Monday, 4 February 2013

‘Currency War’ Allegations highlight Russo-Japanese tensions – a cause for concern in the Far East

Accusations of instigating a ‘currency war’ are never taken lightly, and use of the phrase in an official capacity instantly generates attention. First employed by Brazil’s finance minister in 2010 to describe the process of countries artificially weakening their own currency to boost exports, ‘currency war’ was largely dormant in 2012. But on January 16th Alexei Ulyukayev, the Russian central bank’s first deputy chairman, revived the phrase by blaming the new Japanese government of adopting a ‘very protectionist monetary policy’ that ‘is a course towards a sharp depreciation of the yen.’ Ulyukayev added that: ‘we’re on a threshold of very serious, confrontational actions in the sphere that is known… as currency wars.’

Given that loose monetary policy has been prevalent across the globe of late, it is a bold move by a Russian official to single out a specific nation. While dialogue between Russia and Japan has long been tense, it is a novel development for their frosty rhetoric to involve allegations of currency manipulation. Deteriorating Russo-Japanese relations are an indicator of rising tensions throughout the Far East region as Japan’s waning economy attempts to compete with its emerging market neighbours.

The new phase of ‘currency war’ language was initiated by December’s election of Japanese Prime Minister Shinzo Abe. His pledge to raise the Bank of Japan’s inflation target from 1% to 2% and purchase government bonds until the target is achieved saw the yen weaken sharply even before the implementation of any new policy.

Countries such as Russia and Brazil are concerned that Abe’s ‘quantitative easing’ approach will be broadly copied. Some currencies, such as the yen, may be genuinely overvalued. However, there is the possibility that countries whose currency is not overly strong will pursue a weakening policy to give their exporters a competitive advantage. For every country that benefits from a weaker currency, another must suffer, which could lead to tit-for-tat devaluing measures, hence the initiation of a ‘currency war’. Such an outcome on a widespread scale would be hugely inefficient for the global economy, especially in the Far East. The risks include rising inflation, lower domestic demand as imports become more expensive and a consequent decline in investment.

Along with the Bank of Japan, over the last several years the US Federal Reserve, European Central Bank (ECB) and Bank of England (BoE) have adopted quantitative easing policies and lowered rates to near zero. Conversely, many emerging market economies which have performed well post-2008 must maintain relatively high interest rates to stave off inflationary pressures. Notably, the benchmark interest rate set by the Russian central bank is 8.25%.

The higher yields that can be attained in Russia will keep upward pressure on the ruble, potentially hurting exports. The liberalising of the Russian domestic bond market, meaning foreign investors can buy and sell ruble-denominated treasury bonds through the world’s largest bond settlement system, is also expected to bring in additional capital flows. While economic growth for 2012 is estimated at 3.5%, nearly 1% below that of 2011, the Russian central bank has little room to make sizeable rate cuts as it attempts to manage a recent rise in inflation spurred by rising food costs.

A steady climb in oil prices drove the ruble to eight-month highs in January. Despite its complaints of currency manipulation, the Russian central bank regularly intervenes in markets by utilising its large quantity of currency reserves [Russia currently holds the fourth largest currency reserves at more than $530bn]. The central bank maintains a band which the ruble can trade within versus a US dollar/euro basket; the bank will intervene if the rate moves outside the band. Russia says that the ruble will be allowed to float freely by 2015, but a dependency on oil will have to be addressed if the economy is to withstand price shocks.

As the world’s largest energy exporter, oil and gas make up 70% of Russia’s total exports and almost half of the nation’s budget revenue. A recent study by the European Bank for Reconciliation and Development (EBRD) estimated that Russia can sustain its current rate of oil production for 20 years, comparing unfavourably to other major exporters such as Saudi Arabia and UAE who can maintain their output levels for 70 and 90 years respectively. President Vladimir Putin acknowledged the need to diversify the economy at his state-of-the-nation address in December, but it will be a difficult process. Unemployment is relatively low, but the EBRD found that less than 20% of Russia’s exports have a ‘high skill’ content. While oil revenues should be used to encourage a weak manufacturing sector, Russia will need to create a business environment that will attract significant foreign investment to become truly diversified.

A highly skilled workforce is not a problem for Japan, but export demand and factory output has slowed. The economy is expected to have contracted by -3.6% in 2012. Exports of cars and construction equipment fell markedly, with a drop in demand from China a key factor in the slowdown. Weak domestic demand, owing to a declining and ageing population, is a long-term structural problem. Despite interest rates near zero, chronic deflation has meant that rates post inflation have been positive for much of the last decade. This has kept the yen relatively strong. A weaker currency is expected to boost exports while a 10.3 trillion yen ($114.5 billion) stimulus package will spur growth in the near-term. Abe’s determination to enact his monetary policies is such that he threatened to remove the Bank of Japan’s independence.

Russia, who holds presidency of the G20 in 2013, is likely to use September’s summit as a platform to further lament the monetary actions of the world’s major developed nations. Russia’s eagerness to point the finger at Japan is partly driven by their historically strained relationship, with no peace treaty ever signed after the Soviets claimed the Southern Kuril Islands (Northern Territories in Japan) at the end of World War II. In recent years the influence of both nations has waned in the Pacific region; China has risen as a power, while South Korea’s economic innovation has progressed steadily.

Russian wariness of the new Japanese government is understandable. Abe has spoken of his desire to ‘escape the post-war regime’; essentially meaning a less apologetic view of Japan’s wartime history. The majority of his cabinet are supporters of the Yasukuni Shrine, a military memorial that includes war criminals. In his previous prime ministerial term six years ago, Abe reopened efforts for the return of Japanese citizens kidnapped by North Korea decades ago.

On January 10th this year Japan’s Chief Cabinet Secretary said that the new administration would maintain a policy of ownership of the four disputed Kuril Islands. Several days later Russia’s Foreign Ministry deputy spokesman branded the comments ‘unacceptable’. Treaties on the Kurils’ sovereignty were first made in 1855, with Japan attaining ownership of the four southern islands; a claim that was asserted when Japan defeated Russia in the war of 1904-05. By the end of World War II the Soviet Union took over the islands and subsequently deported all Japanese residents. Today, Russia points to the 1951 San Francisco Treaty as evidence that Japan ceded control, but Japan asserts that the agreement was with the Allies, unaware that the Soviet Union would gain sovereignty.

There have been efforts of partial reconciliation over the years, most notably when Russia offered Japan two of the smaller islands; a proposal that was swiftly rejected. Both sides are guilty of antagonism of late. In 2010 the Japanese parliament passed a law reasserting their sovereignty over the four Kurils; the Russian parliament responded with proposals to revoke Japanese visa-free travel to the islands. Later in 2010 then-Russian president Dmitry Medvedev became the first Russian leader to visit the islands, with several high-level delegations travelling there since.

There are roughly 20,000 Russians on the four islands today living in cold, bleak conditions in the Western Pacific. Japan has promised to reinvigorate the Kurils if ownership can be reclaimed and aside from domestic political motives, is eager to take advantage of the lucrative fishing rights and possible energy reserves in the surrounding area. Russia views the islands as a geopolitically important gateway to Asia.

Both the US and EU have expressed support for Japan in the dispute, most notably when the European Parliament adopted a resolution in 2005 that urged Russia to return the islands to Japan. Russia may feel a sense of alienation, and such a sentiment could only be heightened by the large-scale quantitative easing practices of the Federal Reserve, ECB and BoE. Further distrust of the developed world will make Russia more difficult to deal with, leading to stalemates on political issues such as the Kurils and additional allegations of ‘beggar thy neighbour’ monetary policies.

Japan, whose island disputes with China and South Korea intensified last year, does not need a further escalation in tensions with Russia. There is much to gain from improved Russo-Japan relations. Since the 2011 Fukushima Daiichi nuclear incident reduced Japan’s appetite for further production, the nation has become a large net energy importer. Closer economic links to Russia would enhance efficient energy transport. Discussions in recent years to supply gas to Japan via an undersea pipeline from Vladivostok have not yielded a definitive outcome. Russian officials have repeatedly tried to attract Japanese investment for its Far East energy projects and closer ties could lead to much needed foreign investment outside of Moscow.

Yet it may be difficult to convince both nations’ leaders that a territory compromise is politically advantageous. It is easier for precarious leaderships to turn attention to foreign adversaries rather than risk losing support from nationalists. At times of economic stress, inward-looking policies can take priority. Abe’s aggressive monetary approach may force other countries to pursue similar strategies, which would be an inefficient and potentially destabilising development. He may also seek to use territory disputes as a vehicle to demonstrate strong will in the face of allegedly antagonistic neighbours. Similarly, Putin is not averse to using security threats as a distraction from domestic instability; something which can be expected if Russia’s economic advancement remains sluggish.

With a cynicism towards the US and EU, multilateral approaches involving either entity will likely make little progress in building Russo-Japanese ties. Instead, greater cooperation in the Far East may be the solution. Improved dialogue involving Japan, Russia, China and South Korea is greatly needed, whether in their own summit or via an expanded ASEAN (Association of Southeast Asian Nations) forum. The yen’s sharp devaluation has already raised concern around Asia as evidenced by increased intervention in financial markets by South Korea, Thailand, Taiwan and the Philippines to prevent their currencies from strengthening.

Relations between Japan and Russia are a symptom of the lack of cooperation in the region. Without renewed diplomatic unity, mutually beneficial progress will be limited; something which cannot be said for accusatory rhetoric.

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