By David Veitch
The Bullish and Bearish Outlook for the Japanese Yen.
Home of sumos, samurais and sushi, Japan occupies a unique place within world history. Part of this history involves Japan’s ascendency as a centre for international trade and commerce: salarymen, massive conglomerates and innovation serve as some of the defining features of the Japanese economy. In the world of finance, Japan has also played a pivotal role. Take, for example, the development of the first organized exchange with standardized futures contracts in Dojima, circa 1730.
Despite its storied past, the Japanese economy has recently struggled to find its footing. The Nikkei Index (comprising of 225 stocks listed on the Tokyo Stock Exchange) is lower today than it was twenty-five years ago. Many market observers decry the state of the economy and offer a bleak outlook going forward.
Part of the unique tapestry of the Japanese economy is the Yen. The Yen, often ridiculed for its lack of worth (10 USD is worth almost 1,000 Yen), is inexorably linked to the state of Japan’s troubled economy. To develop an understanding of the value of the Yen going forward, one must first understand the problems at the root of Japan’s economic malaise. A brief assessment points to uncertainty regarding where the Yen is headed.
The Debt Situation
Weighing on the minds of international investors is Japan’s precarious debt situation; many have viewed the debt burden of 189% of GDP in 2009 as unsustainable. While yields on Japanese government bonds remain low (JGB’s 30-year yields are just shy of 2% compared to 4% in the US), interest payments on these bonds currently represent over 26% of government tax revenue. An ageing population and a deflationary environment will lead to shrinking tax revenues for the Japanese government; this has led some to question whether Japan can continue to successfully service this debt.
Japan is currently in the midst of a major demographic shift, similar to what is happening with the Baby Boomers in North America, where the population is rapidly ageing. The degree of this ageing, however, has led many to call the situation a demographic time-bomb. A dramatic decline in birth has occurred in Japan. In 1970, the birth rate fell below the “replacement rate” of 2.1 children per woman, and in 2005 the rate was a paltry 1.26. Eventually, this will lead to a spike in the Japanese dependency ratio, and a decrease in income tax revenues for the government.
The Bullish Argument
A case can be made for the strong positioning of Japanese exports going forward. Japan is one of the few truly developed nations which can be found in South East Asia, a hotbed of economic growth. Japanese exports, which largely consist of vehicles, semiconductors, and electrical machinery, are sure to be in high demand for years to come by Asian countries (which represent roughly half of total Japanese exports) who lack a competitive advantage in the production of these goods. As of late, Japanese exports have risen sharply; data released by Japan’s Ministry of Finance indicates Japan’s exports rose by 40% in April and 32% in May. Such a rise in exports to Asia would lead to an appreciation of the Yen vis-à-vis many developing-market currencies.
Furthermore, the widespread concern regarding the sustainability of the USD as the world’s reserve currency has led many to look for alternatives. The Yen is poised to benefit as investors shift assets out of dollars, and possibly even the much-maligned Euro, and into other currencies such as the Yen. Such a situation would not be impossible, especially given the large size, and hence liquidity, of Japanese stocks and bonds (i.e., an average of Y1,280bn of JGBs are traded daily). In the short-term, a rise in risk aversion, possibly resulting from a deteriorating Euro crisis, could support the Yen. In the long-term, a diversification by foreign governments away from dollars is likely to occur. Signs of such a shift have surfaced recently with record purchases of JGBs by the Chinese. As of now, JGBs represent only 0.6% of Chinese foreign exchange reserves; the potential for this share to increase further is now greater, given that China has signaled that it wishes to diversify away from the USD. Many international organizations are attempting to hasten this shift; recently the UN has called for the USD to be replaced by Special Drawing Rights (SDRs), a basket of currencies used as a unit of account by the IMF, as the world’s reserve currency. A widespread adoption of SDRs would benefit the Yen as it makes up roughly 13% of its value.
The Bearish Argument
The crux of any bearish argument against the Yen is the possibility that a Greek style debt crisis could happen to Japan in the near future. Recently, Japanese Prime Minister Naoto Kan commented that “Japan’s public finances [are] now dire . . . fiscal policy which relies excessively on deficit bond issuance is no longer sustainable . . . financial collapse if we neglect mounting public debt and lose confidence in the bond markets.” Hardly words to inspire optimism in the Yen. If such a crisis were to occur, the resulting decrease in foreign demand for Japanese financial assets would weigh heavily on the Yen. Recent action in the CDS market demonstrates the jitters felt by hedge funds and foreign investors about a potential Japanese default.
Currently, the lion’s shares of JGBs are held domestically. However, as Japan’s population ages and begins to sell JGBs to fund their retirements, foreigners will have to step in with purchases. A likely scenario could be a self-fulfilling prophecy where foreign investors demand greater yields because of the state of Japanese government finances, leading to the Japanese government’s inability to service debt with such high yields, eventually leading to default. As a result, a capital flight away from Japan and toward other currencies and a restructuring of debt (possibly even a domestic default) could occur. There is already some evidence of capital flight from Japan occurring as the Japanese have recently been heavily buying foreign securities.
There is much uncertainty regarding the future of the Yen, given the cross-currents of positive and negative forces at work. While it may be easy for one to point to the past twenty five years of economic problems and suggest that such trends will continue and the Yen will weaken, one must also consider the alternative case. A bullish bet hinging on increasing global diversification of foreign exchange reserves, as well as strong Japanese exports, would likely see USD/JPY and EUR/JPY continue to drift lower. On the other hand, a bearish scenario where Japan undergoes a sovereign debt crisis could see a run-up in USD/JPY, and a rise in the USD/CHF as investors seek haven in Swiss Francs.
In assessing all of the available information however, the picture for the Yen should be taken as bullish. Assessing the headlines of today, most signs point towards further troubles ahead for the world economic recovery, especially in the United States and Europe. A liquid safe-haven currency, which the Yen offers, will be attractive for investors in the months, and possibly years ahead.
The Japanese, known for their politeness, will no doubt have their currency brokers preparing themselves in the years ahead for many calls of wo kaitai yen from foreigners possessing colourful accents.
Disclosure: No positions