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Friday, June 06, 2003

Tunnelling the Bottom of Japan's Deflation Trap

A really rather unusual article from MS's Takehiro Saito, which argues that the decline in personal savings is not alarming since it is matched by a rise in corporate saving. This corporate saving will continue, he argues, since in deflationary times with a rising currency, and weak demand, cash, or domestic bonds (and in particular JGB's) are about the best investment corporate Japan can make. This is of course an extremely vicious circle, which explains why we should be so wary of deflation, and why talk of Germany only being in danger of 'benign' deflation is complete tommyrot. As Saito suggests: "a powerful equilibrium exists with close links among deflation, private-sector savings surplus (current-account surplus), and home country bias supported by yen appreciation and expect ongoing stability in the government funding base."

Despite considerable anxiety about the future of fiscal deficits premised on the loss of saving-investment surplus, we do not view stress applied by the declining household savings rate as a difficult challenge as long as corporate debt repayment continues spurred by asset price deflation. More disconcerting is the quietly advancing evaporation of the yield curve, which has easily surmounted all challenges thrown its way thus far. We believe all of the factors defining yield curve shape are tied together by the central concept of deflation. For example, sustained strong home-country bias exhibited by domestic institutional investors stems from deflation and the zero interest rate. Since real interest rates at home are always positive under zero interest rate policy (ZIRP) and deflation, investors have less incentive to move capital into foreign-currency-denominated assets. Furthermore, in contrast to the rise in real asset value and decline in cash and bond actual value under inflation, real asset value declines and cash and bond actual value increases under deflation. It therefore makes economic sense to hold home-currency-denominated bonds in a deflationary environment despite extremely low nominal interest rates. Forward discount bias from the constant positive discrepancy between domestic and foreign nominal short-term rates in a zero nominal interest rate situation also places upward pressure on yen value. From this perspective, domestic institutional investors are behaving in an economically reasonable manner within the context of deflation and zero interest rates.

Another factor is that excessive competition among financial institutions under debt deflation interferes with the correct economic behavior of setting loan interest rates based on credit risk. We expect long-term yields to stay at extreme lows as long as loan interest rates are inappropriately restricted to lows from the standpoint of arbitrage between bond and loan markets. The abnormality to us is loan interest rates, not long-term interest rates. We have repeatedly stressed the importance of rectifying loan interest rate levels. Yet this is not happening in reality with steady expansion of the overextended government-affiliated financial institution presence. We believe government policy is actually encouraging long-term interest rates to move even lower.
Source: Morgan Stanley Global Economic Forum

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