Currencies: Yen to Yo-Yo

Summary and conclusions

Assuming that the US economy follows a U-shaped trajectory in 2008 (a mild and shallow recession in 1H, followed by a recovery in 2H), USD/JPY has a good chance of selling off in 1H, but rising in 2H. A year of two tales for the US economy should have important cyclical implications for USD/JPY. In addition to the external shocks arising from the US business cycle, the JPY will also be perturbed by four policy-induced growth shocks made in Japan, which should enhance the U-shaped trajectory we see for the JPY crosses this year.

We reiterate our call for USD/JPY to trade down to 103 by June, then back up to 110 by year-end. An economic slowdown in the US and Japan and a general risk-averse financial environment should be positive for the JPY in 1H, while the opposite should be negative for the JPY, as Japanese investors resume pushing down their ‘home bias’ in 2H.

The external demand shock from the US will hurt Japan

Japan is likely to be a ‘higher-beta’ economy vis-à-vis the US than others. First, Japan is still quite exposed to the demand from the US, which accounts for some 20% of Japan’s overall exports. In 2001, when the US fell into a capex-led recession, the contractions in Japan’s exports (down 5%Y in 2001) and its GDP growth (0.2%Y) were instantaneous. Japan was tightly coupled to the US back then, and will probably be so this time around too – in the opinion of Sato-san.

Not only is it still exposed to external demand from the US, unlike most other countries, Japan has extremely limited scope to deploy Keynesian countermeasures to deal with the collateral damage from a US recession. The BoJ is the only central bank in the world that has not yet ‘fully re-loaded’. In addition, the policy rate is so abnormally low that the BoJ will be rather reluctant to ease. Given the circumstances, however, the BoJ is struggling to justify further monetary tightening. Though CPI inflation has finally turned positive again (0.6% in November), this recent rise in prices reflected higher energy costs, i.e., cost-push rather than demand-pull. Not only has there been no sign of a wage-price spiral, if anything wages remain stagnant as the structural changes in the labour market have weakened the bargaining power of workers; this also implies that, when hit by an energy or input price shock, companies could pass on the cost to the workers in order to preserve their margin. As a result, real wages fall in response to an energy shock. Our Japan economist Sato-san suspects that the next move by the BoJ could very well be a rate cut rather than a rate hike, particularly if the Nikkei enters a bear market.

At the same time, a large fiscal stimulus is also out of the question: Japan’s fiscal position is still too weak to allow it to contemplate large fiscal stimulus packages. Although Japan’s primary surplus has shrunk down to a little less than 1% of GDP from -4.1% in 2001, its overall government deficit is still very large at 3.4% of GDP in 2007, even though it has come down from a cycle-high of 8.8% of GDP back in 2002. Interest payments on Japan’s stock of debt remain daunting. Even if Japan achieves its ambitious goal of reaching a primary balance by 2011, its stock of debt – which has just reached 182% of GDP – is not likely to stabilise in the foreseeable future. This is not a solid platform from which to launch a fiscal stimulus package.

Finally, unlike most other countries, the JPY is unlikely to act as an automatic stabiliser in a recession: the JPY tends to strengthen when the going gets tough in Japan, which further exacerbates the slowdown. It is unlikely to be different this time.

Four domestic shocks, driven by (good) policies

My colleagues in Japan (T. Sato and R. Feldman) have made these observations in their recent write-ups. Essentially, three policy-induced shocks will retard domestic demand growth, even though all three policies are sensible, and a fourth policy-induced shock will help undermine capital outflows. In fact, our Japan team is looking for growth to be around 1.0% (+0.9% for the calendar year and +1.1% for the fiscal year), which is down from 1.8% in 2007 and lower than the 2008 forecast by consensus (1.5%), the BoJ (2.1%) and the government (2.0%).

Domestic shock 1. A tightening in the construction code. The Japanese Ministry of Land, Infrastructure and Transport (MLIT) tightened the building code in June 2007 in response to architects who cheated in their earthquake-resistance designs and calculations. For builders, this has dramatically complicated applications for building permits. Construction of condos is likely to be weak until at least late 2008, shaving off 0.3% from overall GDP growth.

Domestic shock 2. A reduction in the loan guarantee for SMEs (small and medium-size enterprises) by METI. SMEs account for 70% of the workforce in Japan and 57% of total value-added. METI used to provide a 100% guarantee on bank loans taken out by SMEs. But this was reduced to 80% in October last year. This will further burden the SMEs. Our colleague Sato-san discusses this extensively in Credit Crunch Coming, January 7, 2008.

Domestic shock 3. A tightening in consumer loan regulations. The first enforcement in January 2007 imposed more severe penalties on illegal lending by non-bank entities. The second enforcement took place in December 2007. The final implementation will take place by mid-2009, which will impose a ceiling on the lending rates of 20%. This legislation was initially intended to curb the number of borrowers with multiple debt, but as Sato-san discusses, this may also impact the SMEs. (Please see Sato-san’s note for further details.)

Domestic shock 4. The FSA’s higher disclosure requirement on mutual fund investments. While the first three domestic shocks will adversely affect Japan’s GDP growth, this fourth policy shock will temporarily discourage retail capital outflows from Japan. The ‘Financial Instruments and Exchange Law’ took effect at the end of September. These regulatory changes are essentially aimed at offering more detailed explanations on the ITF products to investors, i.e., bringing transparency to the marketplace. While there is no reduction in the product classes that can be sold, ITFs have significantly curtailed their offering of mutual fund products as a result of cumbersome disclosure procedures. The Investment Trust flows experienced a sharp contraction in outflows in October as a direct result of this regulation by the FSA. Thus, what is essentially a very sensible regulation has somehow led to a distortion in the JPY market.

USD/JPY to yo-yo

As we argued in The Dollar Smiles in a Recession (December 10, 2007), the world entering the ‘winter quadrant’ should be positive for the JPY (and the CHF). As the JPY strengthens toward 100, the MoF will not likely respond. The MoF’s stance on the JPY is essentially a reflection of the general public’s view, which has, in fact, been changing. For decades, there was a clear preference for a competitive JPY. A merchantilist bias was prevalent. However, with the sharp rise in oil and food prices, and the significant loss in purchasing power overseas, popular opinion is now split on whether a weak JPY is good or bad for Japan. This ambivalence will likely translate into a MoF that will refrain from conducting unilateral interventions to support USD/JPY. If USD/JPY does indeed approach 103 by June, as we believe, this issue of MoF interventions will be discussed by investors.

However, as soon as the global economy reasserts itself, which we suspect could take place in 3Q, and investors’ risk-taking appetite returns, we believe that the JPY will weaken again. The pent-up appetite among Japanese investors for foreign assets is immense – an argument we have made in the past. Capital outflows will resume, as Japan’s financial ‘home bias’ is reduced from what is currently extraordinarily distorted levels.

Bottom line

We reiterate our tactical call that USD/JPY should be sold in 1H. The global economic slowdown and general risk-aversion should assist the JPY’s ascent. But when the world recovers, this trade should be reversed as the structural decline in Japan’s financial ‘home bias’ should resume.

By Stephen Jen London, Luca Bindelli London
Morgan Stanley
January 11, 2008