For the first time this week a foreign country with substantial resources decisively and openly intervened to aid the US in the current financial crisis. The Japanese government and Central Bank, deeply concerned by the rise in the yen’s exchange rate, which was threatening to seriously cut into the competivity and profits of Japan's export industries, as well as destabilise Japan's internal political situation, widely leaked that Japanese interest rates would be cut while simultaneously the Central Bank began to sell yen, and buy dollars, in order to try to drive down the yen's exchange rate. These two moves opened the financial taps to Japanese money to flow into dollars, and into the US, producing an immediate sharp upward movement on the US stockmarket.
Japan is the country with the second largest foreign reserves in the world, at $997 billion, together with an annual current account surplus of $197 billion. Only China, with a $372 billion balance of payments surplus and $1,905 billion in foreign exchange reserves, has greater foreign currency resources for intervention.
The economic reason that Japan decided to intervene may be seen clearly in the graph below. It has been one of key goals of Japanese economic policy to attempt to prevent the exchange rate of the yen rising against the dollar - unlike the situation with the euro, where the eurozone countries have been content to see the euro rise strongly against the dollar. Until the current financial crisis Japan had successfully kept the exchange rate of the yen at its 2000 level or below. Under the impact of the global financial crisis, however, the yen had soared upwards against the dollar, rising by 15 per cent since the beginning of September - from 108.7 yen to the dollar on 2 September to a peak of 92.6 yen to the dollar on 24 October.
The specific configuration of Japan's economy is that a highly internationally competitive series of exporting companies, centred in manufacturing, exist in the context of highly uncompetitive small businesses in most other sectors. The rising yen would both put competitive pressure on the price of Japanese exporters and, by decreasing the price of imports, would place much greater competitive pressure on the large and uncompetitive small business sector.
Strategically economically it would be better for Japan to rationalise this small business sector. But the ruling Liberal Democratic Party (LDP) does not wish to do this for political reasons. The large, and inefficient, small business sector forms a crucial part of the LDP’s political support. The LDP attempts to defend its electoral base even at the expense of lowering the efficiency of the Japanese economy.
This uncompetitive small firm sector cannot be used to stimulate the Japanese economy and indeed is a major drag on it. The LDP therefore, in order to attempt to square this economic circle, centres policy on maintaining a low exchange rate that will allow Japan’s exporting manufacturing companies to flourish, while at the same time the low exchange rate safeguards the small inefficient company sector from foreign competition. For this reason when the Japanese government saw the rapid rise of the yen it felt economically compelled to intervene to drive down the yen through large purchases of dollars - the latter aiding the US financial situation.
Over and above this economic and domestic political imperative is the political one that the United States wants from Japan, in return for military protection, an accommodating financial policy This international political pressure goes in the same direction as the domestic ones.
The result of this intervention by the Japanese authorities is that two major resources are now being deployed to attempt to shore up the US banking system. The first is the transfer of resources from US taxpayers - represented by the Paulson bank bail out plan. This, however, is likely to create political discontent in the US. The second is now aid to the US from Japan.
Japan's willingness to such give aid is, of course, a serious addition to US resources to meet the financial crisis and helps account for the rapid rise in share prices on Wall Street. However two issues are still posed.
First, will the combination of squeezing US taxpayers and Japanese aid be enough to stabilise the US financial system? At least at present the answer is that the situation within the US financial system is stabilised but at the expense of more peripheral parts of the world economic system suffering shortage of resources.
Second, what will be the consequences in Japan itself? The last time Japan made such a large scale intervention to aid the US was after the 1987 Wall Street crash. This intervention was decisive - the reason the US economy was fairly easily stabilised following the 1987 crash was Japan’s aid in the form of a super lax interest and credit rate policy. The result, however, was Japan's late 1980s bubble economy followed by the now 18 year long share market and property market crash and depression that followed from 1990 onwards. It will be interesting to see the price Japan will pay this time.
Whatever it is, however, it is at present considered by the LDP to be a necessary one which is preferable to the rationalisation of Japan's small business sector to withstand a higher yen exchange rate.