Leaving the Plaza Accord behind

Once again, Japan’s experience post-Plaza Accord has been brought up as a mistake to be avoided, against the backdrop of the escalating pressures on China to revalue the renminbi.

This time it was Chinese economist and member of the Central Bank’s monetary policy committee Li Daokui, who said last week that "China will not go down the path that Japan did and give in to foreign pressure on the yuan's exchange rate.”

I personally find the parallel misplaced and the reason is that it confuses the legitimacy of the objective (=revalue an undervalued currency to help towards the correction of global imbalances) with the (in)appropriateness of its implementation. Still, revisiting Japan’s situation during and after the 1985 Plaza Accord can offer valuable lessons for how to do things better this time round—both for China and its trading partners.

So, the mantra linking the Plaza Accord with Japan’s subsequent economic malaise goes like this: The large revaluation of the yen prompted large amounts of speculative capital inflows into Japan which, together with a loose monetary policy, fuelled an asset bubble that then burst pretty spectacularly.

In my view, the key weakness of the argument is in its presumed causality from the yen’s appreciation to Japan’s asset bubble. Of all the factors cited in the literature as contributing to the asset price boom and then bust, the yen’s move is at best an incidental one.

First of all, the rise in asset prices, notably real estate, had been building up even before the Plaza Accord. One key reason behind the increase was the aggressive growth in credit, notably to the real estate sector. This was itself prompted by a host of structural reasons, including inter alia:

The liberalization of interest rates, which, by raising deposit rates, reduced banks’ profit margins and forced them to look for higher-yielding lending opportunities; the opening up of capital market access to corporates, which shifted part of the corporate funding away from the banks and towards the capital markets—this pushed banks to look for new clients to lend, often with higher risk characteristics; and a distorting tax regime governing the real estate sector, which encouraged the holding onto real estate assets, thus restricting supply, while demand was rising.

If there is a lesson for China here, it has little to do with exchange rate policy. Instead, it is that preventing the build-up of bubbles requires a robust regulatory framework for the financial sector—one that penalizes excessive risk-taking and dampens the procyclicality of credit (a lesson that we have come to learn yet again in the aftermath of the subprime debacle).

The second lesson from Japan’s experience has to do with the role of monetary policy in contributing to the boom and bust. And here is where the Plaza Accord deserves criticism—though not for its prescription on exchange rates!

You see, the agreement was not *just* about foreign exchange intervention to realign the nominal exchange rates; it also prescribed global coordination of macroconomic policies to correct the global BoP imbalances. This latter component was a key factor behind the Bank of Japan (BoJ)’s loosening of monetary policy during 1986-87.

As three Japanese academics document here, the BoJ had expressed concern early on about the easy money, the concomitant speculative activity in the real estate and stock markets, and the dangers of a subsequent debt deflation. However, the BoJ proceeded with rate cuts, partly in the face of pressures by its trading partners to stimulate domestic demand (these pressures were made explicit in the Louvre Accord in February 1987, under which Japan pledged another 50bp rate cut in its policy rate).

One can debate of course how big a role monetary policy in itself can play in fuelling asset bubbles of the scale experienced in Japan in the late 1980s. Indeed, those who object to the premise will find a staunch ally in Ben Bernanke! But my main criticism here is that, by calling for stimulative monetary and fiscal policies, Japan’s trading partners confused the cyclical from the structural causes of the global imbalances. The result was a monetary stance that was too loose for Japan; and the diversion of attention away from corrective measures that had to be taken by the likes of the United States.

The situation is somewhat different at the current juncture with China. First, few people dispute that the key reasons behind China’s external surpluses are structural—and, therefore, nobody is really asking China to take inappropriately stimulative measures to increase domestic demand. In the same vein, there is no doubt that structural reforms to rebalance growth domestic demand and, notably, private consumption, would be welcome by the global community.

But this is no reason to dismiss the exchange rate revaluation as *one* corrective tool: First, as I argued here, China has yet to bear the brunt of the (cyclical) correction of global imbalances since the onset of the financial crisis: Even as its own trade surplus has shrunk, the US trade deficit with China has barely moved in US GDP terms. Most of the US adjustment has been borne by other countries.

Importantly, a large exchange rate undervaluation in a country as large as China contributes to the misallocation of global resources—e.g. by prolonging the survival of inefficient companies/exporters in China and/or by encouraging the outsourcing of business to China thanks to an artificially low cost structure.

Bottom line, evoking Japan’s experience under the Plaza Accord as a reason to rebuff pressures to revalue the renminbi is misplaced, if not disingenuous. While nobody can dispute the need for a score of structural measures to fortify the financial sector and contain the formation of bubbles in China, maintaining an undervalued exchange rate can only serve mercantilistic objectives and/or protecting certain industries at the expense of a balanced, efficient and fair allocation of global resources.