Yen depreciation back on track after safe-haven strengthening
A momentary strengthening of the yen amid market panic coincided with reports the government might be having second thoughts about key planks of the reform agenda – the consumption tax and a weak yen. But analysts insist there has been no change of policy, but pension and energy reforms hold the key.
With yen depreciation seen as a fundamental tenet of Japanese policy, and a vital component of Abenomics, it came as a surprise to some when prime minister Shinzo Abe, as well as various Japanese business leaders, spoke out recently about the falling yen.
The PM acknowledged that rising utility costs resulting from the weaker currency undermine profitability, while suggesting the consumption tax increase could be counter-productive if it inflicts too much damage to the economy. Observers have jumped on any evidence of a possible U-turn in his reform plans.
The risk is clear: if the yen depreciates too quickly, it risks dragging Japan into stagflation. Some 30% of Japan’s population are older than 65, and this powerful voting bloc fears its purchasing power being eroded.
Some have suggested such concerns could be driving a wedge between Abe and Haruhiko Kuroda, governor of the Bank of Japan (BoJ), who is responsible for managing the weakening yen.
However, Abe’s comments do not indicate he will move to prevent the yen from weakening, say analysts. He merely wanted to assure the country he would provide fiscal support for any parts of the economy suffering from the negative impacts, they say.
“Kuroda was appointed by Abe and will continue to support him,” says Yujiro Goto, senior FX strategist at Nomura. “As a politician, Abe has to be more sensitive to the opinions of voters, but there is still considerable trust between the two, and the difference between the Bank and the government in terms of policy is minimal.”
While authorities remain relaxed about a weaker yen, how this is achieved makes a big difference to the health of the economy.
“The BoJ will be cautious and will look to avoid excessive FX volatility,” says Valentin Marinov, head of European G10 FX strategy at Citi. “What it doesn’t want to see is a sharp decline in the currency – it wants a gradual grinding lower, maybe to around 115 over time [compared with 106.7 currently]. It isn’t so much the weak yen that businesses can’t live with, as the speed of decline.”
Goto adds: “I don’t think Kuroda or Abe want to prevent the yen weakening, or that there is a specific level at which the yen might be seen as too weak. Both want to see a positive impact on inflation, which is a key policy objective.”
Kuroda would not want to overshoot his inflation target of 2%, says Goto, adding: “But given it is at 1.1% now, and cheaper oil is likely to see it fall in coming months, that is not an issue right now. Next year could see a different stance on yen weakness, if inflation approaches the 2% target as the BoJ forecasts.”
The truism that a weak yen is good for Japan does require scrutiny. The country has long been synonymous with manufacturing prowess and exports, but while a weakening currency is good for exporters, Japanese companies have been moving production overseas. The benefit of the weaker yen has therefore been declining over time, while steadily increasing its trade deficit.
This problem has been mitigated somewhat by declining commodity prices. Cheaper oil has been especially good news, with imported oil acutely important to the Japanese economy since the closure of its nuclear plants.
More respite is expected for the trade balance as the first of its nuclear plants comes back on-stream imminently. Four plants having cleared safety checks, meaning oil imports will gradually fall, further reducing the pressure build-up from a falling yen. This will help to curb the fall in real wages, making consumers feel richer and encouraging spending, say analysts.
Another short-term driver for yen weakness could be reform to the big state funds.
Japan has been trying to cajole its pension funds into making asset-allocation changes in favour of inflation-hedges such as equities and real estate, but the government has in recent years struggled to convince the country’s highly conservative pension funds to change. However, portfolio reforms enjoy cross-party support and are expected by the end of the year at the latest.
In recent days, there have been unconfirmed reports that the Government Pension Investment Fund (GPIF) will increase its allocation target for domestic equities to about 25%, up from 12%, and upsize its combined allocation target for foreign equities and bonds to 30% from 23%, while reducing the allocation target for domestic bonds to 40% from 60%.
These GPIF allocation changes are broadly in line with consensus expectations.
“A pick-up in capital outflows from Japan as the GPIF increases its holdings of foreign assets supports our view that the yen will likely weaken further in the year ahead,” says Mitsubishi UFJ Financial Group.
In addition, reforms should help to boost real GDP.
“It makes sense that the GPIF reform is moving towards riskier domestic asset holdings and away from Japan exporting capital into foreign bond markets,” says Morgan Stanley in a research note. “To compensate for its weak demographics, Japan needs to grow its capital stock, boosting productivity. Without productivity gains, Japan will find it difficult to generate the 5% nominal GDP growth required for sovereign debt sustainability.”
In the meantime, the BoJ looks likely to give itself extra room to manoeuvre by changing the language of its guidance, keeping its 2% inflation target but scrapping the two-year timetable within which it plans to achieve it.
With the economy in such a state of flux, it might be that investor hopes for another expansive Japanese quantitative easing (QE) programme will be unfulfilled for the time being.
“I can’t see Japan [increasing its QE programme] until it has done more preparation, such as opening more power plants and implementing its pension fund reforms, because otherwise it will end up doing more harm than good,” says Citi’s Marinov.
“It’s about sequencing events, making sure you structure the economy so inflation is good for it, like it is in the US. Japan is still set up for deflation, with a high proportion of cash investments.”