Oil and Abenomics in the great yen tug of war

Solomon Teague
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The yen has been quietly strengthening in recent days, amid renewed concerns about global demand pushing down the price of oil and fresh fears over Europe. If this trend persists, it could be problematic for Japanese prime minister Shinzo Abe, who is closely associated with a policy of yen weakness.

The oil price hit five-year lows this week, dipping under $50 per barrel, bringing with it fresh concerns about the state of the global economy, beset by eurozone-driven deflationary pressures.

The implications for Japan are particularly hard to gauge, with jittery investor sentiment and safe-haven flows pulling the yen towards the path of appreciation, and Abenomics and the Bank of Japan (BoJ) doing everything they can to weaken the currency.

The yen’s long-established role as a safe-haven currency makes it a strong candidate for strengthening at any time of risk aversion and uncertainty – along with other currencies such as the rupee and Australian dollar – with exporter currencies like the rouble, Norwegian krone, Venezuelan bolivar and Nigerian naira most exposed to falls.

Many see cheap oil as a quasi tax break, and good news for the global economy, improving the current-account balance via cheaper imports. However, it is harder to quantify the impact of cheap oil on importers, such as Japan, than exporters, say analysts Edward Knox and Nicholas Ebisch at Caxton FX – though in general the effect is positive.

Yujiro Goto, senior FX strategist at Nomura, says: "If oil prices maintain at their current level or continue to decline, Japanese trade deficits would shrink by ¥10 trillion or more per year, potentially leading to a small trade surplus this year. This would decrease USD buying by Japanese energy importers and provide support to the JPY against USD."

Oil prices and the yen2
Source: Nomura

However, the situation is rather more complex, not least because of the impact the oil price is having on inflation expectations. "Lower oil prices can lead to disinflation, which will go against Abe’s strategy to battle deflation," say the Caxton analysts.

BoJ governor Haruhiko Kuroda stressed the importance of this consideration in October and since then oil prices have steadily fallen, dragging inflation expectations down further.

"Japanese core inflation, which only excludes fresh foods, could potentially record zero or even negative growth in Q2 or Q3," says Nomura’s Goto. "As a result, it would be more difficult for the bank to achieve its 2% inflation target in two years. This will increase market expectations for further BoJ easing and the further weakening of the JPY."

This, says Goto, is likely to be the more important factor, "as fast money tends to react more against monetary policy stories. In addition, Japan’s external balance would still be weaker than it was five to 10 years ago, even after the recent oil price decline.

"By contrast, the momentum of portfolio outflows from Japan is getting stronger now. Thus, the improvement in trade balance is not strong enough to change the trend of JPY even in the medium term."

However, Goto believes it may slow the pace of JPY weakness. "We expect the USD/JPY to reach 125 by end-2015, even after the decline in oil price," he says.

Another notable part of the benefit of cheap oil derives from the boost to consumer spending from reduced energy bills, but this is one area where the impact on Japan might be muted compared with some other countries.

Nick Beecroft, senior market analyst at Saxo Bank, says: "It is fair to say the impact of cheaper oil will be weaker on Japanese consumer spending than it will be in the US or UK because Japanese consumers are naturally more cautious, the result of a cultural mindset and an ageing population. Cheaper oil is not going to break that mindset."

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Nick Beecroft

Goto says cheaper oil will find its way into consumers’ pockets. "While Japanese households are less dependent on gasoline than US households, lower oil price and inflation will increase real wages of Japanese households," he says.

"As headline inflation, including the tax hike impact, will definitely slow in April this year, we see a strong possibility of an increase in real wages in Japan from that point. Wage negotiations into FY2015 will also be more positive for the wage environment. Therefore, lower oil prices could boost Japanese household consumption in FY2015."

The situation in Japan contrasts with Thailand and Indonesia, which have reduced their fuel subsidies to capitalize on cheaper bills for consumers, easing the pressure on their budgets. While this might also be an attractive outcome for Japan, Abe looks intent on passing the windfall on to consumers and keeping the political capital that buys him.

However, the nagging doubt remains: even if cheaper oil is positive for consumers and oil importers, why is oil so cheap? If it is, as some suspect, evidence of weakness in the global economy, does that suggest more problems coming down the line?

Investors asking such questions might well look to safe-haven currencies until their concerns are assuaged. And that means yen strength.