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Monday, April 9, 2007

JAPANESE PERSPECTIVES

Excess liquidity stirring global volatility in stock markets


More than a month has passed since the Shanghai stock market plunge sent shock waves throughout global markets in late February. Although share prices have since stabilized, volatility rife in foreign-currency markets, with the dollar-yen rate sometimes fluctuating nearly 2 yen a day.

Stock markets are prone to synchronized global downturns when new types of shock arrive. But it should be noted here that the biggest factor behind the markets' recent problems is excess liquidity.

Even in a global chain reaction, different reasons particular to each country work to push down share prices, and the size of the decline varies.

In the United States, share prices are under downward pressure from pessimism over the U.S. strategy for Iraq, and the possibility that tons of housing loans extended by subprime mortgage lenders will go sour.

In Japan, political uncertainty over local elections and the House of Councilors elections in July are casting a pall over the stock market.

In China, the widening gap between rich and poor -- unbelievable for a country ruled by the Communist Party -- is combining with uncertainties over top leadership reshuffles at the party convention this fall to become major destabilizing factors.

In Europe, meanwhile, the possibility of another interest rate hikes is looming over the market.

However, there is one common factor behind the global stock market slump -- excess liquidity. This liquidity, which cannot be absorbed by real economic activities, moves rapidly across national borders in search of better returns, thereby injecting volatility into share prices and currency exchange rates.

In countries with high interest rates, excess liquidity causes exchange rates, share prices and the prices of such commodities as oil to rise faster than they would based on economic fundamentals. And whenever some negative factor emerges, this hot money quickly evaporates and triggers sharp falls in the financial and commodities markets.

There are three major factors behind this excess liquidity.

The biggest one is the current account deficit of the United States, which is bloated to the tune of more than $800 billion a year. In a vicious circle, the U.S. deficit is automatically recycled into the country as deposits and investments by non-U.S. residents because the U.S. dollar is used as a currency for international settlements.

China and oil-producing countries are meanwhile reporting growing current account surpluses, and it is forecast that the movement of this excess money may increasingly shift toward the euro. If the above-mentioned uncertainties in the American economy prompt the U.S. Federal Reserve to start lowering interest rates, sharp declines in the dollar and U.S. share prices cannot be ruled out.

The second factor is the liquidity in countries that, unlike the U.S., are reporting sharply increasing current account surpluses. The accumulation of foreign currency reserves in China and oil-producing nations boosts their domestic liquidity.

Furthermore, China's massive dollar-buying intervention to avoid the sharp appreciation of the yuan has sharply increased yuan liquidity. Although the Chinese central bank has raised interest rates and the cash reserve ratio, this liquidity has created a bubble in Chinese shares and real estate prices that could collapse one day. The intransparent nature of the bad-loan woes plaguing state-owned enterprises and state-run banks is another latent source of uncertainty.

The third factor is the ultra-low interest rates and abundant liquidity supply in Japan, which has been pursued as a measure against the nation's own bad-loan problem. The Bank of Japan has raised its key policy rate twice since last summer, but the interest rate gap with other major economies remains wide, and the yen-carry trades, in which investors borrow yen on the cheap and invest it in financial tools with higher yields, has multiplied the excess in global liquidity. The recent sharp increase in short-term borrowing by foreign-owned banks in Japan is believed to have financed this practice.

The problems of global imbalances and the low interest rate of the yen have already been discussed by the Group of Eight at a summit in Russia last year, but the situation remains unchanged on both issues, and liquidity continues to increase worldwide.

As excess money moves from one speculative target to another -- ranging from such commodities as gold, crude oil and corn to financial products like bonds, stocks and real estate investment trusts -- the volatility in each market grows. Those markets, meanwhile, remain exposed at any time to geopolitical risks, given that the situation in Iraq and the nuclear problems with Iran and North Korea remain unsolved.

Japanese savings are increasingly being managed abroad because the interest rate in Japan is still extremely low. People should realize that managing their assets overseas carries not only exchange-rate risks but market, credit and geopolitical risks that are of a different nature than in Japan.

Teruhiko Mano is a professor at Seigakuin University Graduate School.


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