Financial Times, Wednesday, 3 May 1995

After last year's disappointing flicker of a recovery, the Japanese economy is now heading firmly back downwards, with nominal GDP growth likely to go negative this quarter. The Americans will suppress a smug smile as the weakness of the dollar indeed turns out to be someone else's problem.

The securities markets, however, have not delivered much punishment to unhedged foreign investors, especially those that are dollar-based. So far this year the Tokyo stock market is down about 16 per cent, but this is neatly offset by the 18 per cent appreciation of the yen. The figures over the past 12 months look remarkably similar.

As for bonds, the picture has been remarkably positive, with the 10-year JGB yield down from 4.6 to 3.4 per cent in four months. The depression-type scenario has broken the connection between bonds and equities, which have gone their own sweet ways.

The key question is whether the Bank of Japan thinks it has done enough damage. Mr Richard Werner, an economist with Robert Fleming in Tokyo who keeps Japanese liquidity trends under a microscope, believes that there is, at last, a sign of a change of policy.

Any relaxation will come, however, after the renewed first quarter squeeze that not only choked the life out of the economy but also sent the yen spiralling upwards as the markets sought to adjust to the imbalance, against the Fed's unabashed looseness in the US.

But there is an oddity here. Equities have been strong on Wall Street but weak in Tokyo, which makes sense given the monetary contexts, but bonds were strong in both countries. Mr Werner seeks to explain this by dividing his liquidity measures into two streams, one which impacts on the real economy and a second which stays within financial circulation. Economic money has been shrinking in volume but there has been enough financial money around to sustain a surge in bonds.

The Japanese authorities are nervous about money-led growth, after the destabilising bubbles that developed in equities and property (not to mention Van Gogh flower paintings) in the 1980s. But now the bubble has reinflated itself in the foreign exchange market, showing that the underlying rigidities of the Japanese economic system have proved intractable.

So the Bank of Japan has been playing a devious game. Everybody outside Japan has for a long time been telling the Bank to print money, for instance through unsterilised foreign exchange intervention. But last summer, when the economy began to recover, the Bank of Japan cracked down again. Now there are anti-strong yen campaigners marching in the streets. The foreign exchange market has at least paused for breath, with the dollar having recovered a few yen after its brief dip below Y80. The official short-term interest rate has been brought down to 1 per cent, but the real change would be a move towards boosting liquidity which would send the yen tumbling quite a long way against the dollar.

It is coming, says Mr Werner. The double dip, he says, has been deliberately applied to force structural changes in Japan's economy. But the Bank of Japan has been playing a dangerous game. Japan is not away far from a systemic financial crisis which would bring echoes of the 1930s. Concealed losses in the banking system are huge. To go too far could trigger a collapse of money supply and a full-blown depression. That would be a kill rather than a cure.

These are deep waters. Possibly a monetary loosening could rebound on bonds, which arguably are enjoying their own mini-bubble. Once Japanese institutions were confident that the yen had turned they might shift into dollar and D-mark bonds yielding twice as much, plus potential currency gains. Perhaps the Bank of Japan could encourage Japanese banks to buy bonds, feasting on 1 per cent money as the US banks gorged themselves on 3 per cent money in 1993. It would be nice while it lasted, but a bond market crash would eventually follow, as it did in US Treasuries.

At any rate, it is hard for the Bank of Japan to pass off the strong yen as a problem only for the rest of the world.