The Japanese yen has now been steadily appreciating for almost three years, from 258 yen to the dollar in the first quarter of 1985 to 128 yen to the dollar in January 1988. It has still not made much of a dent in the size of the Japanese current account surplus, which in fact increased from about $49 billion in 1985 to about $87 billion in 1987. The growth of the surplus will, of course, come down in the next few years, as the effects of the large exchange rate appreciation on the volumes of exports and imports are passed on to their values. But for many reasons—including (1) any residual “J-curve” effects, (2) the fact that the price effect on Japanese exports may be more than offset by their high responsiveness to an increase in world GNP, (3) the unlikely prospect that the value of imports into Japan will continue to rise significantly, given the falling unit value of oil imports, and (4) the increasing inflows of investment income—the size of the surplus will, in all probability, remain quite substantial, even if its growth peaks out.
How large a surplus?
First, some figures. In 1985 the current account surplus amounted to 3.6 percent of GNP. It then increased to 4.3 percent in 1986 (as GNP growth slowed to 2.4 percent compared to 4.9 percent in 1985) and returned to 3.6 percent of GNP in 1987 when GNP grew at 4.2 percent. In 1988, given current expectations about GNP growth, the surplus is expected to surpass $85 billion, even if in proportion to GNP it is reduced to 3 percent. In the medium term, that is up to 1992, assuming that the Japanese economy continues to grow, on the average, at 3.6 percent a year (which is somewhat below its potential), the current account surplus would not fall below $82 billion, even if its ratio to GNP came down to 2.5 nercent.
While Mr. Sengupta is a member of the IMF’s Executive Board, the views expressed in this article are strictly his personal opinions and do not purport to represent the views of the Fund or of his authorities—Editor.
The implications of lowering the ratio of current account balances to GNP must be noted, because sometimes a reduction of that ratio itself may be regarded as a policy target. A country’s current account balance is equal to the difference between its total savings and investment. Hence, even if the rates of savings and investment as a proportion of GNP do not change, the absolute size of the savings-investment gap can be reduced if GNP growth slows. Indeed, if no other policy action were taken by Japan, and only the yen continued to appreciate, the fall in the real value of exports would bring down the growth of GNP, which, in turn, would reduce the current account balance. This would clearly be a sub-optimal policy, not only because of its high cost in lost output, but also because of its implications for the world economy. For years now, growth of the Japanese economy has been a major factor sustaining growth in the OECD countries; a slackening of Japanese expansion could seriously diminish the level of activity in the world as a whole.
Demand, savings, and investment
An alternative approach for bringing down the ratio of current account surplus to GNP would be to reduce the rate of savings and increase the rate of investment. That would mean increasing domestic demand to compensate for the fall in foreign demand (consistent with the fall in the current account surplus), while sustaining the growth of GNP. This is, indeed, the policy that has been chosen by the Japanese authorities, and urged upon Japan by other industrial countries. In 1986, when the Japanese policy measures reflecting the Maekawa Report (proposing comprehensive structural reform of the Japanese economy) were not fully in place, domestic demand grew only at the rate of 4 percent, as in the previous year, and while foreign demand declined sharply because of the yen appreciation, the growth rate of GNP was halved. But by 1987 the growth of domestic demand revived to 4.7 percent, pushing up GNP growth. If Japanese policy were to keep domestic demand growing at about 5 percent per year for the next few years, domestic demand would more than offset the negative contribution of foreign demand. But how feasible is this policy approach, and how much effort will Japan have to make to implement such a policy?
The rates of savings and investment are extraordinarily high in Japan, and the rate of savings has been remarkably stable. For the period 1975-87, total gross savings as a ratio of GNP has varied between 30.1 percent and 32.7 percent, and total gross investment between 27.9 percent and 32.8 percent. For the private sector alone, the corresponding savings rate has been 27.4-30.6 percent and the investment rate 22.8-27.5 percent. Several hypotheses have been advanced to explain the persistently high rate of savings, and most of them relate to structural factors that take a relatively long time to respond to changing market conditions. Besides demographic factors, which can only change slowly over time, the other factors affecting the Japanese household savings rate include changes in net wealth relative to disposable income and the fall in the inflation rate. The effects of these factors seem to have petered out after bringing down the household saving rate from 20 percent of disposable income in the late 1970s to about 15 percent where it has stabilized in the mid-1980s. This is still a very high rate compared to other industrial countries.
These conditions would suggest that unless policies are specifically aimed at reducing the rate of national savings, it is unlikely that market forces will bring it down on their own. Real private consumption in Japan has been growing at around 3 percent a year, on average, over 1983-87, which is higher than in most other industrial countries. It will take a great deal of effort to raise its growth further, on a sustained basis, to a level higher than the projected GNP growth rate of 3.6 to 3.7 percent a year, and even then the effort may be largely neutralized by increased corporate savings to provide for rising capital consumption.
As for investment, the Japanese private sector investment rate has followed a pattern typical of mature economies, one of persistent decline over time. The investment rate fell from 27.5 percent of GNP in 1975 to 23.8 percent in 1987. Although private investment is expected to grow rapidly, it is unlikely to remain much higher than 23-24 percent of GNP over the medium term, when the comparable figure in other mature economies (such as the United States, United Kingdom, and Federal Republic of Germany) is hardly more than 17-18 percent.
The one area where most commentators feel there is scope for a general increase is housing investment which started to pick up in 1983 and accelerated in the following years. This boom was strongly supported by the official policy of lower interest rates and liberalized tax treatment; bank loans for housing in 1987 were twice the level of 1986 and seven times the average of the preceding five years. But it may not be realistic to expect this boom to last for many years unless substantial deregulation is introduced in the land market, and this is a sensitive social factor. High land prices together with the increasing cost of construction materials have already raised the ratio of housing prices to income to the level prevailing just before the housing slump of the early 1970s.
There would still be considerable scope for increasing government investment, especially in public works, and most medium-term scenarios, which provide for large increases in domestic demand, foresee a steady rise in such investment. The main constraint here is the rising government deficit and the authorities’ clear preference for bringing it down. Tax reforms proposed by the Government are oriented toward increasing private expenditure through cuts in individual and corporate taxes and also through a new tax on savings from April 1, 1988. Public expenditure programs are expected to be restrained, except for spending by local governments, the Fiscal Investment and Loan Program, and defense. The Government is concerned about the prospects of increasing demands for spending on social security because of a rapid increase in the over-65 population. It is also worried about the size of the public debt. Gross public debt amounted to 69 percent of GNP in 1986, and debt servicing will account for increasingly large budgetary expenditure in the coming years.
Against this background, it may be unrealistic to expect much further boost to government expenditures in Japan beyond the rates achieved in 1987-88.
Recycling the surplus
The above analysis implies that there are severe constraints on reducing the current account surplus through an expansion of demand, and that it may take quite some time for the surplus to decline significantly. At the same time, if the US deficit comes down, the amount of Japanese capital flowing to the United States will also be reduced. It is, therefore, necessary to work out mechanisms that would allow the Japanese surpluses to be absorbed in the world economy through the generation of corresponding current account deficits in other countries. If this cannot be done, the surpluses will place a further upward pressure on the yen and downward pressure on the dollar. This may slow down economic growth in Japan and affect the expansion of the world economy as a whole, and possibly rekindle inflationary expectations in the United States and other industrial economies.
All efforts to recycle the surpluses to countries that have a potential to absorb them through corresponding deficits would be complementary to the current Japanese policy stance of raising domestic demand. To the extent that such efforts are successful, they would reduce the strains on the Japanese economy and allow for a more orderly adjustment of world payments imbalances. Indeed, if sufficient demand can be created for the Japanese surplus and the corresponding Japanese capital outflow to the rest of the world, it would not only be possible for Japan to sustain a rate of growth closer to its potential, but also allow the United States deficits to be reduced with the least disruptive effect on world trade and payments.
A global view
The Japanese surplus could, in principle, be absorbed by other industrial countries, other than the United States. But this would exert a downward pressure on interest rates, and expenditures in other OECD countries would have to increase more than incomes. Most governments, rightly or wrongly, regard such a course as inflationary; they would prefer Japan to raise domestic demand by increasing consumption and investment, supported by an appreciation of the yen.
However, if a global view is taken of the situation, the Japanese surplus need not be absorbed only among the industrial countries; instead it may become a potential source of expansion for the world economy. It is paradoxical that when a large part of the world economy, consisting of the highly indebted Latin American countries, the debt-distressed poor countries of Africa, and the relatively fast-growing countries of Asia, is in dire need of additional resources in the form of foreign savings, the few countries which have savings to spare are being persuaded to absorb them on their own. If the approach to international policy were different, and concentrated on mechanisms to improve international financial intermediation and to channel savings from countries where they are in excess supply to countries where they are in excess demand, the case of Japan would be regarded as one with great opportunities. The excess savings of Japan, and for that matter of all industrial countries, should find their natural habitat in developing countries to finance the investment needs that cannot be met by the domestic savings of the LDCs alone.
A number of simulation studies have looked into these aspects of global interdependence and analyzed the global impact of increasing Japanese domestic demand on the growth of output, exports, imports, savings, and investment of different industrial and developing countries and of the world as a whole. These studies have also compared the results thus obtained with the effects of an equivalent increase in capital flows to the developing countries. The precise effects would, of course, depend upon the form of these flows, their distribution across the countries, and the policy adaptations undertaken. But, in terms of (1) demand for US exports, (2) improvements in the current account and GNP growth of most industrial countries, and (3) output growth in the developing countries, the impact of an increase in capital flows to the developing countries would be larger than an equal increase in domestic demand in Japan.
An increase in Japanese investment would have a multiplier effect (not very large, given the high rate of savings) on income. This would lead to a modest increase in Japanese imports and, with the US share in Japanese imports being about 20 percent, to a relatively small increase in US exports, and hence a relatively small increase in US output. The effect for other industrial countries would be similar. A capital inflow to the developing countries of the same magnitude, on the other hand, would lead (perhaps after a lag) to an equal increase in these countries’ imports. Since the developing countries’ propensity to import from the United States is much higher than Japan’s, this would have a larger impact on the reduction of the US trade imbalances. According to a simulation by the IMF (using its MULTIMOD model), a $10 billion transfer from Japan to all developing countries for one year would increase US exports by $2.26 billion, whereas an increase in Japanese fiscal expenditures of the same amount would result in increased US exports of only $620 million. The impact on the growth of GNP and the current account balance would be much higher for the United States, Germany, and other major industrial countries in the first case.
Investment opportunities in developing countries, especially when such investments are also vehicles for the transfer of technology, are substantial, as the marginal productivity of capital is much higher there than in the capital-rich industrial countries. But because of the underdeveloped market structure in these countries, the rates of return as reflected by the market fail to capture the full social rates of return and, therefore, normal market forces cannot always, on their own, channel international investment flows to developing countries. Further, major infrastructural investment projects, through their linkage effects, can have an enormous impact on a country’s growth of income. But because their benefits are widely diffused, they can seldom be appropriated in a manner that can be passed on by the market to the investor. So, channeling even domestic investment flows to the most productive activities requires appropriate intermediation mechanisms if optimum use is to be made of national savings. It follows that the channeling of international savings to countries that can absorb them most productively, rather than leaving the process entirely to the market, would also require special mechanisms.
Mechanism for recycling
A comprehensive set of proposals for recycling the Japanese surplus was made by a Study Group of the World Institute for Development Economics Research (WIDER), consisting of Saburo Okita, Lai Jayawardena, and the author.
Proposals for recycling the Japanese surplus to the developing countries have to be built around two basic features. They should provide reasonable security of capital, and they may have to include a subsidy element to allow capital to be raised in the market for countries that can absorb it only at concessional rates.
The WIDER plan indicated a number of ways to incorporate these features in a recycling mechanism. It called for the creation of a Japanese Trust Fund, which could raise funds in the Japanese capital market and on-lend them to developing countries, employing different kinds of guarantee mechanisms and using the Japanese Overseas Economic Cooperation Fund resources to reduce its lending rates. Since recycling the Japanese surplus to the developing countries is very much in the interests of a healthy growth of the world economy, and since there are also large surpluses in other industrial countries (e.g., Germany), it is quite legitimate to expect other industrial countries to share the costs of the guarantee and the interest rate subsidy with Japan. If such supplementary assistance could be secured, the Japanese Trust Fund idea could be transformed into an International Trust Fund which would raise funds on private capital markets in all surplus countries and on-lend them to developing economies.
The technique for implementing the mechanism outlined above would be to use long-term, zero-coupon bonds (which have no interest income, but only full redemption value at the end of the period) as collateral for the principal, and to use a subsidy to reduce the interest cost or to secure a part of the interest costs by annuities (which yield income annually for a fixed period and no redemption value). Both the zero-coupon bonds and the annuities could be purchased from the proceeds of the capital raised from the market and the remainder could be on-lent to borrowers at short-term floating rates. The lending agency could still make a profit if the yield curve has a positive slope, that is if long-term interest rates exceed short-term interest rates, as is usually the case, and no account would be taken of other credit risks assumed by the agency.
Table 1 illustrates the case with an example where the Trust Fund raises ¥ 100 million in the Japanese capital market by issuing floating rate obligations, and then uses a part of the proceeds to buy 20-year, zero-coupon bonds that would mature to ¥ 100 million at the end of the period and thus secure the principal of the issues. The rest of the proceeds are then on-lent to developing country borrowers as 20-year floating raobligations. The savings made by the Trust Fund, in borrowing short (say at six-month floating rates) and investing in long-term, zero-coupon bonds with a higher rate, can be passed on to the borrower, at least partially, in the form of lower rates of interest.
|>fear||Zero-coupon||Loans||Debt||Cash flow||Net cash|
|end||Borrowing||investment||to LDCs||service||tram LDCs||flow|
|0||100||40||60||0||0 + 0 = 0||0|
|1||0||0||0||4||0 + 2.1 =2.1||−1.9|
|2||0||0||0||4||0 + 2.1 =2.1||−1.9|
|15||0||0||0||4||0 + 2.1 = 2.1||−1.9|
|16||0||0||0||4||12 + 2.1 = 14.1||+ 10.1|
|17||0||0||0||4||12+1.7 = 13.7||+ 9.7|
|18||0||0||0||4||12 + 1.3 = 13.3||+ 9.3|
|19||0||0||0||4||12 + 0.8=12.8||+ 8.8|
|20||0||0||0||100 + 4||12 + 0.4 = 12.4||+ 8.4|
The example is based on some assumed rates of interest currently in effect; the numbers could change if interest rates change. But the logic remains valid, so long as there is a sufficient spread between the short- and long-term rates in the market, which is normally the case in Japan. For instance, if the Trust Fund borrows ¥ 100 million at the six-month floating rate of 4.0 percent, it will have an interest servicing burden of ¥ 4 million a year for 20 years. If, from the proceeds of these borrowings, it invests in 20 year, zero-coupon bonds yielding 4.7 percent a sum of ¥ 40 million, that will mature into ¥ 100 million at the 20th year. The Trust Fund can then lend to developing countries the remaining ¥ 60 million, at 3.5 percent a year with 15 years’ grace period, to be repaid in equal installments in five years. The internal rate of return on the cash flow for the Trust Fund would still be 4.8 percent, well justifying the whole operation.
In schemes like this, Japanese savers are fully secured against the risk of non-repayment of the principal. This security would be a great incentive for them, in view of the low-inflation environment of Japan. The risk of non-payment of interest is however expected to be assumed by the Trust Fund, which like any other lending agency would try to minimize risk through its operational methods and diversification of portfolio. In addition, the Trust Fund would bear the risk of a possible loss in asset value if interest rates changed and the spread between short and long-term rates narrowed.
The main problem of limiting these operations to the Japanese capital market alone is that the market for such zero-coupons in Japan is not very large. If the Trust Fund operations went into billions, as envisaged in the scheme, it would have to look for alternative markets, particularly in the United States. In that case, the Trust Fund would have to bear, as usual, the credit risk of non-payment by borrowers, and the risk of a loss of asset values for the zero-coupons and other fixed-rate securities they hold, if interest rates and the spread between long-and short-term rates changed. There would also be an exchange rate risk between the yen and the dollar which could be appropriately shared between the Trust Fund and the borrowing countries.
Table 2 illustrates a loan program, which can be operated by the Trust Fund, or by an individual borrowing country, when money is raised in dollars from the international capital market, say at 8 percent (which should be equal to the LIBOR plus a sufficiently large spread), and the principal is collateralized with $19.6 billion worth of zero-coupon bonds for 20 years at 8.5 percent. If nothing else is done, and the remainder of the proceeds is used by the borrowers, the interest costs they will have to bear will increase, and the lenders will have to bear the full credit risk of possible non-payment of the interest. Alternatively, a part of the interest cost could be secured by investing in annuities a part of the proceeds, say $20.4 million, yielding every year $2.8 million for 20 years. The remaining $60 million could be used by LDC borrowers, which would have to pay a sum of $5.2 million every year as interest cost. This reduces the risk to the lenders of the non-payment of interests, and at the same time brings down the effective cost of borrowing, as measured by the internal rate of return on the borrowers’ net cash flow, to only 5.9 percent.
The purpose of this exercise is to show that it is possible to work out mechanisms so that funds can be raised in private capital markets and on-lent to developing countries, by securing the capital and a part of the interest risks through appropriate, market-based collateralization, and also keeping the effective cost of borrowing reasonably low. Similar schemes may be worked out to protect against specific risks if these appear to be of greater concern at a particular time.
Assistance by creditors
If market-based mechanisms were actively supported by creditor governments, the process of recycling could be made smoother. For example, if guarantees were provided by governments, directly or through some of their agencies (such as the Export-Import Bank), it would reduce the need for market-based collateralization. Similarly, if a part of the costs, both of the collateral and of the interest payments, were met from government funds, it would be much easier for the funds to be absorbed in those countries where they could have the largest impact on output, employment, and social returns. The examples given above also suggest that the cost of these subsidies will not be disproportionately large. A $2 billion investment in a 20-year annuity at 8.5 percent would yield about $280 million every year for 20 years. If this amount were provided by governments, the effective cost of borrowing would be reduced by more than half.
Contributions of these magnitudes are not large when seen in a proper perspective. Indeed, since these schemes would be expected to improve the operation of the world economy, it would be legitimate to expect that the Japanese efforts should be complemented by the support of other creditor countries, and attempts be made to mobilize the surpluses available in the private capital markets in the world as a whole for promoting development. The process of recycling surpluses would then become a truly effective example of international cooperation.