Cyprus Post-Crisis Progress

Explaining Japans DeflationCould it happen in Lebanon?

Deflation is a rare economic condition that indicates general deterioration of the economy manifested in a general decline in prices (broad-based). No country in recent times has been hit by deflation as hard as Japan has; two decades of sluggish growth, rising unemployment, and loss of global competitiveness were dubbed chronic deflation era or the lost decades.

The causes of deflation reveal structural weaknesses in Japans financial and socio-economic systems; and the failure of the monetary policy[footnoteRef:1] where Bank of Japan failed to manage inflation expectations (a key tool in monetary policy) was due to its slow and inefficient responses and loss of credibility. [1: Ito, T. and Mishkins, F.S. (2004) severely criticized the monetary policy and dubbed its failure as the most likely cause of deflation in Japan (Ito, T. and Mishkins, F.S. (2004). NBER Working Paper Series: Two Decades of Japanese Monetary Policy And The Deflation Problem).]

Roots of Japans Economic DownturnThe run up to deflation starts in the mid-80s when core inflation in Japan (CPI excluding food) fell to zero due to the following factors that also lead to an asset price boom[footnoteRef:2]: [2: Baig, T. (2003). IMF Working Paper- Asia and Pacific Department: Understanding the Costs of Deflation in the Japanese Context. ]

1- Tight monetary policy2- Aftermath of earlier oil shocks3- Rapid buildup in capacity (positive supply shock or negative output gap)4- Appreciation of the yen5- Gradual removal of trade barriers (supply shocks from emerging economies)

EffectsThe subsequent burst of the bubble in the early 90s revealed huge amounts of non-performing loans that eroded banks balance sheets.Transfer of wealth did not add up to a zero-sum game as deflation increased the real debt burden for debtors while the sharp decline in collateral values eroded balance sheets of lenders.In fact from 95-98 several housing loan companies, credit unions, banks (large[footnoteRef:3] and small), and securities firms (large and mid-size) failed. [3: Hokkaido Takushoku, Long-Term Credit, Nippon Credit ]

On the macro level this lead to curtailed spending and investment and to a decline in aggregate demand.

As short-term interest rates hit zero, real interest rates remained positive[footnoteRef:4] and conventional monetary policy based on pure manipulation of short-term nominal interest rates does little to turn the tide (Bernanke, 2002)[footnoteRef:5]. [4: Real interest rate = nominal rate inflation; in Japan real = + deflation (nominal = o and deflation is negative inflation)] [5: Bernanke, B. (2002). Deflation Make Sure It Doesnt Happen Here. Before The National Economists Club, Washington, D.C. ]

RemediesThe monetary policy is not limited to conventional tools to stimulate the economy (S-T interest rate manipulation). Bernanke (Bernanke, 2002) argues that the central bank either alone or in cooperation with other parts of the government can further stimulate the economy by: Managing expectations which necessitates a credible central bank Expanding asset purchases and menu of buys: S-T and L-T bonds to bring down L-T interest rates, equities, foreign-currency denominated bonds, NPLs, etc. Extending loans to banks at low interest rates Imposing explicit ceilings on interest rates of L-T treasury debt Influencing yields on L-T privately issued securities through the discount window (central bank lends to banks that in turn lend to companies that issue securities) Cooperating with fiscal authorities that implement broad tax cuts or increased government spending paired with open-market purchases to avoid any interest rates hikes (stimulates consumption) Implementing structural economic and financial reforms Note that Bernanke does not recommend manipulation of the foreign exchange to fight deflation although it was done back in 1933-1934 by Franklin Roosevelt when the dollar was 40% devalued against the gold.

Why It Took So LongWhen S-T interest rates hit zero, the economy would be in need of non-conventional monetary policies to jump-start the economy.

The BoJ is often criticized as not being proactive enough or not having taken preemptive measures to control neither the asset bubble nor the recession that followed its burst: Bernanke and Gertler (2001)the central bank waited too long before tightening monetary policy during the bubble period, and delayed in easing once the economy headed downward (Baig, 2003).

Series of mistakes[footnoteRef:6]: [6: Ito, T. and Mishkins, F.S. (2004).]

Slow structural reform in regulated sectors Slow policy response to NPLs (cleanup process of the banks balance sheets took 15 years to complete- Nishizaki et al, 2012[footnoteRef:7]) [7: Nishizaki, K. et al (2012). Chronic Deflation in Japan ]

The August 2000 interest rate hike Newly independent BoJ (April 1998) was more conservative, timid, and tentative thus fell in the independence trap Inefficient communication by the BoJ destroyed its credibility Wrong expectations of the economic conditions Consumption tax rate increase and the repeal of income tax cut in April 97

In addition, the demographic deterioration lowered the natural rate of interest and expectations for future income growth (Nishizaki et al, 2012), and the additional shocks of the Asian financial crisis (July 97) and the default of the Russian debt (August 99) aggravated the recession and hampered recovery.AbenomicsIn 2013, Japan seemed to have gotten out of its deflationary spiral generating positive inflation of 0.4% (IMF data) and on its way to recovery as GDP grew 1.54% (IMF data). Even the stock market rebounded with the Nikkei 225 rising 77% and the Topix index rising by 70% (Hausman and Wieland 2014[footnoteRef:8]). [8: Hausman, J.K. and Wieland J.F. (2014). Abenomics Preliminary Analysis and Outlook. Brookings Papers on Economics Activity, Spring 2014 Conference.]

However, the Prime Minister Shinzo Abes three arrows to restore Japans economic health fell a little short of expectations in part because Japans new monetary policy is not yet fully credible (Hausman and Wieland 2014). The three arrows consist of: Monetary regime shift:i. Setting an explicit inflation target of 2% (by 2015)ii. Aggressive quantitative easing including BoJ acquiring construction bondsiii. Doubling the monetary base (by 2015)iv. Correcting the excessive Yen appreciationv. Setting negative interest ratesvi. Revising the BoJ Act Fiscal stimulus measures:i. Public works package of $100 billionii. Social welfare spending: pensions, health care, nursing care, and family benefitsiii. Increasing consumption tax to 10% (by 2015) Structural reforms:i. Stimulating private investmentsii. Increasing womens share of leadership positions to 30% by 2020iii. Joining the Trans-Pacific Partnership (TPP) which would liberalize and deregulate protected industries such as agriculture, healthcare and open up utilities to competition

Could it happen in Lebanon?We conducted a brief comparison between Japan and Lebanon in the table below and we comfortably conclude that deflation is unlikely to occur. In addition, Bernanke (Bernanke, 2002) presents 3 measures that a country should take to prevent deflation: Preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero Ensure financial stability in the economy: healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks Central bank should act more preemptively and more aggressively than usual in cutting rates when inflation is already low & fundamentals of eco suddenly deteriorate

BDL is in line with all these measures even though its capital markets are less developed; however the establishment of the Capital Market Authority (CMA) is aimed at reinforcing the markets, attract FDIs, and galvanize BSE.

FactorJapanLebanonNote

Exchange RegimeFloatingPegged to the $The Yen's appreciation during recession aggravated the situation.

Monetary PolicyReactiveConventionalProactiveConventional & Non-conventionalDuring Japan's deflationary spiral, BoJ stuck to conventional methods of stimulating the economy while non-conventional methods like buying L-T bonds, equities, NPLs were needed. BDL takes the lead in creating non-conventional tools to stimulate the economy: subsidized loans, circular 331.

Does not setinflation targetInflation-targetOnly recently with Abenomics has Japan set a target for inflation at 2% to help manage expectations, a key tool in MP.

Private DebtAvailableNegligible to nilContributes to Lebanon's low NPLs rate.

Central BankNewlyIndependentIndependent sinceinceptionOnly in April 1998 was BoJ given independence to be able to take faster decisions amid frequent political deadlocks; a situation familiar to Lebanon.

Low credibilityHigh credibilityTo this day the BoJ is trying to restore its credibility that was lost through a series of mistakes committed amid the recession especially not committing to a specific inflation target and the August 2000 interest rate increase. BDL conversely gained worldwide credibility as its MP and financial engineering consistently helped Lebanon navigate the 2008 global crisis, its prolonged instability and frequent political deadlocks.

Sovereign DebtInternalInternalBoth Japan and Lebanon protect themselves from foreign creditors.

Asset BubbleLate 80sNoneJapan's deflation has been triggered by the burst of the asset bubble in early 90s. Even though Lebanon's real estate boomed from 2008-2010, it is hardly an asset bubble and today the real estate sector in Lebanon has stabilized without any negative repercussionto the economy.

NPLs & CollateralHighLowJapan's NPLs have been decreasing from their high in 2002 of 16.4% (major and regional banks according to KPMJ Loan Portfolio Advisory: Global Debt Sales, 3rd ed, Japan) to 4.9% in September 2011. Lebanon's NPLs in 2013 are 3.38% (BDL source).

Demographic ConditionsAgingpopulationAgingpopulationThe aging population lowers the natural rate of interest and expectations for future income growth. Lebanon should take note of that especially that it's population from 2015-2020 is expected to have a negative growth of 0.71% according to UN, World Population Prospects: The 2012 Revision and thereafter from 2020-2050 to grow at a maximum rate of 0.67%.

Sources:

Shiratsuka, S. (2003). The asset price bubble in Japan in the 1980s: lessons for financial and macroeconomic stability.

Bernanke, B. (2002). Deflation: Making Sure It Doesnt Happen Here. Washington, D.C., USA.

Okina, K., Shirakawa, M. and Shiratsuka, S. (2000). The Asset Price Bubble and Monetary Policy:Japans Experience in the Late 1980s and the Lessons.

The Economist (March 18, 2013). Once more with feeling.

Nishizaki, K., Sekine, T., Ueno, Y. and Kawai, Y. (2012). Chronic deflation in Japan.

Ito, T. and Mishkin, F. S. (2004). Two Decades of Japanese Monetary Policy and The Deflation Problem. NBER Working Paper Series 10878.

Baig, T. (2003). Understanding the Costs of Deflation in the Japanese Context. IMF Working Paper WP/03/215..