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Japan and a Weaker Yen
28 Mar 2014
In October 2012, it became clear that the Yen was beginning to weaken. It was as important then as it is now because if Japan is to enjoy any sort of growth, they will need a weaker currency to provide the catalyst and to generate inflation. This article will attempt to argue that a weak Yen is both desirable and achievable, in particular against the US Dollar.
This time last year, Japanese politicians and central bankers were trying to build a consensus about having a weaker currency. For a long time, there had been a strong view that the Yen had to weaken dramatically for Japan to grow its way out of the intractable problems it is facing - it was only a matter of time before they had to take action.
To put some background in place, the Japanese Government is in a fiscal hole and their overall government debt continues to rise. Coupled to this is a demographic picture that is potentially catastrophic in economic terms. As can be seen in chart 1, the working age population and dependency ratio in Japan is declining alarmingly and is likely to continue that decline beyond the next generation.
It is almost impossible to generate real economic growth when the working age population is set on this downward path. Older people consume and save less which is not beneficial for either consumption, investment or for financing the government. Chart 2 shows how unsustainable the Japanese Government’s finances are. Interest costs are rising, even with borrowing costs at near record lows, because the overall debt is so large. It is almost impossible to imagine that fewer workers (i.e. taxpayers and consumers) can support ever more social security and interest payments.
Without GDP growth, Government debt could spiral out of control as can be seen in the Japanese Ministry of Finance’s own data in chart 3. It is clear that the simplest way to generate growth will be via inflation – hence a weaker Yen is essential.
In the business world, an important event occurred in October 2012 that may have forced a change in Japanese Government policy and provided a catalyst for this aggressive new policy set. Softbank (a Japanese Telecom and Internet company) announced a US$20 billion investment into Sprint, the third largest US telecoms carrier. At that time, it would appear that corporate Japan saw very little opportunity for domestic investment. The industrial and electronics sectors (which Japan has been built on) have followed a similar thought process; looking at a domestic economy with zero growth potential and a relatively high cost base because of the extraordinarily strong currency. Business concluded then that they must plan to cease domestic production and seek to move this abroad. This makes perfect business sense which must have forced the hand of the Government to build a consensus for policies designed to weaken the Yen.
As can be seen in the monthly chart (chart 4), the US Dollar fell from 270 to 79 against the Yen over the last 30 years. This made US assets very cheap, and production in Japan very expensive. A weaker Yen will help Japan significantly. However, we are not talking about a move from 79 to 104 (the high seen recently). If the Japanese authorities can print enough money and persuade their international colleagues that a weaker Yen is in everybody’s interest, the Yen can weaken and the Dollar strengthen to 120 and beyond.
So what has happened over the past year? Japanese Prime Minister Abe was elected in December 2012 promising dramatic change and the yen weakened substantially until this past spring. Since then, both the currency and the equity market have gone into hibernation until the last few weeks. The Yen is beginning to weaken again and the equity market is breaking higher. It is important to associate a weak currency with a higher Japanese equity market. Both are inter-dependent and mean that one will lead to the other.
So why should the Yen begin to weaken again now? The answer lies in the policies that Prime Minster Abe has identified. Abenomics is about “three arrows” which are essentially;
1. Monetary stimulus via Quantitative Easing.
2. Fiscal consolidation to tackle the unsustainable Government debt position.
3. Structural reform.
It will be difficult to claim any major wins on the structural reform front for a long time simply because the results take a long time to appear. Fiscal consolidation will be extremely difficult to achieve simply because the problem is so large. We fear that changes here will be little more than symbolic for the time being. So that leaves money printing.
In April this year, the Bank of Japan announced “shock and awe” tactics in the scale of quantitative easing they were planning. They announced that they would double the monetary base within two years. Relative to the size of the economy, the programme is about three times larger than the current US Federal Reserve QE policy. As with the US, the aim is twofold; to force investors out of safe, low yielding cash, and into riskier assets such as Japanese equities and overseas assets as well as weakening the currency to generate growth and, in turn, inflation.
We really should not underestimate the reality that the Japanese authorities are almost totally dependent on Yen depreciation to generate economic growth and higher asset prices. They may try and hide behind quantitative easing being purely a domestic policy, but a weak Yen is a target of the authorities.
This is the crucial point to remember when thinking longer term or when seeking structural, secular trades in foreign exchange. A one off 25% currency move is simply not enough for Japan to generate the lasting economic growth needed to tackle their fiscal hole (the recent downgrade to GDP and a weaker Tankan business report highlight the bigger issues at hand even after a 25% currency move). They need constant currency depreciation for the policy to work in the longer term. Therefore, after the currency depreciation starting over a year ago, the year on year depreciation has already slowed which means that the authorities in Japan will be working hard to build on policies to maintain a weak currency environment.
It is often easier to find the liability currency when seeking structural trades, it is perhaps human nature to seek out the dangers ahead rather than focus on the positive global opportunities. Given that the Japanese authorities remain fully committed to “Abenomics” we have put together a strong case for a dramatically weaker currency over time. Naturally, as foreign exchange managers we have to decide on the asset currency. What will work best when shorting the Yen?
Whilst the Euro (and Sterling to a certain extent) have enjoyed aggressive rises in the past few weeks, we remain concerned about the long term attraction of the Euro in a broadly uncertain European environment. It would not surprise us if, in the coming quarters, the European Central Bank launched its own version of quantitative easing to weaken their own currency but that’s another story.
It is the US Dollar that we believe will be strong. There are several reasons to be bullish about the US Dollar. In simple and historic terms, it looks cheap but there have been some obvious headwinds in the recent past which appear to be diminishing. The US economy has been the best performing economy of late and there is every chance this will continue. Plenty has been written about the ability of the US domestic economy to generate growth and, especially compared to other economic blocks, the US has done a good job. Added to that is the new tailwind provided by new technologies in power generation and manufacturing. The move towards oil independence is a powerful support to the currency over of the long term.
However, it is the combined possibilities of an end to the Government impasses and a beginning of the end of quantitative easing which will have the most significant impact on the currency in the short term. A deal was done in Washington in December, the Government is funded until mid-January and the debt ceiling until early February. This is hardly a robust scenario given their track record but there appears to be a genuine desire to avoid the recent ludicrous debt ceiling and budget debates that can so destabilise confidence. We have no idea at this stage whether the Democrats and GOP can craft a grand bargain between now and early next year but chances are much greater that they will try, both from political necessity and economic reality.
Only a month ago, after the Chairman Bernanke’s September press conference after the FOMC meeting, it was easy to imagine the Fed maintaining quantitative easing at US$85 billion per month for longer. Since then, the economic and especially the employment data has proved strong enough to suggest a taper is imminent, if not in December then early in 2014. This conclusion is boosted by the fact that more hawkish voting members will be added to the committee at the start of 2014.
Whilst the US Dollar has not always weakened when the Fed has been printing, periods of strength in the currency have generally occurred when expectations were rising that the Fed was at least contemplating an exit strategy. This likely also coincided with some sort of better economic data.
We should conclude by pointing out that many investors have regretted believing in the powers of Japanese authorities to implement their policies in the past and, for that matter, many investors have regretted assuming the US will stop printing money at the right time. Having said that, there seems to be a real opportunity in the potential for Dollar/Yen to strengthen in the coming quarters.