The weaker yen isn’t a panacea for Japan’s ails

JAPAN’S new government has wasted little time in trying to free the country from deflation, economic stagnation and a strong currency. It intends to act aggressively.

It has “three-arrows” within its arsenal: bold monetary policy, flexible fiscal policy, and a growth agenda. The yen’s recent slide suggests that the market currently has faith that these arrows will hit their targets. Since elections on 16 December, the yen has fallen by 6 per cent against the dollar, currently sitting around ¥88.55.

But the economic fundamentals may not be on Japan’s side. Deflation in Japan implies higher real interest rates – bullish for the yen. And the country has tried to engineer inflation before, with little success. There are question marks over whether recent yen weakness can be sustained.

MASTER OF PUPPETS
Prime Minister Shinzo Abe has been heaping pressure on the Bank of Japan (BoJ) to loosen monetary policy. And it appears to be working. A 2 per cent inflation target is likely to be adopted at its next policy meeting on 22 January.

This target will have implications on monetary easing. Chris Scicluna of Daiwa Capital Markets thinks that the BoJ will need to add further to its ¥101 trillion (£622bn) of easing – ¥36 trillion of which was added in the second half of 2012 – until the target is maintained.

Annualised inflation came in at -0.2 per cent in November – the sixth straight month of deflation. Abe believes that a medium-term target is essential for markets “to react”.

His active approach has also led to questions about the BoJ’s independence. If the Prime Minister has his way, the next governor, who will take office in April, will act “in line” with his political principles.

STRUGGLING ECONOMY
Although consumption and service sector data has improved, Japan’s economy is still in bad shape. The country is in its fifth recession in the past 15 years. And the BoJ has downgraded growth prospects for eight of nine regions for the second consecutive quarter, mainly due to soft manufacturing and subdued international demand for Japanese goods.

This hasn’t been entirely due to yen strength. Japan’s territorial dispute with major trade partner China has resulted in a 20 per cent fall in exports to the region over the last year. Trade data released last week showed the extent of the gloom, as Japan reported the largest current account deficit in almost a year.

To combat this, the government has approved a fiscal stimulus package worth ¥20 trillion (including local government projects). It believes that this will result in 2 per cent growth, and generate 600,000 jobs.

This buoyed markets, adding to yen weakness. But it is questionable whether it is enough to achieve the growth target. Scicluna argues that growth will only come in at around 1 per cent this year – half Japan’s target.

WILL THE POLICIES WORK?
Domestic savings have predominantly been used to finance Japan’s gargantuan government debt, which exceeds 230 per cent of GDP. But as its aging population depletes domestic savings, more international money has begun flowing in. How long international investors will tolerate high debt is debateable, since high debt hinders economic growth.

Japan has only had a reprieve in international markets due to deflation. If the country succeeds in engineering inflation, patience may dissipate, leading to a spike in bond yields. Ultimately, this would also be a drag on growth.

Japan has been trying looser policies like this for two decades – and mostly without much success. Throwing stimulus at Japan’s problems does little to address the structural issues anchoring the country, like an ageing population and corporate uncompetitiveness.

So far, it has talked the yen down. Even the effects of the stimulus package will not filter through immediately. And Scicluna points out that we still do not fully know Abe’s medium-term economic agenda (for example, whether he will try to eradicate Japan’s primary deficit by the start of the next decade), which will only be known in July.

RIDE THE LIGHTNING
For traders, the economics only affect long-term positions. Investor sentiment will prevail in the short-term. This was illustrated yesterday, when the yen strengthened after jittery traders misinterpreted comments from economics minister Akira Amari.

HSBC has cautioned traders not to fight the selling pressure on the yen in the run up to the BoJ’s meeting, saying “sell the rumour, buy the fact”. And there is plenty of selling pressure, given that net yen short positions are near multi-year highs (see chart).

In the long-term, yen weakness will only be sustained as long as Japan’s economic policies are successful. Until then; trade what you see, not what you would like to see.