Posted by: Dirk | September 9, 2010

Capital inflows? Kekkou desu.

“No, thank you”,  says Japan to Chinese capital inflows, as reported in the FT today:

Japan has raised concerns about China’s recent sharp increase in purchases of Japanese government bonds, highlighting nervousness about its impact on the strengthening yen.

“There is something unnatural about the fact that China can buy Japanese government bonds while Japan cannot [buy Chinese bonds],” Yoshihiko Noda, the Japanese finance minister said on Thursday.

This issue is hard to explain from the point of those supporting free financial markets. If markets were efficient, why complain? Of course, the market is not free, as Yoshihiko Noda pointed out: while China can buy Japanese bonds, the opposite is not possible. To put it more bluntly: the Chinese interference with (more or less) free markets disturbs the equilibrium. Japan has always intervened to put the yen where it wants it be, but with the Chinese influence that is getting hard to do.

Capital flows from China to Japan, putting upward pressure on the yen. Since Japan cannot retaliate, it would have to buy bonds from the rest of the world in order to let the capital flow out again and release the pressure. So, capital today is allocated by central bank or, in China, government planning rather than by market forces. This has been going on for some years now and is a main cause of the crisis we are in. Net exporters like China and Germany build up claims against deficit countries like the US and the PIIGS, which are losing competitiveness constantly and are more and more unlikely to be able to repay since they are losing more and more jobs.

The imbalances are not new, in fact, Japan and Germany industrialized by this strategy as well. However, there was cooperation in the Bretton Woods system with devaluations of the dollar every now and then. This cooperation we don’t see today, so instead of devaluation of the dollar we see devaluation of nominal debt values. Stocks have tanked as a result of this, and only the fact that portfolios are diversified worldwide has clouded the view on this. When net exporter hold more and more debt of the net importers, the burden of adjustment falls on capital owners in both types of countries.

However, there is unemployment coming up and that might not be cured because of the balance sheet story. Firms repair their liquidity and debt positions and refrain from investing. As long as they keep doing this, unemployment will be elevated. This is a result of the international monetary system, which has been dysfunctional for years now. Without fixing this, there will be no chance of sustainable recovery. Whoever fixes its regional system first probably will come out with a head start into the 21st century: China and the US, or the euro zone. The race is on.

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