Japan is ready to try anything to weaken yen
JAPAN’s Liberal Democrat Party (LDP) emphatically took control of the country’s lower house on Sunday. The outcome was anticipated by currency traders, who expected the dovish LDP leader Shinzo Abe to walk into the job of Prime Minister, becoming Japan’s seventh leader in as many years. Although many believe that the LDP’s victory heralds a new era of a weaker yen, there are still reasons to be cautious.
Since elections were called last month, the yen has lost over 5 per cent of its value against the US dollar, dragging the currency to its weakest point since April 2011. It currently sits at around ¥84 per dollar. Japan’s government bond yields are also creeping up on expectations of looser economic policy; though they still remain low by most countries standards, at around 0.75 per cent.
The partnership between the LDP and the New Komeito Party gives the ruling coalition two-thirds of Japan’s lower house – a super-majority – which can override any vetoes from the upper house. “The scale of the electoral shift significantly surpassed expectations,” says Gareth Berry of UBS, and “this should facilitate the process of legislative reform, helping Abe push through his manifesto pledges”.
DOUBLE-BARRELLED
The coalition now has a firm mandate to pursue a double-barrelled fiscal and monetary approach to tackle deflation and the stronger yen.
On the monetary front, it is likely that interest rates will be lowered to zero from around 0.1 per cent, that the inflation target be increased to 2 per cent, and the government will legislate to have greater influence over the Bank of Japan. There are also plans for a “currency warfare fund,” where money created from (potentially unlimited) quantitative easing will be used to purchase foreign bonds, thus weakening the currency.
Japan will also pursue an expansionary fiscal policy via stimulus programmes like infrastructure and defence spending, to establish a nominal GDP growth target of 3 per cent.
OVERDONE OPTIMISM
“The political change has been a catalyst for yen weakness, rather than a driving force,” says Simon Smith of FxPro. In the medium and long term, the performance of the yen will still be determined by fundamental factors.
There are also questions over whether the LDP can implement the structural changes necessary to help Japan beat deflation. Paul Chesson of Invesco Perpetual says that “political developments are likely to have a limited long-term impact. The LDP’s ability to implement its plans, as well as the actual impact of the policy changes on the economy, remain uncertain”.
David Rea of Capital Economics notes that “increased political pressure may mean substantial easing is likely, but this does not mark the dramatic change in policy that markets expect”. Indeed, the Bank of Japan already pursues aggressive monetary policy, currently targeting 1 per cent inflation. However, it has been unsuccessful in meeting this target so far, and Rea is sceptical whether more easing can help.
Further, the Bank of Japan’s new policy board will not be known until March 2013. Japan’s upper house still retains a veto on who will replace governor Masaaki Shirakawa, regardless of the coalition’s super-majority.
YEN OUTLOOK
Analysts are mixed whether the Bank will add to its asset purchase programme when it meets for its two-day meeting today. Capital Economics thinks that the Bank will leave policy unchanged, increasing the ceiling of its asset purchase programme by ¥12 trillion (£88bn) in January. But UBS predicts that the Bank will increase its programme by ¥6 trillion this week, and Berry says that any dips in dollar-yen could be a buying opportunity for those with a medium-term view.
Traders should not take Abe’s words as gospel. There are many hurdles to achieving a weaker yen. The US Federal Reserve’s own monetary easing policy will compete with that of the Bank of Japan. In the face of this, Thomas Stolper of Goldman Sachs doubts whether policymakers can succeed in weakening the yen, particularly since the Federal Reserve has shown an unlimited monetary resolve. An escalation of the Eurozone debt crisis may also push safe haven capital flows out of the euro and into yen, which is entirely possible within the next year.
However, one of the most fundamental risks to the yen is if policymakers fail to achieve their bold ambitions. If the market loses faith in Japan’s fiscal and monetary resolve, this could manifest itself through a stronger currency.
The yen bears should learn the lessons of the past two decades: approach with caution. It may not be the time to celebrate just yet.