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Friday, February 23, 2007

Italy's Economic Problems Under The Spotlight

As Manuel points out in his accompanying note, Romano Prodi's resignation as Italy's Prime Minister is a rather sudden and dramatic, but scarcely unexpected, development. The immediate political crisis may be resolved as rapidly as it appeared, but again as Manuel indicates it may only serve as a prelude for further things to come, and the fragility of any government coalition which may be put together only underlines the difficulties Italy will almost certainly have in addressing what are important ongoing economic problems. This brief note will simply attempt to outline some of the main problems, in order to contextualize the political problem a little.

The Deficit

First and foremost among Italy's immediate economic problems is the question of the government deficit. The debt to GDP ratio in Italy - which is currently somewhere in the region of 107% of GDP - is second only to Japan in magnitude, and the short term position has only been deteriorating of late, with estimates for the 2006 deficit being around the 5% GDP level.

All of this has, of course, placed Italy in somewhat bad odor in Brussels, and lead to the opening of an ongoing excess-deficit procedure from EU Economics and Finance Commissioner Joaquin Almunia under the terms of the revised Stability and Growth Pact. The seriousness of the situation hit the headlines last October when the credit rating agency Standard and Poor's downgraded Italy's credit rating from AA to AA-. All of this would come to have an even more ominous dimension if the situation continued and Italy's credit deteriorated further as the ECB has already indicated that should the grade drop below A, then they would cease to accept Italian paper as part of their reserves.

The upshot of all this is that the Prodi government adopted a fairly restrictive budget in fiscal terms for 2007 in an attempt to bring the deficit for this year down to within the 3% limit set by the EU SGP. Now this budget has been extensively criticised for it's shortcomings (and here, and again see the OECD view here), especially for the emphasis it places on tax increases and one-off measures over structural adjustments in expenditure as a way of addressing what are, after all, long term issues (shades of the German VAT hike here, except that in this case it is personal taxation for higher income earners which bears the brunt rather than consumer taxes), nevertheless it is obviously a step in the right direction, and what matters now is the follow-up, and especially the need for a major attempt to put some sort of order into the long run problems with the pensions system which in the context of the rapid ageing of Italian society (and here) is evidently not sustainable as it is.

And it is in this follow-up process that is precisely the issue in the current crisis, since there is no consensus at all on the need for these kind of reforms among the components of the Prodi coalition (which is why I feel the best outcome which could be expected from the crisis is the incorporation of the old Christian Democrats in the coalition, but again as Manuel indicates, it is far from clear that the left can tolerate this).

As Morgan Stanley's Vladimir Pillonca noted in a useful summary of Italy's current economic situation on the GEF back in January, the very good economic performance (at least by Italian standards, around 2.0% y-o-y, which was a significant increase on the lackluster average of 0.6% achieved during the years 2000-2005, but was still well below the eurozone average of 2.7% for 2006 ) attained during 2006 has had a positive impact on the short term debt dynamic. The trouble is that with most forecasts indicating a mild slowdown in global and eurozone growth this year, and lingering doubts persisting about the short term sustainability of momentum in Germany (Italy's chief export market) it is hard to see this dynamic being sustained across 2007, and any faltering of Italian growth will immediately begin put pressure on the underlying fiscal deficit situation and will once more raise the spectre of a further credit downgrade from Standard and Poor's.

Human Capital

Another preoccupying feature of Italy's forward looking situation is the net human capital balance that the country is sustaining. I have written extensively on this topic here (and here). The heart of the problem is that Italy has a substantial outflow of young educated people (as exemplified by the fact that the percentage of university graduates leaving the country in search of a brighter future is now running at some 4% of the total, up from 1% at the start of the 1990s). This situation takes on added importance in the light of the fact that Italy now has relatively few children (a Tfr of around 1.3) and in fact the Italian population stopped reproducing itself back in the early 1990s. To some extent this situation is offset by a large and steady inflow of migrants into Italy (which is to some extent responsible for the continuing buoyancy of the Italian economy) but I think it is important to think here about the human capital implications of what is happening. I think there is a general consensus among those who study the ageing societies problem that public finances are only sustainable in some of the worst affected societies if their economies manage to achieve a substantial move up the value chain into higher-value-added economic activities. Attracting migrants in substantial numbers to carry out low value work may help short term GDP numbers (as well as the government revenue position) and may indeed help correct some of the structural deficiencies in the population pyramid, but this alone will not turn Italy's welfare system and the associated funding issues from a unsustainable to a sustainable one. To achieve this target Italy needs to retain its talented young people, and put them to work in economic activities which are commensurate with their abilities. Hence the need for major reforms in the labour market, in the ease of setting up businesses (reducing red tape) and in the cost structure associated with the initiation of new types of economic activity.

And here again is another difficulty with Prodi's coalition, since one part of the coalition may well resist such changes ferociously.

Growth Weakness

As has been suggested above, Italy's growth problem is not a new one, and has been persisting for many years now. As can be seen from the chart below Italy's performance has substantially lagged behind that of the other main EU economies since the start of the nineties.

Indeed, as Italian economist Francesco Daveri points out in an extremely interesting podcast (Productivity Growth in Europe), Italy's growth rate has been steadily declining at about the rate of 1% a decade since the 1960s. Again this decline in trend growth has been associated with a steady stagnation in the rate of productivity growth, as Daveri outlines in this paper. Such is the downward secular tendency in Italian growth that it has really become impossible to clearly identify what trend growth is now in Italy, and thus it is hard to determine what part of 2006 growth is simply a temporary 'spurt' and what part is a real improvement in the underlying situation. Only 2007 will begin to make this point clearer. However it is obvious that if any real and lasting progress is to be made on this front, then substantial structural reforms are urgent.

Ageing and Saving?

Part of the issue with the immediate outlook for the Italian economy is the question of just what will be the propensity to save of Italian consumers and wage-earners from any forthcoming increase in income stemming from the recent comparatively good times and the apparent tightening in the Italian labour market (a tightening which is, remember, in part produced - as in the German and Japanese - and here - by the ageing process itself, since the larger number of workers to be found in the retiring older generations are not matched by equivalent numbers in the younger ones that replace them, although this tendency is in part offset by raised participation levels from young women in comparison with their older counterparts, but at the same time it is negatively affected by the increasing number of years spent in education before entering the labour market).

Claus Vistesen and I have already been addressing this ongoing weakness in domestic consumption in Germany and Japan, but it is worth pointing out that while the Italian State may be extraordinarily profligate, Italian citizens are not, and have a comparatively high level of personal saving (there is little in the way of a proerty boom to be found in Italy) as this report from McKinsey and Co outlines. So the most likely scenario is one of mid-term continuing weakness in consumption, and the best possibility for growth would seem to come from structural reform and growing export dependence.

The Outlook Going forward

As mentioned above Vladimir Pillonca offers a pretty balanced assessment of the immediate outlook for the Italian economy. Recent data for both consumer confidence and business confidence are certainly better than many (myself included) actually anticipated, and the Italian consumer appears to be remaining surprisingly robust (although we still need to see some real hard data for 2007, and we also need to see how the political crisis impacts on the confidence mood).

Also Italy seems to have begun to wake itself up to the advantages of a Japan/German style export-lead growth model, and there are serious moves afoot from Italian companies to try and leverage the opportunities which India seems to be offering (here, in Italian unfortunately). Confirmation of this tendency is already to be found to some extent in the recent data, which show that industrial orders have been moving up sharply on the back of significant rise in orders from abroad - 13.4% y-o-y in December, following a 6% m-o-m jump in November alone. So whilst there are evident downside risks (such as the impact of the VAT hike on consumption in Germany, the relatively high value of the euro, the fiscal tightening implicit in the 2007 budget, and the interest rate raising policy of the ECB), and while it is still impossible to see at this stage whether or not Italy will have a brush with recession in 2007 (due in part to difficulties in assessing capacity and trend growth movements at this early stage), there are evidently some significant positive elements at work - in particular those coming from corporate restructuring and the growing global export mentality of a core section of Italian higher-value-added industry (with the Fiat group notably taking the lead here), as well as from the growing numbers of migrants now working in Italy, who, as well as being employees remember, will also be customers and taxpayers.

Clearly the rapid rise of a number of the key developing economies (a process which, ironically, is significantly facilitated by the cheap interest rate environment produced by the presence of the "carry trade") offers important opportunities for Italy, Germany and Japan to thrive in the short term on export growth, it only remains to be seen (and to hope) whether or not these possibilities will be thrust asunder in the Italian case by a return of the old enemies of political instability, cynicism and pessimism.

Wednesday, February 21, 2007

Japan In The Front View Mirror

This week the Japanese economy has suddenly become the centre of everyone's attention, and just today we have the news that the Bank of Japan has finally bitten the bullet, and gone for a further 0.25% increase in its overnight lending rate. However I cannot help having the unfortunate feeling that everyone is so busy eagerly looking forward (to the recovery, the end of the carry trade, or whatever) that they are making the glaring and rather irresponsible error of forgetting to check on what has been happening behind, and in the only all too recent past.

The G7, as everyone by now probably knows, has just reasserted it's faith in the view that the Japanese economy is well on course to recovery. According to the official statement:

“Japan’s recovery is on track and is expected to continue. We are confident that the implications of these developments will be recognized by market participants”

Now this is a strange statement, since there are plenty of indications coming out of Japan that there are subtsantial doubts about this, and particular there are doubts about the resilience of domestic consumption in the current recovery, as Claus has already ably explained in two excellent posts (here and here). Since Claus will comment further on the details of the current decision, what I would like to do in this note is step back a bit, and reflect upon some aspects of the situation which should give us all cause for serious thought.

In particular there is the issue of deflation, and the danger that Japan may once more fall back into the deflation trap. I say once more, since at the present time I am already getting a strange feeling of deja vu, since few seem to remember that the current approach was tried and found wanting once before, back in 2000. Paul Krugman writing at the time had this to say:

So what if last Friday the Bank of Japan finally ended its "zero interest rate policy" (yes, ZIRP)? After all, it's only a quarter-point rise, in a faraway country that doesn't interest most Americans now that it no longer seems a dangerous competitor. And yet I would not be surprised if future economic historians look back at Friday's move as the beginning of the end for an era, and not just in Japan.

For one thing, this move by the Bank of Japan is a much bigger deal than you might think, because of its potential impact on expectations. By raising interest rates, even slightly, when the economy is still depressed, the B.O.J. in effect signals anyone in Japan who might be feeling stirrings of exuberance that it is likely to step on the brakes in earnest if the economy actually shows any signs of booming, or if consumer prices start to rise even slightly.

All of this is now of course simply history, but it is the sort of history for which many market participants - as opposed to academic economists who follow the Japan problem - seem to have remarkably short memories, and yet the consequences of that history remain, and are it seems, once more coming back to haunt us. As is well known the BoJ subsequently had to back away from the premature 2000 attempt to 'normalise' interest rates, but it seems that little has been learned from that experience. In fact, as is even less-well remembered, this failure constituted the second dent in the BoJs credibility as a deflation fighter. I say the second dent, since it is important to keep in mind that there was an earlier one, and this dent wasn't produced by the the failure to prevent the rise in asset prices that took place in Japan in the late 1980s and which gave rise to the eventual bubble. No, I am talking here about an episode which too place during the years between 1990 and 1995, during which period, according to a later consensus, the BoJ consistenly failed to act swiftly and decisively enough in lowering rates in order to try to prevent deflation occuring in the first place.

The locus classicus of this consensus is a short but influential paper by Ahearne et al (Preventing Deflation: Lessons from Japan's Experience in the 1990s. Alan Ahearne; Joseph Gagnon; Jane Haltmaier; Steve Kamin, Federal reserve Board, International Finance Discussion Papers, June 2002), which was widely read and quoted upon (and notably in the present context by Stephen Roach himself) during the the 2002-03 'deflation watch' period in the US, since it was seen as a central piece of acquired doctrine. Given the importance of all this I will now take the liberty of quoting the paper abstract in full (although reading the paper itself is strongly recommended):

This paper examines Japan’s experience in the first half of the 1990s to shed some light on several issues that arise as inflation declines toward zero. Is it possible to recognize when an economy is moving into a phase of sustained deflation? How quickly should monetary policy respond to sharp declines in inflation? Are there factors that inhibit the monetary transmission mechanism as interest rates approach zero? What is the role for fiscal policy in warding off a deflationary episode? We conclude that Japan’s sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities’ failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan’s experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity.

Note the last sentence in particular: when the risk of deflation is high "stimulus, both monetary and fiscal, should go beyond the levels conventionally implied by baseline forecasts of future inflation and economic activity". And where exactly are we right now? Well it is hard to be certain, but certainly there is a widely held view that the risk of Japan falling back into deflation is not a negligable one.

Now one of the key episodes in the whole lamentable Japan deflation affair took place in the period between May 1994 and January 1995. As Ahearne et al note, the BoJ was at the time busying itself selling the idea that the worst of the long recession was over and that a new phase of economic recovery was on the point of opening up:

The BOJ maintained this (the low interest rate) policy stance unchanged through 1994, as hints of recovery began to emerge. In May 1994, the BOJ observed in its Quarterly Bulletin (pp. 32-33) that “Japan’s economic growth appears to have stopped weakening, against the background of progress in capital stock adjustment as well as the permeation of stimulative effects of monetary and fiscal policies to date.” By November, the BOJ noted that the economy was “recovering gradually,” with all categories of spending showing strength, and long-term interest rates moving up in apparent response.

Ring any bells anyone?

The anticipated recovery, of course, did not materialise as envisioned, there was a sharp slump in equity values and the BoJ was forced to respond by reducing its official discount rate to 0.25% in September 2005, at which level it remained until being lowered essentially to zero in 1999.

There is another difficulty which is also associated with the current consensus narrative on Japan, and that is associated with the current value of the yen. In a useful piece in the Financial Times yesterday, David Pilling (who is generally an excellent Japan watcher) drew attention to the way in which many would seek to put pressure on the Japanese authorities to do something to facilitate an upward movement in the value of the Yen:

There is one more element to add to this potent mix. In the past few weeks, Tokyo has come under pressure from European – though not US – officials over the weak yen which, in trade-weighted terms, is at 20-year lows. Some European finance ministers have linked the issue to Japanese interest rates being 5 percentage points below those in the US and the UK. As well as making Japan’s exports “unfairly” competitive, the criticism goes, the wide differential has fuelled the so-called carry trade, encouraging people to convert cheap yen into higher-yielding foreign assets.

Now let's just think about all this for a moment. Japan is being encouraged to raise rates, not primarily because of the internal needs of the Japanese economy, but in order to address possible problems being caused by the very low (some would say undervalued) level of the yen, and to help ease concerns about the impact of the ensuing carry trade. Fine. But what I ask if this tightening (or as some would say 'normalising') process only serves to send Japan back into deflation again? Well at the very least we would be back with ZIRP, and with it would come another prolonged period of carry-trade activity, with the likely additional consequence that the yen would be lead to weaken even further, as confidence in the BoJ and the Japanese economy suddenly ebbed, and as a further outflow of funds from Japan occured.

And just in case all this isn't enough, we might like to think about the work of Lars Svensson. Lars is Professor of Economics at Princeton University, and is one of the experts on that strange phenomenon known as the liquidity trap, which is of course intimately related with the deflation question, and about which much heart searching has been going on in recent years. So what does Lars have to say about possible policy methodologies for exiting from a liquidity trap (which is of course one of the problems which has been ailing Japan):

"In an open economy, the Foolproof Way (consisting of a price-level target path, currency depreciation and commitment to a currency peg and a zero interest rate until the price-level target path has been reached) is likely to be the most effective policy to raise expectations of the future price level, stimulate the economy, and escape from a liquidity trap. It is the first-best policy to end stagnation and deflation in Japan."
From the abstract of the paper Monetary Policy and Japan's Liquidity Trap (January, 2006).

Now let's leave aside at this point the throny question of whether the 'foolproof path' is as foolproof as it actually seems in the absence of any convincing analysis as to why the problem is such a protracted one in Japan (as well as the associated issue of just who exactly the 'fools' are that Lars would seek to protect us against in framing the idea in this way), the important point to note here is that the best advice one of the world's leading experts on how to handle Japan's problems can give is that they should systematically depreciate the currency, and then hold it down with some sort of peg. He is absolutely clear, allowing a rise in the value of the yen would simply raise expectations of a continuing weakness in prices (and remember this was also Krugman's point back in 2000) and hold Japan firmly in the grip of deflation. So those who now talk about the yen being currently 'undervalued' would do well to bear this in mind. Simply egging the yen upwards will only perpetuate deflation and send Japan careering back towards the re-introduction of ZIRP, which would of course only fuel the carry trade even more, and so on, and so on.

In closing, just three simple points. The first comes from David Pilling's piece mentioned above:

On one side of the debate, many academic economists argue that it is ludicrous even to consider raising rates now. Stripped of energy costs – the normal practice in other advanced economies – Japanese prices are still falling. Few textbooks, to put it mildly, advocate tightening at such a juncture.

Rarely has the distinction been more stark, there is a complete disparity between the advice and thinking of theoretical macroeconomists, and that of policy makers, central bankers, and market analysts. We are, of course, about to get to see who is in fact right (economics has the virtue of being a science which refers to a real world, so spin can only go so far), and my only hope is that one way or another the consequences of any error being committed at the present time are not too serious.

Secondly, lurking behind all this, as I have been indicating, lies the mirky question of why precisely deflation has been plagueing Japan for so long now. Only yesterday Stephen Roach served us up what must still be the consensus view on the situation:

The difficulty Japan is having in extricating itself from a post-bubble deflation may well be emblematic of deeper problems that continue to afflict the world’s second-largest economy. This same difficulty may also be having an important bearing on Japan’s competitive prowess. The damage from the bubble may well have been so wrenching and so fundamental to the system that it simply may be asking too much of Corporate Japan to rise quickly from the ashes and hold its own against the rapid emergence of China, the intense determination of Germany, and the solid gains evident by exporters elsewhere in the developing world.

So the problem stems, on this account, from the difficulties being encountered in extricating Japan from post bubble headaches. But this bubble burst some 18 years ago now. Really I fail to find this a very plausible account, and especially in the light of the fact that in recent years Japan has introduced wide reaching and extensive structural reforms (so yes, the centrality of structural reforms hypothesis is also under test here). As is by now well known to all our regular readers, Claus and I have been advancing another hypothesis, related to demography, Japan's ageing population, and the secular downward trend in the internal consumption GDP share. There is a hypothesis, it seems to fit much of the data reasonably well, and yet there is a a remarkable lack of enthusiasm for even considering this possibility. One notable exception here is MS's Robert Alan Feldman, who as Claus has been noting (and here), has been struggling with the 'something funny' feeling about the Japan consumption pattern. Methinks he is on the point of getting to the heart of the matter. Keep on scratching Robert!

Finally, there is the issue of what will happen to BoJ credibility if they have actually gotten this all wrong. Here I can do no better than cite Hidenao Nakagawa, secretary general of the Liberal Democratic Party (as quoted in this Bloomberg article)

The government's ``chilly, tacit acceptance of the move was based on the reasoning that the BOJ would be left accountable for any subsequent slowing of the economy,'' said Shinichi Ichikawa, chief strategist at Credit Suisse Group in Tokyo.

So the BoJ will remain accountable. Be warned! You are all playing with fire here, and I hope you realise it, since the livelihood and well-being of many millions of people depends on getting this one right.

Thursday, February 8, 2007

Why Japan Matters To India

Well Indian blogger Nanubhai has certainly stirred up a storm with his overheating post. So now that the initial burst of energy has started to die-down, and the dust has begun to settle, it may be well worth sifting through the various pieces that constitute this whole debate, to try and see what exactly is at issue here, why the issues are important, and what can be learnt from the episode.

Amongst the many topics of not inconsiderable interest would be to think about what can be learnt about the whole development process from studying the Indian case, and this topic is by no means an incidental one, as there are still plenty of countries stuck back-there in the mire of poverty, and if they can learn anything from the Indian example about how economic break-out works, then apart from getting the benefits from its own growth process India can also help others to see how they too might move forward.

So this will be the first of a series of posts to try work through the issues raised, which have, of course, been accumulating fast, indeed such issues seem to be mushrooming far faster than our capacity to assimilate them has.

Today I am going to start the process off with an India-Japan comparison, in part since the India-China one so often generates more heat than light, but also in part since I want to argue that you cannot make any sense of the current 'capacity growth' debate in India unless you take into account what is happening in Japan, and the impact of Japanese deflation on the global liquidity situation.

I want to hammer-home here two points concrening what is new and different in the post turn of the century Indian situation, and underline the fact that the presence of these changes make all that talk about growth rates in the 1980s and the 1990s rather dated to say the least.

Firstly India now increasingly forms part of a global economy, so global factors need to be thought about much more than they were say ten years ago. The most obvious example of this is to be found in the rapid acceleration of high value services, and the migration of a lot of ICT related activity to India, a phenomenon which can't be understood, IMHO, outside of the 1995-2000 internet boom-bust cycle in the USA.

Now the impact of these high value services has been, as many would note, rather more strategic than decisive, since they still account for only a very small share of overall GDP. Thus we could say they have been something of a catalyst to a process rather than the process itself. By the same token, it is now impossible to look at Reserve Bank of India monetary policy outside of the general global liquidity context, things just aren't decided locally any more.

All this is only going to become even more important as India gradually incorporates in the global economy, and as the share of external trade in GDP only climbs and climbs.

So what is needed insofar as the economic debate in India is concerned is something of a change of mindset. There is a rather dated feel about many of the arguments which are being marshalled around the capacity issue, they seem to have been prepared and honed in the context of yesterday's problems, and and as a consequence they are often found to be woefully lacking when fielded to confront the problems of today, problems which are in many ways very different from those to be found back in the decade of the 90s. Indeed I think this is precisely why the Economist article is causing so much fuss, since it may quite simply be the last gasp of a view of the world which no longer holds, a view whose closest adherents find it ever so difficult to let go of.

The second point I would want to underline in the appparent high degree of interconnectedness of so many things we are seeing here. Things have suddenly become more complex, and what appears to be a small and isolated phenomenon in one country or region may in fact turn out to have important and significant consequences elsewhere. I could cite the way in which China's need for soy beans has fuelled a significant national growth spurt in Argentina or Brazil, or the way in which climatic change may be accelerated by growth and yet subsequently turn round and have a secondary unexpected impact on growth itself, but today I simply want to think about what is happening to interest rate policy in Japan, and why this is important even (or especially) for people in India.

In order to to this I would refer back to a comment by Andiron in Nanubhai's post:

"Liquidity has reduced the deficit as payments are lesser, but the risk premium will go up dramatically. As foreign economies cool, remittances to India will dry up leading to more current account problem..(>5%)..A large portion of $ 180 bil reserves is a mouse click away from disappearing.. Lots of palapappans forget, that last 4 yrs were unusual in liquidity.. It is time to pay higher risk premia.."

Now despite the peculiar way in which this is expressed the comment does go straight to the heart of the matter. Have the last four years been unusual in liquidity terms, or can we expect more of the same? This is the issue. In fairness to them I suspect that the writers at the Economist are sort of making the same assumption that Andiron is, whilst I am certainly assuming the contrary, and this is precisely one of the big reasons I imagine that trend growth may well accelerate in India, since cheap finance will be available to make it possible. Is this in iteslf a good thing or a bad thing? Well people can argue afaiac ad infinitum on this, the problem is that it is a very probable reality, and what we need to focus on in this debate is the world we are likely to see, not the one we would like to see.

(Incidentally, I should point out that the liquidity issue is only part of the reason I go with Nanubhai, there are other reasons which I will try and explain in other posts, but the liquidity environment is one part of the picture, and an important one).

Now, OK, why is Japan important?

Japan is important due to the existence of something called the "carry trade". So just what is the carry trade? Well simply put the carry trade is a phenomenon which is based on the existence of substantial interest rate differentials between countries (with a secondary driver being the anticipated direction of future currency movements). Japan has become an important focus in this trade due to the existence over long periods of time of zero or near-zero interest rates. So if you want to borrow money in a country like India with interest rates significantly above zero, and if you anticipate that over the appropriate time horizon the value of the rupee is going to rise relative to the value of the yen (which given the large anticipated economic growth differential between these two economies seems a reasonable enough assumption) then it makes a lot of economic sense to borrow in Japan and spend in India. The net result of this is that development in India becomes cheaper than it would have been, since the cost of capital - or the so-called risk element - goes down.

Now applying normal Econ 101 type market reasoning to this situation you might imagine that the result of this process would be that interest rates in India would go down and those in Japan would go up, based on the increased availabilty-of and demand-for funds. Well if you thought this you would be half right and half wrong. Long term rates in India will of course be pulled down by this process, and this will give a lot of headaches to people over at the RBI in implementing monetary policy since their ability to control both rates and the money supply will be affected. But interest rates in Japan will not necessarily be affected at all, since Japan has long been caught in a rather strange and unique situation known as a liquidity trap. Now the easiest way of describing the problem is to say that the Bank of Japan has created a kind of monetary black hole (via a policy known as quantitative easing) and what this means effectively is that the more quickly the bank throws money into the economy the more quickly it disappears, without - and this is the key point - having any noteable impact on the country's inflation rate (Japan has been struggling since the early 90s with a phenomenon know as deflation). As a consequence interest rates in Japan do not move up, so the two country mini-market model (Japan-India) process descibed above simply does not equilibrate, and Japan acts as a kind of negative attractor (deliberately using a term from chaos theory) for interest rates, gradually sucking in the rest.

Well, it isn't all quite as simple as this, but I imagine you may be getting the picture.

So just how important is the yen carry trade?

Well as the ever excellent Brad Setser points out (citing the FTs Gillian Tett) no-one really knows, but the number might be anything up to a trillion dollars. This number is almost certainly rather on the high side, but that being said, there is a very, very large quantity of money going the rounds here. As Gillian Tett says:

Just how large the carry trade is, nobody really knows ... But whatever the precise number, what is clear is that carry trades have been fuelling the dash into risky assets in the past couple of years.

After all, with Japanese interest rates at rock bottom and the yen on a downward path, it has been frighteningly easy for any hedge fund to borrow in yen, invest in something yielding, say, 5 per cent a year, apply a bit of leverage and – hey presto – produce returns of 20 per cent, or more. Conversely, if an investment bank wants to create a collateralised debt obligation but cannot sell the riskiest debt tranche, it can put this on its own books – funded by ultra cheap yen. The yen has thus been tantamount to the ATM of the global credit world – spewing out (almost) free cash.

Given this you can understand just how much the leaders of the G7 would like the Bank of Japan to start raising rates, and how much this is going to be talked about this weekend in Essen. And much as I hate to have to disagree with Anantha Nageswaran, I take the view that the world's central bankers haven't stopped trying to intervene in market processes over the last twelve months, by forcing up interest rates to what they call normalised rates. In the case of the EUs ECB they have only met with moderate results in their crusade (and with potentially worrying consequences as we may be about to see in Germany), and in the case of Japan the most that they have been able to extract is one quarter point raise. And according to Bank of Japan policy board member Hidehiko Haru, gioven that internal consumption in Japan is congenitally weak and that there's no imminent threat that rising prices will cripple economic growth (indeed there's every danger of falling back into deflation) then there's no hurry to start raising rates again any time soon.

Also, of course, it isn't only from Japan itself that the carry trade is at work. Andy Mukherjee in an interesting Bloomberg column recently drew attention to the possibility that people might like to borrow in yuan to buy rupees. The rationale for this may seem strange, but Andy explains it like this:

"According to the ABN Amro economists, the appreciation in the Chinese currency is already in the price: Forward traders expect the yuan to rise about 5 percent against the U.S. dollar in one year. The risk of a sudden, large revaluation, from its current level of about 7.78 to the dollar, is low.Even if you agree with this assessment, how do you borrow yuan to buy rupees, beating capital controls in both China and India? The offshore forward markets may offer a solution."

"The implied interest rate on borrowing yuan for one year, according to my Bloomberg, is just 0.15 percent in the non- deliverable, offshore forward market where trades are settled in U.S. dollars. That compares with an inter-bank rate of 0.63 percent on borrowing Japanese yen.
One-year non-deliverable forward contracts on the Indian rupee currently offer implied interest rates of 7.93 percent. There is, thus, a neat 7.8 percent interest-rate differential -- or ``positive carry'' -- to be pocketed from selling yuan forward (against the dollar) and buying rupees forward (against the dollar).

But back to our main topic: just why is it that Japan is finding it so difficult to raise rates and bring an end to the yen carry trade? Well here's the rub, at least if you are a writer at the Economist it is, since the underlying issue is a demographic one, but not this time the demographic dividend which India is just begining to benefit from at this point, and which they seem to want to attempt to trivialise so much, but rather the demographic penalty of an ageing society which is busying diverting resources away from consumption and towards saving. And what do you think our dear friends at the Economist have to say about all of this? That Japan is underheating? Not at all: Japan's recovery is going from strength to strength. Talk about the world turned upside down.

Footnote: some good background explanation into the real ongoing difficulties Japan has in raising domestic consumption and interest rates can be found in these two posts (and here) from Claus Vistesen.