Japan's FX Hall Pass

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Includes: DBJP, DEWJ, DXJ, EWJ, EWV, EZJ, FJP, FXJP, FXY, GSJY, HEWJ, HFXJ, HGJP, HJPX, JEQ, JPN, JPNH, JPNL, JPXN, JYN, YCL, YCS
by: Lipper Alpha Insight

By Amareos

Awkward handshakes aside, Japanese PM Abe must be breathing a sigh of relief following his recent meetings with President Trump. After witnessing public criticism by the new US administration towards China and Germany[1] about their undervalued currencies, there was considerable speculation that the spotlight would also fall on Japan as it too has[2] been persistently leaning on foreign demand – including the US – to bolster its economic growth rate.

After all, consider the statistics. Last year Japan recorded its second-largest current account surplus, which at USD 184bn represented a 26% increase on 2015’s surplus. Of that, roughly a third – some USD69bn – came from net exports of goods to the US alone. This gap in bilateral export and imports puts Japan second only to China – albeit a long way behind given China accounts for roughly half of the US’s USD 700bn annual trade deficit.

So how come Japan appears to have gotten away with it? An apparent exception to the pro-protectionist Trump agenda?

The answer lies on two fronts. First, and perhaps most obvious, especially in light of the recent missile test by the North Koreans[3], Japan is seen by the US as a key ally in a region where geopolitical tensions have been warming up. Although Trump back-pedalled to some extent on his brash challenge to the One-China policy during his recent call with President Xi Jinping, many are concerned that the two economies remain on a long-run collision course.

Given the recent change in personnel running the White House and their domestic-orientated “America First” bias this more pessimistic viewpoint has been given new credence and, as a result, has been gaining traction. However, in our view, this is an incorrect reading of the situation. Rather than being viewed as the instigators, the new administration is better considered as catalysts, simply accelerating a process that was already well underway.

This is premised on the fact that it is difficult to envisage the dominant economic and military superpower – the US – quietly and tacitly acquiescing to the emergence of a challenging economic (potentially over time also military) superpower– China. Although we didn’t realize it at the time[4] the envisaged scenario has a long history and is known as Thucydides trap[5], so named after the ancient Greek who observed that,

What made war inevitable was the growth of Athenian power and the fear which this caused in Sparta.”

History may not exactly rhyme but is certainly does echo and we cannot be alone in hearing an echo of that sentiment in the language of modern politicians.

Thankfully, such a negative outcome is not assured. Nevertheless, it will take some very deft and nuanced political handling to avoid it; skills not readily associated with President Trump but, as his recent One-China backtrack suggests, perhaps ones he is fast acquiring[6]. Given their regional importance, maintaining a good working relationship with Japan’s government will undoubtedly be viewed as beneficial by the US administration in this regard[7].

Second is a less prosaic reason, one it requires delving in the international macroeconomics, specifically in relation to currency valuations.

Most economists have been brought up to believe that over the long-run free-floating currencies move in such a way as to bring about equilibrium to an economy’s external position. Hence, sustained external surpluses – China, Japan and Germany have the three largest current account surpluses in the world –are the hallmark of a “fundamentally” undervalued currency whose self-correcting tendency to appreciate is impeded.

In the case of China and Germany the impediment is patently obvious. China’s government has a longstanding policy of guiding the exchange rate while Germany by virtue of its membership to the single currency (whose overall net external surplus is considerably smaller than Germany’s[8]) also does not have a fully free-floating currency[9].

For a US administration keen to foster domestic growth, the impeding of a market-clearing external-surplus-reducing currency appreciation by such countries is increasingly viewed as mercantilism, which as per the following Wikipedia definition constitutes economic nationalism whose,

goal is to enrich and empower the nation and state to the maximum degree, by acquiring and retaining as much economic activity as possible within the nation’s borders.”

Hearing another echo?

While superficially similar, in the sense that Japan is – as mentioned – running a sustained current account surplus, its motivation for doing so is less about gaining economic superiority (mercantilism) and more about survival[10].

For the reasons we outlined in an earlier Market Insight[11], Japan’s fiscal position is so dire that it is virtually impossible, certainly politically, to put government debt back onto a more stable trajectory by domestic consolidation measures alone. To give some sense of the enormity of the task facing Abe’s government a 2013 NBER working paper[12] examining Japan’s fiscal position estimated that the required fiscal adjustment lies “in the range of 30-40% of total consumption expenditure”. That is huge.

Historically, the Japanese government has been able to rely on domestic private investors to finance its fiscal deficit; a tenable position when its economy was sluggish and deflationary pressures widespread. However, the stated goal of Abenomics is to generate stronger economic growth and achieve a consistently positive CPI inflation rate so as to bring to an end the inexorable rise in Japan’s government debt/GDP ratio via boosting the denominator. The problem with this policy is that, if successful, it makes holding JGBs a losing investment in real terms, and very likely nominal terms as well given the number of investors keenly anticipating the so-called JGB “death spiral.”

It was for this very reason that the BoJ adopted the 0% yield target last September. As we stated at the time it was a political imperative. That imperative has not altered. Also as we stated at the time, and contrary to the prevailing tone of much of the research commentary on the policy change, the implications were profound and would serve as a catalyst to a substantial weakening in the JPY and rise in the Nikkei – both of which occurred.

Taking a look at the impact the BoJ’s policy goal shift has had on crowd thinking, we can observe a marked improvement in Japanese economic growth sentiment since September (see exhibit below); a positive and welcome development given the important role expectations play in determining subsequent economic outcomes – aka animal spirits.

Exhibit 1. Crowd Sourced Sentiment Economic Growth & Inflation – Japan

Source: www.amareos.com

Much less successful, however, has been the reflationary impulse. Even though actual CPI inflation in Japan has turned positive in y/y terms, the crowd clearly does not envisage the rise as being sustainable, given future inflation sentiment has fallen back to its long-run average. This is a clear indication of how strongly entrenched the deflationary mind-set still is in Japan. Similarly, the rebound in positive sentiment towards Japanese equities has faltered – see exhibit below – and is now back to levels witnessed just prior to September’s BoJ meeting.

Exhibit 2. Crowd Sourced Sentiment vs. Price – Nikkei 225

Source: www.amareos.com

Overall, capitulation by the crowd in these two key areas indicates the BoJ will be forced to continue to calibrate monetary policy settings to such an accommodative degree that the depreciating JPY trend persists[13].

This may not be the ideal set of circumstances for Trump to fulfil his “America First” ambition, but neither would he like one of the US’s key allies suffering the damaging economic consequences of a sovereign debt crisis, which could flare up if the BoJ is forced to alter its policy goal because of its impact on the exchange rate, especially when geopolitical tensions in the region are heating up.

That said, for the avoidance of doubt, we expect Trump and his team to keep the pressure on Japan to implement other economic measures – especially on the structural reform front – to ease the burden on monetary policy to rectify the dire fiscal position and reduce the scale of JPY depreciation that is required. We also would not rule out occasional verbal intervention from the US so as to not appear biased, something that would make it harder to criticise China and Germany for maintaining undervalued exchange rates.

Similarly, periodic “risk-off” bouts in global markets will occur – indeed, as we warned a few weeks back one may be just around the corner[14] – and this will likely, if not logically[15], result in bouts of JPY strength. However, none of the above should detract investors from expecting the JPY’s long-term depreciating trend to persist.

Sentiment Analytics are based on Thomson Reuters MarketPsych indices


[1] Japan received only a glancing sideswipe from Trump in comments made prior to the meeting.

[2] And continues to with just released Q4 GDP data showing net exports were a significant positive contributor.

[3] As we warned was likely in a recent Market Insight Kim Jong-un has followed in his father’s footsteps of using missile launches to test the reactions of the new administration – see here.

[4] We began seriously contemplating a likely escalation in US-Sino tensions back in 2009 – long before Trump was even considering throwing his hat into the Presidential ring.

[5] We recommend this article.

[6] Less positively references to Trump being a “paper tiger”, a phrase previously used by Chairman Mao to describe ineffectual threats, is unlikely to play well with a President whose ego is beyond doubt – see here.

[7] Obviously, the same also applies to South Korea.

[8] Does anyone seriously doubt that if the DEM were still around it would be trading anywhere near the current EUR exchange rate level? No, we thought not.

[9] Its bilateral exchange rate versus the other eurozone members was “irrevocably” locked on December 31, 1998.

[10] This is not us engaging in hyperbole.

[11] See here.

[12] See here.

[13] Adjusting the yield target upwards, of which there has been some recent chatter, really only constitutes a tweak. What matters is that the yield target remains, and at a level that is significantly below the BoJ’s CPI inflation target. That being said, we would consider such a tweak to constitute a policy-making error – albeit a minor one.

[14] See here.

[15] For reasons we outlined here.

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