Sounding more the cheerleader than the economy minister, Japan’s Akira Amari told investors that this week’s equities sell-off was no great cause for concern. The 7.3 percent drop in the Nikkei 225 Stock Average on May 23 was the steepest one-day decline since the earthquake in the spring of 2011.
Amari is right: Japanese policy has changed for the better, and the drop in stock prices isn’t a repudiation. But it is a reminder that nervous markets are always capable of springing surprises and that strengthening the global financial system is still urgently needed.
Analysts pointed to two triggers for the sell-off in Tokyo -- neither directly related to developments in Japan. First, Ben S. Bernanke, chairman of the U.S. Federal Reserve, riled investors on May 22 when he told Congress that the Fed might curb its program of quantitative easing if the economy keeps improving.
Newly released minutes from the Fed’s most recent policy meeting showed that some officials think the central bank could start tapering its purchases as soon as next month. When the brakes are applied, investors will see this as the end of an era of very cheap money and a signal to be more cautious about buying stocks and other risky assets -- and perhaps as the moment to pile out of those investments.
Second, intimations of costlier global borrowing coincided with bad news about flagging growth in China. A preliminary estimate of China’s closely watched Purchasing Managers’ Index gave a reading of 49.6 -- lower than expected and a sign of the first manufacturing contraction in seven months. A slowdown in China will hurt Japanese exporters, helping to explain the plummet in Japanese shares.
Bear in mind, though, that the Nikkei had risen by more than 50 percent since the start of this year. This week’s setback eliminated about two weeks’ worth of that increase, leaving stock prices higher than they were at the start of May. Tokyo has been on a tear, and abrupt corrections shouldn’t come as a surprise. It is telling that hints of tighter money and news of slower growth in China were greeted calmly in London and New York.
The main lesson from the sell-off is banal, but worth emphasizing because it is so often forgotten by investors and governments: Financial shocks happen. Policy can’t eliminate them, but it can mitigate them -- and it must do everything possible to prepare for them.
Japanese policy has moved decisively in the right direction under the new leadership of Prime Minister Shinzo Abe and Bank of Japan Governor Haruhiko Kuroda. The central bank has raised its inflation target and committed itself to a bold program of monetary stimulus. This is the right remedy for an economy trapped in deflation. The signs are that it is working -- higher bank lending and consumption caused growth to accelerate in the first quarter. This week’s stock sell-off doesn’t change that judgment.
Yet Abenomics is a work in progress. The government has talked of far-reaching supply-side reform -- including energy-supply deregulation and trade liberalization -- as the essential complement to the new macroeconomic policy. Japan’s over-managed economy needs this badly. It is necessary in its own right, and there is a further benefit: greater resilience. The more confident investors are about the country’s long-term growth prospects, the easier it will be to combine sustained monetary stimulus with financial stability.
There is unfinished business in other economies as well. The markets’ anxiety over Bernanke’s position on asset purchases is a reminder that the Fed’s exit from QE could be difficult, and not just for the U.S. Bernanke’s admirable commitment to transparency doesn’t make his task any easier, because Fed policy makers aren’t united on exactly what the policy should be.
With the recovery only slowly gaining momentum, unemployment still high and inflation suppressed, it is too early for the Fed to pull back on QE. But it isn’t too early for regulators to strengthen their financial systems against the stresses that unwinding monetary stimulus is certain to cause.
Reform of financial regulation is moving far too slowly, especially in Europe. Banks are inadequately capitalized and still fragile. Reaching for yield is exposing investors and their creditors to new risks.
Money has to stay cheap for now, but it won’t stay cheap forever. That is a promise of turbulence to come. Let’s make sure our financial systems are ready for it.
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