Considering gold's recent correlation with risk assets, its traditional connotation as a safe haven has really not dictated its price action in recent months. However, the fact that gold is unencumbered by the counter-party risk that is pervasive amongst traditional asset classes means that this safe haven classification cannot be unilaterally compromised in the long-term. While short-term trading patterns in gold may have adopted a transient correlation with risk assets, any one of a number of different catalysts could erode investor confidence in conventional investments and trigger a flight to quality that should ultimately benefit gold.
The cause and time frame for this paradigm shift in risk tolerance are uncertain, but the characteristics that have afforded gold its monetary connotation over thousands of years will not be fundamentally changed by a few years of counterintuitive trade. This consideration is important because along with gold, the Japanese yen has historically been considered a safe haven asset as well. However, recent developments within the Japanese economy can and will categorically affect the yen's safe haven status. Considering the shrinking availability of safe haven assets, gold will naturally benefit from the yen's diminished role as a bastion for investors fleeing broader market uncertainty.
The IMF estimates that Japanese debt as a percentage of the nation's GDP reached 237% in 2012 - the highest such ratio in the world. What has enabled Japan to accumulate such a massive debt load in relation to its total economic size - while countries like Greece and Portugal ran into funding concerns when their debt-to-GDP ratios were significantly lower - is the fact that Japan has enjoyed trade and current account surpluses for decades. The current account measures both a nation's balance of trade and balance of payments (i.e. interest, dividends, etc. that are paid to a nation on its overseas holdings and vice versa).
Besides substantial incomes from its sizeable overseas holdings, Japan has enjoyed a current account surplus for decades. This reality has meant that Japan has not had the same reliance on foreign creditors to finance its deficits as other nations (i.e. Greece, Portugal, etc.). Additionally, Japan has also benefited from substantial domestic demand for its debt which similarly diminishes its reliance on foreign funding. The percentage of Japanese government bonds (JGBS) held domestically has shrunk in recent years as safe haven demand from foreign investors, and the fact that JGBs are some of the few "riskless" sovereign bonds offering a positive real rate of return (i.e. the yield is higher than the prevailing rate of inflation in Japan), drives foreign investment in the JGB market. Despite this trend, more than 90% of Japanese debt is held domestically. However, Japan's aging population and shrinking savings rate pose a risk to the nation's independence from foreign creditors as domestic demand for JGBs is set to continue sliding lower.
Japan's Current Account
In 2011, Japan realized its first annual trade deficit since 1980. A confluence of different factors helped manifest Japan's deteriorating terms of trade; most prominent among them were a strong yen and the nation's move away from nuclear energy. A strong yen makes Japanese products more expensive abroad which in turn can decrease the nation's exports as consumers prefer to buy cheaper products domestically or from Japan's competitors. Before the Fukushima disaster, Japan derived 30% of its electricity from nuclear reactors; estimates suggest that nuclear power could have been providing more than 40% of Japan's electricity by 2017. However, public backlash following the disaster has forced the government to move away from nuclear energy. As a result, Japan is expected to import as much as 84% of its energy requirements. This means that imported oil, natural gas, etc. will negatively weigh on Japan's trade balance without much hope for short-to-medium term alleviation. Considering that Japan cannot shift its energy consumption and infrastructure overnight, the government will do what it can to weaken the yen in a bid to drum up higher exports to mitigate the detrimental effects the country's energy imports have on its overall terms of trade.
A more recent development weighing on Japanese exports is a territorial spat with China over a chain of islands thought to be rich in natural gas and oil deposits. As tensions over the islands' ownership continue, trade between the nations has dropped 3.9% in 2012 while China's General Administration of Customs reported an 8.6% drop in Chinese imports of Japanese goods. Considering neither nation has indicated a willingness to completely resolve the issue, trade tensions between China and Japan are set to continue which will add pressure to Japan's trade balance going forward.
However, a trade deficit does not necessarily mean a current account deficit. The current account includes not only trade, but also the balance of payments (i.e. interest, dividends, etc.) that a country pays out and also receives as income from overseas holdings. The IMF puts Japan's foreign currency reserves at around $1.19 trillion. Due to large incomes derived from these holdings, Japan can generally maintain a current account surplus despite its chronic trade deficits since 2011. However, in November 2012, Japan booked its sixth monthly deficit in the broader current account. Last January, Japan realized its largest monthly current account deficit since 1985 when they started tracking comparable data. The five monthly current account deficits Japan has experienced before this most recent development in November all occurred in the month of January and are attributed to a seasonal slowdown in trade as the result of the holiday season. While Japan's income from its overseas holdings should help to mitigate the pressure of deteriorating terms of trade, if those cash inflows are insufficient to help Japan maintain its overall current account surplus, the nation will be increasingly reliant on foreign funding for financing.
If Japan is indeed forced to rely on foreign funding, its high debt-to-GDP ratio and flagging current account surpluses will mean that investors will demand higher yields on JGBs than what is currently offered. In an environment where Japan is forced to pay higher and higher interest on its debt, the nation could potentially begin cashing in its extensive overseas holdings which would provide the government with much needed cash without raising the overall cost of servicing its existing debt. However, the problem with drawing down its overseas holdings is that such a practice would further erode Japan's current account balance over time. When that cash runs out, Japan will be back in the same position as before: subject to rising debt yields as foreign creditors demand higher compensation for the fiscal risks associated with the Japanese economy - except this time the diminished foreign holdings and associated weakening of Japan's current account balance will compel foreign investors to demand even higher yields on the nation's debt offerings.
As indicated, Japan has largely sustained its debts domestically without having to resort to foreign creditors. However, demographic considerations - the country's aging population and its shrinking savings rate - mean that Japan can no longer rely solely on domestic bond sales to continue funding its deficits and refinancing its debts. This increased reliance on foreign creditors could eventually subject Japan to the same style of funding pressure that crippled Europe's periphery and necessitated a succession of bailouts.
In 2006, Japan recorded a slightly higher number of deaths than births - a phenomenon not seen since 1945 when Japan was defeated in World War II. Ever since, Japan has been a "net mortality society" with deaths exceeding births on a consistent basis. By 2040, more than a third of the Japanese population will be aged 65 or older and the nation will have a median age of 55. In this environment, Japan's working-age population will have dropped by 30%. At the current rate, Japan's population - which is now at 127 million - will drop to around 106 million.
While we could explore the catalysts behind Japan's demographic landscape, to remain on topic we will simply take for granted that the country's population is aging, and doing so rapidly. With this in mind, the swelling ranks of retirees will need to increasingly utilize their savings to accommodate living expenses, medical bills, etc. So while ever-rising numbers of Japanese retirees are cashing in their JGBs, the population of working-age adults available to pick up the slack in savings is shrinking. This will apply pressure to the JGB market and could precipitate a rise in yields irrespective of Japan's fiscal situation.
Besides a shrinking population of working-age savers, the overall savings rate in Japan has been shrinking as well. Savings as a percentage of disposable income in Japan was as high as 14% in the 1990's but has since dwindled down to less than 3%. The Organization for Economic Cooperation and Development (OECD) indicates that Japan's savings rate was 2.9% in 2011 and forecasts this rate will fall to 1.9% in 2012 and 2013, before dropping further to 1.5% in 2014. While these are just projections, the prospects of a shrinking working-age population that successively saves less each year is an ominous indicator for future domestic JGB demand.
Reduced domestic JGB demand will inevitably force Japan to sell larger quantities of its debt to foreign investors. This reality will subject Japan to higher funding costs as foreign creditors are less anxious to lend to a government with the largest debt burden as a percentage of GDP as well as a questionable outlook for its once-admired current account surpluses. To top things off, Japan entered a technical recession after the nation revealed that its economy contracted by 3.5% in the third quarter of 2012. Battling deflation, economic contraction, unfavorable demographic developments, and deteriorating terms of trade, Japan is becoming an increasingly unattractive credit risk all the while its once-independent funding requirements inexorably become more reliant on foreign capital.
As the risks to the Japanese economy are fairly plain to see, the political landscape is changing with the population favoring more outspoken politicians espousing various platforms that promise an end to deflation and reinvigorated economic expansion. Due to a landslide victory at the end of last year, the Liberal Democratic Party (LDP) and a coalition partner now represent a two-thirds majority in Japan's lower house of the Diet. This event also propelled former Japanese Prime Minister Shinzo Abe back into that position as he promises to defeat deflation and stand up to the Chinese in the territorial dispute over the Senkaku island chain.
More as a result of expectations rather than any substantive policy decisions, the yen has sold off on Abe's rhetoric and recently reached a 2 ½ year low against the U.S. dollar. Realizing the risks of a deteriorating trade balance and chronic current account deficits, Abe seems to be placing much of his policy impetus towards weakening the yen in a bid to drive exports higher and end deflation.
Pressured by the Abe administration, the BOJ has recently adopted a 2% inflation target in the hopes of defeating deflation in Japan. For reference, the last time Japan had an inflation rate of 2% was in 1997. According to data compiled by Bloomberg, Japan has experienced deflation (or falling prices) for 10 of the last 15 years since 1997. Further eroding the plausibility that the BOJ will meet this target in the short-term was a forecast that was published along with the BOJ's policy statement which indicated the central bank expects a rise in consumer prices of just 0.9% in the fiscal year starting April 2014. So despite the target, the central bank doesn't seem to think that 2% inflation is achievable in less than a few years.
Considering the substantial obstacles facing the BOJ on the road to 2% inflation, the central bank has announced a new bond purchasing program that will commence in 2014 which entails open-ended, monthly bond purchases of 13 trillion yen ($145 billion). This measure, similar to the Fed's open-ended bond purchasing program ($85 billion a month), will be supportive of gold, precious metals in general, and most intrinsically valuable assets as it represents another round of dilution to one of the world's premier currencies. In a joint statement released by the government and BOJ, the two entities pledge to "strengthen their policy coordination," in a combined testament to their ultimate goals of weakening the yen and achieving inflation.
While Abe's government recently announced a new round of stimulus measures, totaling some 20.2 trillion yen, it has not yet taken specific actions to drive the yen lower. However, to this end, Abe did "pledge to consider" establishing a fund to purchase foreign securities in a bid to achieve further yen depreciation. As the fund sells yen to purchase securities denominated in foreign currencies, the government could reasonably expect to push the yen lower. Nomura Securities Co. and former BOJ deputy governor Kazumasa Iwata indicate that the fund's size could be as large as 50 trillion yen ($558 billion). Such a fund will probably only be incorporated if a sudden bout of risk aversion, or some other sentiment shift, causes a dramatic and rapid reversal in the yen's recent slide.
The proposed fund highlights Abe's commitment to his vision of an economic recovery predicated on a weaker yen. As the government cannot address energy-driven trade imbalances or demographic developments in the short-term, a weaker yen is one of its few remaining options to engender an economic recovery.
The yen has dropped significantly in recent weeks but could realize a trend reversal in short order as the result of any one of a number of risk-off catalysts (i.e. US debt ceiling debate, stalled bailout negotiations for Cyprus, etc.). However, realizing Abe's weak-yen policy skew, the full scope of measures he seems willing to adopt to limit yen strength - like the half a trillion dollar fund for purchasing foreign securities - and the BOJ's impending open-ended bond purchases, many investors in a risk-off environment may reconsider the traditional yen acquisitions amidst a flight to quality. Instead, considering Abe's preference for a weak yen and the long-term, structural concerns facing the Japanese economy, investors seeking safe harbor will eventually begin allocating funds towards other avenues. This may not happen immediately, but as Abe incorporates the proposed fund and other such weak-yen measures in response to a spike in yen demand, investors will slowly but surely realize there are greener pastures available to them.
Shrinking Pool of Safe Havens
If we look at the conventional safe haven alternatives to the yen, the two major players are the U.S. dollar and the Swiss franc. However, one can quickly see that both currencies and their associated economies are subject to some of the very risks that could precipitate a risk-off development within global markets. The U.S. dollar for instance is subject to the highly fractious debate surrounding the debt ceiling and sequestration (across-the-board spending cuts) that an 11th hour Congressional deal postponed for two months.
The Swiss franc on the other hand is tied to the export-driven Swiss economy which is inextricably dependent on the broader European economy. With the bulk of its exports going to its European partners, the Swiss economy is not immune to the malaise currently permeating Europe. The Swiss National Bank (SNB) adopted an unofficial peg to the euro at a rate of 1.2 and has successfully defended this level against undue franc appreciation by promising to print unlimited quantities of francs for sale in the open market to depress its value. While these measures may not stop investors looking for a safe parking lot for their cash, it does effectively limit any upside potential speculators could realize by going long francs. More importantly, the unorthodox measures the SNB has been forced to take (and will be further forced to take to combat another round of risk-off-driven franc investment) leaves a certain degree of ambiguity as to how such actions will influence the Swiss economy going forward. This uncertainty will detract from the franc's allure as a safe haven even as political uncertainties in the U.S. do the same for the dollar.
Considering the besieged safe haven status of the world's traditional "riskless" currencies, gold continues to remain attractive as it is unencumbered by the sovereign and economic affiliations that plague conventional currency "safe havens." While recent gold trading patterns have not reflected those of a safe haven, gold's transient correlation with risk assets should not detract from the long-term allure of owning something unburdened by increasingly detrimental counter-party risk. Going forward, the weak-yen policies increasingly adopted in Japan - combined with the economic concerns that will continue to plague the U.S. dollar and Swiss franc - will continue to support gold as it slowly but surely reclaims its title as an asset of last resort.
Speculators interested in a high degree of liquidity and an online marketplace should explore the many exchange-traded products that track the value of gold. However, for those truly concerned about diversifying away from traditional counter-party risk and insulating a portion of their wealth from the unfettered monetary dilution taking place in the U.S. and Japan, physical gold is a must.