Israel
Revolution in the Ballot Box
Feb 09, 2006

Serhan Cevik (London)

Without a proper institutional architecture, elections alone do not guarantee democracy. Decades of political isolation and economic depression resulted in an unsurprising outcome in the Palestinian parliamentary elections: the Islamic Resistance Movement known as Hamas won 76 seats in the 132-member legislative council, while the late Yasser Arafat’s Fatah party kept just 43 seats. Free and fair elections are obviously a step in the right direction towards empowering ordinary Palestinians, but elections alone do not guarantee sustainable democratisation and socio-economic progress. For that, a country needs a variety of democratic institutions and collective memory, both of which do not really exist in the Palestinian territories. Moreover, there are a number of unknown issues concerning the structure and orientation of a Hamas-led government. Thus, investors must be vigilant in analysing the implications of the overwhelming rise of a party that is still considered as a “terrorist organisation” by Israel and the west.

Palestinians voted against mismanagement, corruption and economic misery, not for violence. Even though Hamas did not win an outright majority of the popular vote — receiving 44.4% against the 41.4% that went to Fatah, the electoral system still led to a revolutionary shift in the Palestinian political landscape for the first time in 40 years. In our view, the emergence of Hamas as a dominant force in the post-Arafat era is an outcome of political failures and economic shortcomings that created anarchy and social exclusion. In other words, the election result reflects the failure of the “peace process” to secure a lasting peace settlement and the collapse of the status quo that neglected to improve living conditions of impoverished Palestinians. This is why we think that Hamas’s landslide victory is not necessarily a popular support for the Hamas charter calling for the destruction of Israel. Indeed, opinion polls show that more than 70% of Palestinians, including 60% of those who voted for Hamas in the election, are against violence and demand reconciliation with Israel on the basis of a two-state solution.

Hamas’s political evolution will be slow and problematic, in our opinion. Similar to the experiences of the African National Congress in South Africa and Sinn Fein in Northern Ireland, Hamas — now a principal power in politics — cannot resort to violence without delegitimising the Palestinian Administration. However, despite the fact that Hamas has demonstrated some degree of restraint and moderation by agreeing to “maintain an atmosphere of calm” during and after Israel’s disengagement from the Gaza Strip and northern Samaria, it would be naïve to expect political rationalisation and institutional transformation in the near term. Given its long-standing rhetoric against Israel’s sovereignty, Hamas will likely experience a slow and problematic evolution, if at all, towards a political entity. Moreover, Hamas is not a secular organisation and may choose to impose a religious agenda on the Palestinian society by introducing sharia as a primary source of legislation. In addition, without the culture and institutions of liberal democracy, the transfer of power from Fatah to Hamas possibly will not be smooth and the resulting polarisation will make it difficult to reinitiate negotiations with Israel and therefore to improve economic conditions in an isolated Palestine. This is why the best possible option is a power-sharing agreement between Hamas that has limited governance experience and Fatah that still holds the presidency and key positions in the security apparatus.

The Hamas factor will play a decisive role in the Israeli elections. Even before the Hamas victory, Israel has gone through significant political ‘shocks’ ranging from the break-up of the Likud Party and the leadership change in the Labour Party to the incapacitation of Prime Minister Ariel Sharon. Although his new party still has a strong showing in opinion polls, the emergence of Hamas as a leading player will no doubt alter political dynamics before the Israeli elections at the end of next month. However, all these shifts do not change the need for a comprehensive peace agreement. As we have long argued, Israel has an outstanding economic potential (mainly stemming from its impressive stock of human capital) but needs the peace dividend to realise that potential and to address socio-economic shortcomings. Of course, that can only be achieved through moving beyond unilateral steps (such as the Gaza withdrawal and building a security fence around the West Bank). In our view, the forthcoming elections may accelerate the de-polarisation process towards the centre that has long been under way at the voter level and thereby allow for territorial concessions required for making peace with the Palestinians.

Prudent economic policies are the best cushion against uncertainty. The rise of political uncertainty is always detrimental to economic performance, but maintaining prudent economic policies should provide a reasonable protection against exogenous shocks. Moreover, Israel’s macroeconomic fundamentals are strong enough to withstand adverse developments. With robust economic growth and an undervalued exchange rate, we expect the Bank of Israel to continue with its monetary tightening cycle and to keep market expectations in line with the desired path.

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Japan
Three Stages of the Monetary Debate
Feb 09, 2006

Robert Alan Feldman (Tokyo)

What’s New

Three key issues loom on monetary policy:  (1) when and how to end quantitative easing, (2) when to end the zero rate policy, and (3) whether inflation targeting will be introduced. The consensus answers to these three questions are:  soon, with reserves down to Y6 trl by August; in autumn 2006; and maybe, with a soft guideline not a hard target.

Conclusion

In my view, the consensus is off the mark on all three. My view is:  later, with reserves down to Y6 trl around December; in spring 2007; and yes, this year. My conclusion is based on a different view on the risk-return trade-off faced by the BoJ, a different view on prices, and a different view on politics.

Market implications

The consensus sees an early rise of rates at the short end, and implies a higher risk of a sudden yield rise at the long end. My view sees a later rise of rates at the short end and a lower risk of a yield spike at the long end.

Risks

(1) BoJ could see the risks differently than in my analysis. (2) Inflation could rise faster than in my forecast. (3) Political factors could prevent inflation targeting.

Good News and Bad News

Monetary policy is back in the news, with a number of senior policymakers commenting on future monetary policy. The good news is that comments are conciliatory. The bad news is that all of key issues remain unresolved. (1) When will the BoJ end quantitative easing, and will the end be quick or measured? (2) When will the zero interest rate policy (ZIRP) itself be lifted? (3) What will the monetary regime be after the end of ZIRP?

A Fruitful Debate

More conciliatory comments from policymakers have helped to push the debate forward. The background to the reemergence of cooperation comes from both personnel changes and public response. The main personnel change concerns the advent of Economics Minister Kaoru Yosano to the Economics Portfolio. He has taken a more behind the scenes approach to coordination between the government, the Diet, and the BoJ, and this approach has allowed a cooling off period, after the threats of BoJ Law changes made last year by some politicians. Moreover, the public reacted negatively to political criticism of the BoJ. Hence, decorum required lowering the intensity of the debate, at least in public.

This outcome did settle one issue. There is now agreement that the BoJ has operational independence but not goal independence. The former concerns the choice of tools to achieve the objectives of policy. The latter is choice of objectives. Operational independence is already guaranteed in the BoJ Law, which states “ The Bank of Japan’s autonomy regarding currency and monetary control shall be respected.” [Article 3, section 1]. However, goal independence is not. Indeed, the BoJ is tasked by law with several goals:  (a) “issue banknotes and carry out currency control” [Article 1, section 1], (b) “ensure smooth settlement of funds … thereby contributing to the maintenance of an orderly financial system” [Article 1, section 2], and (c) “through the pursuit of price stability, contributing to the sound development of the national economy. [Article 2]. Thus, the law states the goals but leaves the tools to the BoJ.

Quite importantly, however, the BoJ Law does NOT say who should determine the goals. That said, since the law grants the BoJ autonomy only with respect to tools, the implicit message is that someone else is responsible for deciding the goals. In this sense, it is questionable whether the BoJ has the legal authority to set an inflation target.

When and How Will QE End?

The upshot of this debate for the three questions above is that the BoJ does have the right to decide what it wants on quantitative easing. That said, the next stage of the debate on quantitative easing is beginning:  Should the BoJ exit from quantitative easing in one step, or should the exit be gradual?

On one hand, even if the BoJ ends the quantitative easing in one step, it will take a few months for all of the money market operations to mature. Therefore, excess reserves will remain in the system for a time. More important, however, is the signal that BoJ sends to the market about ZIRP. A “one-step” end to quantitative easing (i.e. a return to interest rate targeting, with only natural roll-off of excess reserves over 3-4 months) would send a message that “ZIRP ends in the autumn, so long as the CPI remains above zero.”

A multi-step path for the end of quantitative easing would send the message that “ZIRP will stay in place until the end of the glide path.” For example, if the quantitative easing target is lowered from Y30-35 trillion to Y25-30 trl, the implication is that about 5 policy decisions would have to be made in order to end quantitative easing. If the initial step were taken on 28 April, then the final end of quantitative easing would come around September, assuming no major downward surprises to prices or the economy.

Which path is more likely, the one-step path or the multi-step path? The market consensus is that the one-step path is more likely, but I disagree. So long as inflation hovers at low levels, there is no compelling case for the BoJ to hurry. Moreover, the risk to moving too early is quite high. Should the BoJ move early and the inflation rate turn negative again, the BoJ would be accused of a policy mistake. There could be legislative consequences, even if such rhetoric is quiet for now. Moreover, Policy Board members who vote in favor of an aggressive policy that turns out to be wrong will wear this albatross for years to come. They are likely to be cautious. Finally, there remains much uncertainty about how the bond market will react to the end of quantitative easing. The risk of an adverse reaction is probably not worth the gain from an early end. For these reasons, I believe that quantitative easing will be ended in a multi-step process, not a single-step one.

When Will ZIRP End?

After quantitative easing ends, the next step is to end ZIRP itself. The current market consensus, based on a one-step end to quantitative easing in April, is that ZIRP itself will be lifted around September. As my colleague Takehiro Sato points out, this view was strengthened by a recent statement by PM Koizumi that he hoped an end to deflation could be declared before he leaves office at end-September.

However, in my view and Sato’s, the final end of ZIRP will come only in spring 2007. Sato and I see no inflationary threat. Moreover, we see the BoJ Policy Board’s core inflation forecast for FY006 (+0.5%) as too optimistic. In addition, the BoJ’s own risk-return tradeoff on moving too early versus moving too late remains tilted toward a later end to ZIRP.

The Post-ZIRP Policy Regime

Exiting ZIRP without a replacement framework could disturb markets. Hence, even before ZIRP ends, the government and the BoJ will have to come to some accord on the post-ZIRP monetary regime. The speed with which such a decision can be taken is illustrated by the case of the UK. With inflation targeting as part of his party’s election manifesto, PM Blair took office on May 1, 1997, and declared an inflation target on June 12.

In Japan, the introduction could be just as quick, because no legislation would necessarily be required. The process would likely require a debate by the Council on Economic and Fiscal Policy (CEFP). Since much work has been done on inflation targeting already, it will not require a long lead time for the CEFP to prepare for such a debate.

However, the role of the CEFP is legally defined to be “research and advice” to the prime minister on matters of general economic importance, fiscal policy, budget policy, and other important economic issues. (See http://www.keizai-shimon.go.jp). For inflation targeting to become government policy, the PM would have to agree to the CEFP advice, and ask the Cabinet for approval. In turn, the BoJ Law says, “. . . the Bank of Japan shall always maintain close contact with the government and exchange views sufficiently, so that its currency and monetary control and the basic stance of the government's economic policy shall be mutually harmonious.” [Article 4] (emphasis added). Thus, if the CEFP recommends an inflation target, the PM agrees, and the Cabinet approves, the BoJ is obligated to set policy consistently. Moreover, the BoJ is obligated to explain its decisions. The BoJ Law says, “The Bank shall endeavor to clarify to the public the content of its decisions, as well as its decision making process, regarding currency and monetary control” [Article 3, section 2].

Since inflation targeting can be introduced quickly, it will not be necessary to have a prolonged period of discussion between the end of quantitative easing and the end of ZIRP. Rather, the length of this period is likely to be determined be data on inflation and real growth. In short, the question of determining a new monetary regime -- i.e. deciding whether Japan should target inflation and if so what level -- is inherently a political decision. Where there is a political will, there is a political way.

The Politics of Inflation Target Introduction

With the clock ticking toward the end of the Koizumi government at the end of September, the most likely scenario is that inflation targeting will be considered (and I think adopted) by the government by that time. The new prime minister will face a host of issues, and have scant time to give top priority to inflation targeting. By the time attention can be paid to inflation targeting, ZIRP may well be ended, and Japan would be without a monetary regime.

However, the UK experience suggests another scenario. The candidates to succeed PM Koizumi could make inflation targeting an issue of debate. If the new PM has taken a pro-inflation targeting stance during the campaign, then introduction would be quick. If not, introduction could be delayed considerably.

Investment Implications

For investors, especially bond investors, this debate is crucial. The consensus view is full of dangers, in my view. A one-step move to end quantitative easing could bring forward the expected timing of the end of ZIRP, disturb the bond market, and steepen the yield curve. An early end to ZIRP, particularly if core inflation is only barely above zero, could be similarly disturbing. The lack of a monetary regime after the end of ZIRP could be even more disturbing. A discretion-only monetary regime raises the possibility that BoJ would remain more exposed to political pressure, and thus more likely to wait too long to hike rates if inflationary pressures were to mount, for fear of retaliation by the Diet. Thus, this consensus view would eventually require a higher risk premium in bond yields.

On the contrary, my view would likely reduce the risk premium in yields. A multi-step end to quantitative easing would clarify expectations of interest rates over the next year, with lower risks of a policy mistake. A later end to ZIRP would allow real interest rates to be low throughout 2006, solidify real growth, and enhance the sustainability of economic reforms. Finally, introduction of an inflation target would protect the BoJ from political interference, would anchor price expectations, and thus would reduce the risk premium in bond yields.

Of course, a reduction of the risk premium requires inflation targeting to be credible. In flation expectations respond much ore to actual inflation outcomes than to policy announcements. Therefore, the immediate introduction of a 2% inflation target, as suggested by last year’s Cabinet Office “21st Century Vision for Japan,” is probably impractical.

To achieve credibility, a two stage process may be needed. Not only the BoJ but also other agencies and ministries in the government would have to commit first to a more modest target (e.g. core inflation exceeded 1% YY), and outline concrete steps in their own jurisdictions to achieve the target. Once initial success is achieved, a final target could then be introduced. For the final target to be credible, the different agencies will have to prove that they can work together, even without PM Koizumi to knock heads.

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