Cautionary Lessons from Japan and Taiwan

Clearly China is not the only nation to be concerned about the scope for further, and perhaps stronger, appreciation against the US dollar. Despite mounting US pressure, however, renminbi appreciation was kept to a mea­sured, quite gradual pace over the first two years following the July 2005 currency reform.

Table 2.2. Comparison of Japanese and Chinese Export and CurrentAccountPerformance

Notes: Export growth is based on home-country currency values; share of US imports is based on US dollar values; share of US imports in the 2000s uses data from 2000-2003; China's current account figures are based on 1982-1989 data for the 1980s and 20OO-2002 data for the 2000s; Japan's current account figures for the 2000s are based on data from 2000-2004.

Source: Eichengreen (2007, p. 77).

opened to US goods in conjunction with an immediate and substantial rise in the New Taiwan dollar (Hon, 2004). The effects of Taiwan's experience with sharp currency appreciation are considered along with the lessons from Japan's experience. Japan, after having initially negotiated currency appre­ciation quite successfully following the breakdown of the Bretton Woods system in 1971 (Eichengreen, 2007, chapter 3), subsequently appeared to suffer considerably from acceding to incessant US pressure for additional currency appreciation in the 1980s. McKinnon (2005, p. 77) actually sees “the appreciating yen up to the mid-1990s as the main source of Japan's deflation and low-interest-rate liquidity trap.”^[32]

Overall, the Japanese and Taiwanese experiences suggest that currency appreciation carries substantial riskbut does not necessarily have the calami­tous consequences suggested by McKinnon (2005).^[33] Indeed, Japan contin­ued to enjoy export growth of 14.6% in the 1970s, down only slightly from the 1960s, and a rising share of US imports, even as the yen appreciated by approximately 41% from its old Bretton Woods parity of 360 yen/$US to an average of 211 yen/$US in 1978 (see Table 2.2). The yen initially appreciated by 17% in 1971 alone (see McKinnon, 2005, p. 88). The con­tinued rise in Japan’s share of US imports, reaching 18.5% in the 1980s, triggered further US pressure on Japan but, at the same time, suggests con­siderable resilience to the already substantial currency appreciation since 1971. Eichengreen (2007, chapter 3) concludes that although the appreci­ation did negatively affect Japanese exports and investment, the contrac­tionary effects were offset by rapid growth in the world economy - with world income enjoying a cumulative 12% gain during 1972-1973. Eichen- green (2007) also points to beneficial effects of continued Japanese exchange rate intervention to lessen volatility, coupled with expansionary monetary and fiscal policy.

The Japanese real economy clearly fared less well in the face of renewed US pressure that, following the Plaza Agreement of September 1985, saw the yen appreciate from an average of 239 yen/$US in 1985 to a high value of 128 yen/$US in 1988 - representing a fresh overall appreciation against the dollar of approximately 46%. Renewed strengthening of the yen in the early 1990s took the exchange rate all the way to 80 yen/$US in April 1995. Although Japan’s current account surplus continued to rise, export growth declined from 14.6% in the 1970s to 5.3% in the 1980s and only 2.3% in the 1990s (Table 2.2). There was also a noticeable shift of manufacturing FDI from Japan to South-East Asia after the Plaza Agreement. Japan actually moved into deflation in the 1990s following the collapse of its hitherto rapidly rising equity and housing markets. The collapse of land values proved particularly damaging given its role as collateral for loans, with severe balance sheet effects for individual and commercial landholders as well as Japan’s banking system (on this linkage, see, for example, Kuttner and Posen, 2001, and Burdekin and Siklos, 2004). The asset price collapse came not only at the end of an extended period of currency appreciation but also at the time of an abrupt tightening of monetary policy by the Bank of Japan.

Although many factors undoubtedly explain Japan’s failure to weather the second period of sharp appreciation, Japan’s current account surpluses, like its foreign exchange reserves, continued to rise - making it unclear that US pressure ever secured the trade benefits thought to accrue from a stronger yen.

When Japan was forced into appreciating the yen several times from the mid-1980s into the mid-1990s, it was thrown into a decade-long deflationary slump with no obvious decline in its large trade surplus, which has persisted up to the present.

However, the earlier 1970s experience seems to refute the premise that deflationary effects of currency appreciation are inevitable.^[34] Taiwan’s expe­rience in the late 1980s also suggests that substantial appreciation, while naturally weakening export performance, need not have such drastic con­sequences.

As shown in Table 2.3, Taiwan’s export growth slowed from 29.41% in 1986 to 1.67% in 1990 in the face of a 30.2% currency appreciation between 1986 and 1989. Taiwan’s current account surplus declined from a peak of $US 18,003 million in 1987 (representing nearly 20% of Taiwan’s economy) to $US 10,923 million in 1990, thereafter generally remaining around 1984-1985 levels before trending upward again after the Asian financial crisis. The rate of foreign reserve accumulation slowed in the face of the currency appreciation but continued to trend upward. Adjustment to the rapid currency appreciation may have been aided by central bank intervention that limited the rate of appreciation to no more than one cent a day, thereby preventing any sudden, discrete jumps in the exchange rate (Hon, 2004). Another factor was that negative effects of the appreciation on Taiwan’s exports to the United States were partially offset by gains in Europe and elsewhere, with the New Taiwan dollar actually depreciating against such currencies as Germany’s Deutsche mark and the Japanese yen during the same late 1980s time period. Even as Taiwan’s US market share fell back from 48% in 1985 to 32% in 1990, Taiwan’s European market share rose from just 10% in 1980 to 18% by 1990 (Gee, 1994, pp. 93-94).

Xu (2008) concludes that the New Taiwan dollar appreciation exceeded what was justified on a purchasing power parity basis and was likely driven upward more by short-term capital inflows than a nonsustainable current account balance.

Table 2.3. Taiwan’s External Position, 1982 2000

Note: NTD/SUS refers to the number of New Taiwan dollars per US dollar.

Source: Central Bank of the Republic of China (Taiwan) (http://www.cbc.gov.tw).

of pending currency appreciation, would seem to justify caution in the permitted range of exchange rate adjustment. In the late 1980s, Taiwan’s central bank maintained a relatively easy money stance, reducing interest rates to cushion the effects of the currency appreciation, and the rate of real GDP growth remained relatively robust, dipping only from 7.8% in 1987 to 5.4% in 1990 (Xu, 2008). While producer prices actually declined during 1987-1991 in spite of accelerating rates of credit expansion, asset prices surged - with the Taiwan Stock Index rising from 1,100 at the end of 1986 to 12,000 in early 1990 while average housing prices in the area around the island’s capital, Taipei, more than quadrupled (Chen, 2001).

As with Japan at the end of the 1980s, Taiwan’s asset price boom ended with a major collapse, and the island’s stock market lost approximately 75% of its value in six months during 1990. Also in common with Japan was the central bank’s adoption of an easy money policy to compensate for the negative effects of the currency appreciation. Even though China’s own currency appreciation has so far been quite tightly contained, the parallels with inflationary pressures being channeled into asset markets rather than goods markets are all too obvious in light of China’s stock market gains in 2006-2007 - as addressed more thoroughly in Chapter 8 of this volume. It also does not seem that permitting rapid currency appreciation to occur did anything to alleviate overall credit expansion rates in Japan and Taiwan in the 1980s.

Taiwan’s appreciation may admittedly have conferred longer-run benefits in encouraging an advance into more advanced, technologically-intensive export activities that are Taiwan’s hallmark today. For example, Chen, Schive, and Chu (1994) note a sharp increase in the ratio of products with higher degrees of capital intensity, and a decline in the ratio of products with high degrees of labor intensity, among Taiwan’s exports over the 1986-1991 period. Xu (2008) also emphasizes expansion in the service sector aided by the effects of the currency appreciation in raising domestic real income levels as tradable goods became relatively more affordable.^[35] It is doubtful that China could readily handle even the modest slowdown experienced by Taiwan, however, and there must also be concern that allowing freer appreciation of the renminbi would run the risk of allowing speculative capital flows to push the currency too far too fast.^[36] The less severe conse­quences experienced by Taiwan, as well by Japan in the 1970s, must also be set against the calamitous developments in Japan following its own “second round” of major currency appreciation in the 1980s. Perhaps the most vivid cautionary lesson of all is China’s own experience in the 1930s, however, to which we will return in Chapter 5 of this volume. There is certainly good precedent for Chinese authorities to be concerned about the risks of more rapid currency appreciation - whereas past experience suggests that such appreciation has had surprisingly little effect on the trade surpluses enjoyed by the countries concerned, leaving little hope that a move by China today could be expected to have much, if any, lasting effect on the United States’ own yawning trade deficits.