Diminishing returns from weak yen triggers Abenomics fears

The victory by Masuzoe, the LDP candidate backed by prime minister Shinzo Abe, should bolster the chances of one of Abe’s cornerstone economic strategies – engineering sustained nominal annual economic growth of 3; there has been no average annual nominal GDP growth for 15 years – being implemented, says Sean Yokota, head of Asia strategy for SEB, in Singapore.

“His victory will place Tokyo as the model for economic reforms, where Tokyo will become one of the special economic zones, and additionally Masuzoe is calling for reforms in taxes, Japan joining the Trans-Pacific Partnership free-trade agreement, and loosening the labour market where he is open to more foreign workers,” he adds.

However, this growth, together with another cornerstone of Abenomics – achieving at least a 2% rate of inflation every year from 2015 – which largely entails the Bank of Japan (BoJ) buying ¥7 trillion ($69 billion) per month in domestic assets (plus a separate ¥25 trillion per year credit-loan programme), carries substantial risks for the country, according to the IMF.

That these concerns are beginning to gain traction in investors’ minds might be evidenced by the recent jump in Japan’s default risk – as implied by credit default swaps prices – to the most among developed markets this year.

In broad terms, as first spelt out by the IMF in its Global Financial Stability Report (Update) October 2012, and reiterated in subsequent releases, although Japan was trapped in chronic deflation, it was “a stable equilibrium”, with the real value of savings rising due to almost zero inflation, despite the concomitant perennially low interest rates.

 

However, with inflation now at substantially higher levels – the consumer price index in December was 100.9 (2010=100), up 0.1% from the previous month, and up 1.6% over the year, according to figures from the Ministry of Internal Affairs and Communications – and Japanese government bonds (JGBs) yields picking up, the IMF warns of a spike in debt costs and a domestic flight from JGBs.

This, in turn, says the IMF, could trigger a problem in Japan’s banking system, as the holdings of JGBs by Japanese banks account for 900% of their tier 1 capital. 

 

This high level of debt-holding by Japan’s banks is as characteristic of Japan as it is of euro area sovereigns under market pressure, and is expected to increase over the medium term, particularly for smaller, regional banks, the IMF concludes.

Such risks could reach a tipping point, according to a statement from Moody’s on January 14, with a sustained worsening of Japan’s current account into a structural deficit that could well trigger a sharp increase in government debt cost.

In this context, even with a yen that has depreciated from around 75 to the US dollar to more than 100 presently, since Abe became PM in 2012, Japan’s trade deficit widened to ¥11.47 trillion last year, from ¥6.94 trillion in the previous year – the third straight year of deficit, and the longest since records began in 1979.

And on Monday morning, data were released showing the current-account deficit widened to a record in December, to ¥638.6 billion, against November’s gap of ¥592.8 billion.

 

“Part of our strong conviction that the yen will fall over time is that, put simply, Japan needs a much weaker currency, but unfortunately for Japan, it is becoming very clear that the yen move to-date is nowhere near enough for this dynamic to play out,” says Ric Deverell, global head of commodities, GFX and Asia strategy for Credit Suisse, in London.

“Having traded sideways for five months, the boost to inflation and output growth looks to have already peaked, and while year-on-year rates of growth are still moving in the right direction, the sequential data are already showing the impact is fading, and the surge in exports seen earlier last year having also peaked.”

 

Worse still, given this backdrop, is the further potentially negative economic effect of the April increase in the sales tax – to 8% from 5% – which makes this year a “crunch year for Abenomics”, says Michael Taylor, chief credit officer for Asia Pacific for Moody’s, in Hong Kong.

Credit Suisse’s Deverell adds that his concerns about the economy – which has a more than JPY1 quadrillion debt burden, the world’s largest as a proportion of GDP – will be exacerbated if the government goes ahead with the tax increase, as is almost certain, given how difficult a task it is to end 15 years of deflation.

“While theoretically it should be possible, at a minimum the government needs all macro policies pointing aggressively in the same direction until it is achieved,” he says. “While tightening fiscal policy is necessary in the medium term, in our view a short-term tightening would all but guarantee a policy failure and a return to deflation.”

One of the key prerequisites for any hope of ending deflation, concludes Deverell, is a dip to at least 120 against the US dollar, but, like many in the markets, HSBC’s global head of FX strategy David Bloom, in London, believes that much of what can be done to weaken the yen further has been done, and is also priced in at current levels. 


 

“A further monetary stimulus in Japan is likely in 2014, but this is already widely anticipated, and should not provide an upside shock for USD-JPY,” says Bloom. “Also, the long-awaited capital outflows have yet to materialize, undermining one argument for further JPY weakness.

“Abenomics structural reforms have been underwhelming, and look an unlikely catalyst for a higher Nikkei and associated rise in USD-JPY, and any unexpected tapering trauma in global markets would likely see USD-JPY lower.”

In fact, says Mitul Kotecha, global head of FX strategy for Crédit Agricole, in Hong Kong, the past several weeks have seen Japan register net inflows of capital in large part due to repatriation by Japanese investors. Indeed, Japanese investors were net sellers of foreign stocks for 15 out of the 16 weeks to end-January 2014, and were also net sellers of foreign bonds for five straight weeks to end-January.

 

“While foreign investors have been net sellers of Japanese equities, they have actually stepped up their buying of Japanese bonds, with the net result being that the JPY has faced upward pressure from such inflows over recent weeks,” adds Kotecha. “And looking ahead, assuming that risk-appetite improves and US yields increase, net capital outflows are expected to resume, which will put further downward pressure on the JPY.”

 

Moreover, the effect of the hike in the sales tax, although it is expected by Japan’s government to raise around ¥13.5 trillion every year, is likely to be compounded when taken in combination with the decline in the country’s real wages.

In this context, Japan’s base wages adjusted for inflation last year matched a 16-year low in 2009, according to figures released last week, with pay – excluding bonuses and overtime payments – having dropped to 98.9 in 2013 on the labour ministry’s index (2010=100).

Having said all of this, the yen is still one of the world’s top funding currencies for carry trades, on a par with the Swiss franc, and, provided that the funding gains are not completely eroded by sharp moves in the currency, then this is likely to continue for as long as low comparative rates to the rest of the world continue.

 

In this respect, says Derek Halpenny, European head of global markets research for Bank of Tokyo-Mitsubishi UFJ, in London, there appears to be a greater prospect that March’s shunto – the annual negotiations between key unions and corporations – is likely to see the 1.0% base wage increase for the next fiscal year demanded by Rengo – one of the main trade unions in Japan – agreed to by Japan’s big corporations this year.

“This would certainly help increase confidence over sustainable inflation ahead, and higher inflation and lower real yields in Japan should encourage greater capital outflows from Japan, helping to keep the yen on a gradual depreciation path,” he concludes.