Watch for the yen's reverse

Author: David Roche

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The Nikkei index has been racing up in the past couple of months. This reversal has been based on a cacophony of optimism about Japanese recovery. As a result, the yen has also rocketed upwards against the US dollar and the euro.

I reckon this optimism is misplaced and so is the yen's strength. Consumers underpinned Japan's first two quarters of real GDP growth, contributing 0.5% points and 1.1% points to total growth of 0.1% year on year and 1.1% year on year in Q1 and Q2, respectively, of 1999.

Consumers could only do this because of past fiscal stimulus packages. These boosted Japan's housing cycle, in particular. Housing completions boost consumption of the items needed to furnish and equip them. Housing starts will now turn down, along with the decline in housing loans, now that government financing has ended. Indeed, as the impact of last year's huge $200 billion fiscal programme runs out of steam, consumption will wane further.

To keep priming the pump, the government has now launched yet another fiscal stimulus package of over ¥18 trillion ($172 billion). But this is worth only about ¥6 trillion in real new spending, or about 1.3% of GDP, spread over the period up to March 2001. That means it will compensate for the end of previous stimulus programmes and so prevent the economy falling, rather than generate any dynamic recovery.

The great hope of the optimists is that Japan will recover through a private consumer boom. It's true that household savings rates are high and may continue to fall. But corporate rationalization is likely to cause job losses. Japanese companies will have to fire 30% of their workers - and scrap 30% of their asset base - if they are to match corporate EU's return on assets. And recent data show employment and wages to be falling already.

External trade is unlikely to provide much further impetus to growth. Recovery in Asia will lift Japan's regional exports but Japan's current account surplus, 2.7% of GDP, is already close to cyclical highs. It would have to go on expanding to provide a positive boost to GDP growth.

Unfortunately, it's more likely to fall, for two reasons. First, other Asian economies are now highly competitive vis-à-vis the stronger yen and will garner market share in Japan. Second, corporate restructuring in Japan means that more production will be shifted offshore, resulting in a structural increase in imports of manufactures. So Japan's external accounts will be a drag on growth to the tune of 0.6 to 0.7 percentage points of GDP a year.

That leaves the Japanese authorities as the rainmakers when it comes to achieving growth. And my forecast is for continuing drought. My cynical view is that cheap money and fiscal-deficit spending can do no more than keep Japan's jellyfish economy rising and falling in the deep sea swell of the global cycle until coral is made of the bones of the ruling Japanese political mafia and some much more dynamic political paradigm rules.

So disappointing growth figures from here on are likely to undermine the yen, although a positive base effect from the second half of 1998 could mask the underlying deterioration for a few months more.

Before that, the Japanese authorities may well be forced to try to stem the yen's rise. So far, the Bank of Japan has resisted pressure to allow its rising stock of dollars to swell yen money supply. It does not want to become the milch cow for the Japanese government's rising budget deficits and bloated public-sector debts. So, instead, it has sold on the ministry of finance's financing bills to domestic banks to mop up any increase in base money as a result of its purchases of dollars. This leaves the growth rate of Japanese power money flat, at around 6% year on year.

There are, however, other ways in which the yen could eventually weaken without a major policy shift by the authorities. First, the US Federal Reserve could jack up rates more than the market expects next year. Second, foreign equity flows into Japan, which have had a significant positive impact on the yen, are likely to tail off. Foreign investors are already pretty close to a neutral position in Japanese stocks and they have been net sellers of Japanese government bonds for some time. So although foreign investors may remain a source of yen strength for a little longer while they continue to rebalance their equity portfolios in Japan's favour, the upside seems quite limited.

Once institutions see that the yen has peaked, offsetting outflows could rise dramatically. After all, who would opt to own the bonds of a bankrupt state that are set to flood the market at less than 2% yields, when the US offers a shrinking stock of the world's safest bonds at over 6% yields?

David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com

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Watch for the yen's reverse

Author: David Roche

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