How China Is Killing Japan Economy Slowly

Tonight’s Financial Times has a eye-popping story, that the survival of Sharp, one of Japan’s top consumer products manufacturers, is in doubt:

Sharp has admitted there is “material doubt” about its ability to stay in business as it warned of a second year of record losses, deepening the gloom surrounding Japan’s once dominant consumer electronics industry…
The warning came a day after Panasonic stunned investors by projecting a second consecutive $10bn loss. Panasonic’s share price dropped a further 19 per cent on Thursday.
Sharp and Panasonic, along with Sony, are the most consumer-focused of Japan’s large technology companies. All three have suffered as prices for flatscreen televisions and other household items plunged globally.
A strong yen and competition from lower-cost manufacturers elsewhere in Asia have turned the products that once underpinned their success into financial millstones. Last year, the three groups suffered a combined net loss of Y1.6tn – a figure that Sharp and Panasonic will come close to matching between them this year.

The story correctly notes that an immediate cause of Sharp’s problems are botched investments in liquid crystal display manufacture. But a big, arguably the biggest, part of the story, is how long the yen has remained in nosebleed territory. Most observers thought a yen above 90 would be catastrophic for Japanese exporters, even allowing for the fact that they have moved a lot of production to lower-cost centers elsewhere in Asia. And the yen maintained that price from the crisis onward, and more recently has sustained the astonishing level of above 80 even in the face of intervention by the Bank of Japan. And there’s a reason for that. China has been buying yen, forcing Japan to buy dollars to keep the yen from going even higher. In other words, China has been accumulating yen and shifting the “dollar manipulation” onto Japan. The common view, that China is the largest foreign buyer of US Treasuries, is dated. In 2012 to date, Japan has purchased more, and its dollar reserves nearly equal China’s.
This post from Tim Duy in 2010, “Yen Intervention, or Why Japan is Now Carrying China’s Water,” lays out how this worked:

Now, suppose Japanese officials believe that intervention is required regardless of the G-20. Presumably, they will give US Treasury Secretary Timothy Geithner a phone call to at least keep him in the loop, if not to receive his implicit consent. One wonders if Geithner will recognize what he would be consenting to: Japanese intervention, if it occurs, means that Chinese authorities managed to get Japan to acquire their Dollar reserves for them. Instead of buying Dollars, China buys Yen, which in turn induce Japan to buy Dollars. This maintains the artificial capital flows to the US while allowing China to escape accusations of being a “currency manipulator.”
Since then, Japan’s currency challenge only intensified, culminating in last week’s almost comical complaint from Japanese policymakers:

Japan’s government said it will seek discussions with China over the nation’s record purchases of Japanese bonds as an appreciating yen threatens to undermine an economic recovery.
Japan is closely watching the transactions and will seek to maintain close contact with Chinese authorities on the issue, Vice Finance Minister Naoki Minezaki told lawmakers in Tokyo. Finance Minister Yoshihiko Noda suggested at the same hearing that it’s inappropriate for China to buy Japan’s bonds without a reciprocal ability for Japanese to invest in China’s market.

Did policymakers recognize the irony of their situation? It is not exactly a secret that Japan has made frequents excursions into the currency markets. But apparently they feel that intervention should be limited to Dollar purchases. Surely another Asian nation wouldn’t play the same game on them?
Alas, the Chinese did – under pressure to “loosen” the renminbi – and pushed the Japanese into intervening last night to tame the surging Yen. In effect, the Chinese managed to get the Japanese to do their Dollar buying for them. Honestly, I have a hard time faulting the Japanese. They are facing a serious deflation problem, and pumping Yen into the system is an appropriate response (all though, they might simply sterilize the intervention, which would be, in my opinion, a policy error).

Note that this post was written shortly after China announced that it was moving to more “market based” rates, which pretty much everyone (save yours truly) thought was a Big Deal, and in the next few months, indeed proved to mean far less in the near term than breathless commentators had thought (all you needed to do was read how the new basket mechanism worked, it was really not hard to foresee this outcome). China had announced this change shortly before Geithner looked likely to designate China a currency manipulator, which served to buy more time. Duy continues by speculating whether Geithner was fooled by this subsequent move (of directing its currency manipulation through the yen) or playing along:

So, Geithner finally realizes the extent of the Chinese nonevent. Recall the press fanfare that accompanied the initial Chinese currency announcement – journalists falling all over themselves to speak brightly of China’s economic maturation. How many of those stories were sourced by Treasury officials crowing about the breakthrough that allowed them to avoid labeling China a currency manipulator? And where does this leave Geithner? Either complicit in trumping up the most minor of policy adjustments, or completely sucker punched by his Chinese counterparts. Honestly, I don’t know which is worse.
What it all boils down to is this: There apparently is no motivation for global central banks to stop directing capital inflows at the US in an effort to support mercantilist objectives. If it isn’t China, it will be some other economy. And equally apparent, there is no motivation among US policymakers to address such government directed capital flows.

So this outcome was predictable. In some ways, it’s impressive that Japanese manufacturers were able to hold out this long in the face of the the catastrophically high level of the yen. But as someone who worked with the Japanese, I’m sorry to see these great companies on the ropes. Japanese, unlike Americans, respect entrepreneurs because they promote employment, and they also take a craftsman-like pride in high quality production. It’s sad that companies that upheld those values may not make it, in large measure to financial and geopolitical issues (the US unwillingness to rock the boat with China) rather than pure competitive merits.
Update 7:00 AM: I put this in comments, and decided it needed to go in the post proper:
OK, due to the hour, I did truncate the argument maybe more than I should have.
1. China still runs a dirty float. It manages the RMB in a wide band v. a basket of currencies. The dollar is far and away the biggest currency in this basket (IIRC, ~ 60% ). So even though QE in theory weakens the dollar, China will move its RMB price to (substantially) adjust. A modified race to the bottom.
2. Nevertheless, China’s terms of trade with the US have been worsening, not due to the RMB per se, but price increases in China due to inflation. If you have a fixed currency exchange rate, and you have 10% inflation and your trade partners have 0% inflation, your goods will be 10% more costly to them in a year.
3. But sending the yen to the moon has meant (to the extent it can) Japan has gotten hit even worse than China. So while China has lost some exports to US repatriation of manufacturing (yes, that IS happening) and smaller Asian markets (Vietnam, Bangladesh), it has reduced these losses by eating into Japan’s market via goosing the yen.