appreciated from 250 yen (to USD) in September 1985 to around 120 yen in 1987. China would probably prefer a managed and gradual appreciation of its currency, similar to Singapore, of between 5-10% per annum. It remains to be seen if they will succeed.
Some observers think there is opportunity to craft a new Plaza Accord since both countries agree on a stronger yuan. David P Goldman and Uwe Parpart note “senior Biden Administration officials have suggested Western nations might unite behind a major revaluation of China’s yuan, along the lines of the 1985 Plaza Accord with Japan. Surprisingly, some Chinese economists have welcomed the idea – surprising because China in the past viewed the Plaza Accord as the end of Japan’s ascendancy and has been vociferous in denouncing a repeat. But the China of 2021 isn’t the Japan of 1985, and China has its own reasons to want its currency to appreciate, just as the United States has good reason to let the dollar fall…Depending on what China is offered in return, Beijing might let the Biden Administration declare victory in a currency negotiation”. In my view, such agreements are unlikely because China appears to have been put off by US insistence on conditions such as on how China can manage its currency and on enforcement mechanisms to ensure compliance.
The strong currency paradigm needs to be revisited though. In the traditional “beggar-thy-neighbour” paradigm, countries compete by cheapening their currency to increase exports and accumulate gold reserves (as in the 1930s). Variants of modern economic illnesses – such as hollowing out, the Dutch disease and Japanification – are associated with large capital inflows and strong currency and reinforce the mercantilist view that strong currencies are a disadvantage.
In the globalised, informationalised and financialised setting of today, the mercantilist “cheap currency” logic is being turned on its head. Exchange devaluations may work at the margin but generally this is outweighed by the potential damage from inflation, falling asset prices and capital flight.
In this regard, the disconnect between cheap prices and trade success is growing. Japan’s earlier and China’s current success are driven by efficiency, precision and, most of all, great products. A strong currency gives a country an edge in the global competition for resources, technology, standards, information and finance just like how strong share prices helps companies acquire their competitors. Conversely, the success (or value add) of an economy can be gauged by how it is able to attract foreigners to purchase domestic assets (properties, financial products) at a high price. A strong currency should be accompanied by a strategy to facilitate local assets to be sold at high premiums. This will generate forex earnings which can be redeployed to buy foreign goods or assets on the cheap.
It should be asked whether the US will tolerate a considerably weaker USD as political risks are growing. A weak US dollar implies acceptance of higher inflation rates and eventually higher interest rates. During the 1980s, the US demonstrated the ability to ride through the political turbulence to emerge stronger economically. But then the labour share of the economy was considerably higher. However, the labour share has declined considerably and the domestic political backlash could be fiercer this time.
Conclusion
The situation between US and Japan in the mid-1980s is different from today’s confrontation between US and China. The Plaza Accord revolves around an export nation accepting the need to appreciate its currency for the sake of international cooperation. The Plaza Accord was an agreement for readjustment as Japan did not seek to challenge US hegemony. Today’s competition between US and China is part of a great power confrontation with the two nations facing off across many fronts. In this context, the objective of a modern currency war is to gain advantages for its currency to dominate monetary space. In a strong yuan-strong USD regime, China will end up competing with the US on imports and to be the world’s largest consumer. Hence, the forthcoming currency war is more likely to be a contest of currency strengths[2] rather than weaknesses; and on usage[3] rather than on trade competitiveness. If there are any lessons to be learnt from the Plaza Accord, it is whether China and the US can avoid Japan’s fate of the Lost Decades in the aftermath of the Plaza Accord. The other pertinent question is whether the yuan will emerge as a genuine challenger to USD supremacy in a way that the yen never did.
References
David P Goldman, Uwe Parpart (31 January 2021) “Plaza Accord II: Currency a catalyst for US-China deal?” Asia Times. https://asiatimes.com/2021/01/plaza-accord-ii-currency-a-catalyst-for-us-china-deal/
Huijian Wu (10 January 2021) “Why did the US succeed in hindering the rise of Japan but fail to stop China?” Quora. https://www.quora.com/Why-did-the-US-succeed-in-hindering-the-rise-of-Japan-but-fail-to-stop-China
Joshua Felman, Daniel Leigh (April 2011) “Did the Plaza Accord cause Japan’s lost decades?”. Box article in IMF World economic outlook: Tensions from the two-speed recovery. file:///C:/Users/user/Downloads/_box14pdf.pdf
Lyn Alden (14 February 2021) “Economic Japanification: Not what you think”.
Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society. http://www.amazon.com/dp/B01AWRAKJG
Phuah Eng Chye (5 June 2021) “Global reset – Two whales in a pond”. http://economicsofinformationsociety.com/global-reset-two-whales-in-a-pond/
Phuah Eng Chye (19 June 2021) “Global reset – Monetary decoupling (Part 1: Sterilisation and QE)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-1-sterilisation-and-qe/
Phuah Eng Chye (3 July 2021) “Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-2-economics-of-large-central-bank-balance-sheets/
Phuah Eng Chye (17 July 2021) “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-3-consequences-of-diverging-policies/
[1] Lyn Alden uses the term “Japanification” to refer to the stagnation that Japan’s economy experienced over the past three decades.
[2] Such as a strong Yuan policy challenging a strong US dollar policy. See “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”.
[3] “Global reset – Monetary decoupling (Part 5: The end of USD supremacy – Will it be different this time?)”.