The Japanese threat to manufacturing

The greatest threat to Australian manufacturing is now the Bank of Japan.

That's because if the Bank of Japan succeeds in its drive to bring inflation to Japan, the yen will continue to depreciate and push the Australian dollar to an all-time high. Of course, if the Japanese economy recovers it may become a bigger buyer of Australian resources, but that won't help manufacturing.

Yesterday I attended a session of the Australian Industry Group's national executive meeting, and the main thing on the minds of the chief executives present was not the state of Australian politics, but the dollar. When will it come down? Will it come down?

I was able to pass on research by JP Morgan's Tom Kennedy to the effect that if the BoJ achieves its 2014 inflation target of 0.9 per cent, the yen/US dollar exchange rate would be 98 (currently 93.38) which would take the Australian dollar trade weighted index "close to an all-time high”. (The yen represents 13 per cent of the TWI, second only to the Chinese yuan at 22 per cent).

The BoJ's ultimate inflation target is 2 per cent. If it achieves that, the USDJPY rate would be 105 and the Aussie TWI 81, the highest level since 1984.

Last week's G20 communique stated: "We will refrain from competitive devaluation.” This latest G20 group hug, denying the obvious currency war going on, is expected to mean simply that Japan will refrain from targeting its exchange rate. But no problem with targeting inflation, as it's now doing.

In the modern world of monetary policy and macro economics, targets blur. All of the indebted nations of the west are trying to generate inflation because it's the only way out of their debt vice: they can't run surpluses and pay it off and they can't just default on their bonds, so they must stuff the bonds down the throats of their central banks and then surreptitiously write down their value via inflation. It's the only way, and they're well into it.

Inflation is both the cause and effect of currency devaluation. By printing money to buy bonds and targeting higher employment and higher inflation, the central banks of America, Europe and Japan are also targeting a lower exchange rate.

The Australian dollar TWI used to closely track a combination of the cash rate and commodity prices, but in 2010 that relationship broke down as the United States Federal Reserve and then the European Central Bank began their "quantitative easing” programmes (buying bonds).

Since then the cash rate has been cut 1.75 per cent and the RBA index of commodity prices has fallen 20 per cent, yet the Aussie TWI has appreciated 15 per cent, from 67.7 in early 2010 to 77.8 today. Against the US dollar, it's up 20 per cent from 86.8 to 103.6 this morning.

The frustration around the table at the AIG executive meeting yesterday was palpable. Energy and land costs in Australia are among the highest in the world, and our currency is one of the few that is going up rather than down.

In this context, the Labor government's "industry and innovation” plan this week is a drop in the ocean, not that anyone expects a big dollop of deficit spending to support manufacturing, or expects the Reserve Bank of Australia to join the currency wars and target higher inflation.

The Reserve Bank and the Labor Party have done what they can. The cash rate is now as low as it's been for 40 years and despite some problems with unionised construction, wage costs overall are not really a problem.

But despite record low interest rates, monetary conditions for Australian businesses are at a record high. The JP Morgan monetary conditions index, which includes the impact of the exchange rate, is sitting close to an all-time high.

That's because the transmission mechanism between interest rates and the exchange rate has broken down, in turn because of three waves of quantitative easing by first the US, then Europe and now Japan.

Japan, straw, camel's back.

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