Oil and Abenomics in the great yen tug of war
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.”
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.”
In extremis, you could see Abe reach for a new,
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.
However, Goto believes cheaper oil could also be risk positive. “Lower oil prices also encourage central banks struggling with disinflation – the European Central Bank, Riksbank, SNB and BoJ – to be more accommodative, which is also positive for risk taking. Thus, in the medium term, lower oil prices should not be risk negative but risk positive.”
Whatever happens, the BoJ looks up for the fight and has shown it is prepared to act decisively at any hint of yen strengthening. Ratcheting up its quantitative-easing programme and printing more money is not the only way Japanese authorities can exert influence.
Goto says: “Abe would put pressure on Japanese firms to increase wages in order to generate positive inflation momentum. If JPY appreciation accelerates significantly, Abe could consider FX intervention. However, this is not our main scenario.”
And while negative inflation pressures will undermine Abenomics in one way, by adding some upward pressure to yen, it will help it in other ways. With corporates benefiting from cheaper oil, Abe might find the ground is more fertile for the third arrow of Abenomics: structural reforms.
Some progress on labour-market reforms for example, that have been painfully difficult to enact as corporates struggle with profitability, would be a welcome boost for Abe and offset his troubles fighting the appreciating yen.
Indeed, Abe might reflect that of his three arrows – fiscal stimulus, monetary easing and structural reforms – it is only the second one that has had any real traction.
Saxo’s Beecroft says: “So far, the BoJ has done most of the heavy lifting for Abenomics and Abe has not been able to do as much fiscal stimulus as he would like, given the state of the Japanese budget deficit. But cheap oil is a different kind of stimulus which could form part of that first arrow.”
Beecroft downplays the impact cheap oil will have on the yen. “I don’t think cheap oil is going to cause that much upward pressure on the yen that it will threaten to derail Abenomics,” he says.
Beecroft concedes that cheaper oil could indirectly lead to upward pressure on the yen if it encourages more belligerence from Russia and increased fears of an occupation of Ukraine, for example, but says that does not look likely.
If such a crisis were to seriously challenge Abenomics, or if cheap oil did lead to more stubborn upward pressure on yen, a determined BoJ would also have other weapons in the arsenal it could call on.
Beecroft says: “In extremis, you could see Abe reach for a new, fourth arrow from his Abenomics quiver: the outright monetization of government debt, the central bank writing off the debt and financing the government outright.
“The government and the BoJ would be very hesitant about doing this – it would be reserved for very extreme circumstances – but it is there as an option if it ever really needed to convince people they mean business and won’t allow the yen to strengthen due to safe-haven flows.”