Strong Yen Belies a Worrisome Japanese Economy

A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.”
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Investors have enough to worry about: the crisis in the euro area, the uneven U.S. recovery and the probable hard landing in China. So I hate to be the bearer of more worrisome tidings: They also need to start keeping a watchful eye on Japan.

The world’s third-largest economy has been in a deflationary depression for two decades, with very low, if not negative, gross-domestic-product growth, and deflation more often than inflation. True, first-quarter GDP rose 4.1 percent at annual rates after a flat reading in the fourth quarter of 2011. The strong showing is largely attributed to increased domestic demand due to government spending and incentives to help the country recover from the March 2011 earthquake and tsunami, and similar rates of growth aren’t expected in coming quarters. The first-quarter GDP deflator, a key price indicator, rose 0.02 percent, its first increase in more than three years. Prices, excluding food and energy, fell 0.3 percent in April.

Given this 20-year deflationary depression, the yen’s enduring strength against the dollar and other major currencies is a mystery.

Plaza Accord

It takes about 78 yen to buy $1 today. In 1985, it took about 250 yen. That was the year the U.S., France, Germany, the U.K. and Japan met in New York and reached what became known as the Plaza Accord. The agreement was aimed at strengthening the yen and weakening the U.S. dollar as a way to curb Japan’s export juggernaut. Nevertheless, the Bank of Japan flooded the economy with cheap money in order to offset the depressing effects of a stronger yen.

A lot of that money found its way into real estate and stocks and propelled the Japanese bubble economy of the 1980s. But the bubble burst: The Nikkei 225 Stock Average peaked at 38,916 on the last trading day of 1989 and has fallen 78 percent since. Land prices are down 77 percent from the peak in the third quarter of 1990.

The yen has maintained its strength for several reasons. First, Japan has pursued a mercantilist foreign-trade policy that recalls France in the 17th century. Exports have been promoted by the government-industrial complex known abroad as Japan Inc., with a concentration on cars, electronics and other industries designated for global dominance. Meanwhile, imports have been discouraged. A government official once proposed banning the importation of U.S. skis on the grounds that they hadn’t been tested on Japanese snow. And so, until recent years, the trade surplus persisted. The yen also has been buoyed by the steady repatriation of earnings and the money inflow to Japan’s immense holding of foreign assets.

Second, investors have viewed Japan as a haven during periods of turmoil, including the 1997-1998 Asian debt crisis, the 1990s dot-com bubble and its 2000-2002 collapse, the U.S. subprime-mortgage boom and meltdown, the global recession that followed in 2008-2009 and, most recently, the European sovereign-debt crisis.

Third, investors are well aware that repeated Japanese currency interventions designed to curtail the yen’s strength haven’t worked for long. In early May, officials threatened to step in again to hold down the currency but didn’t take any action at the central bank’s May 23 policy meeting. The yen jumped. True, the government hasn’t usually been joined by the U.S. and other major countries in trashing the yen, though the Japanese central bank has asked the country’s major banks if they could help it intervene overseas during European and North American trading hours.

In any event, intervening against your own currency should be relatively easy: It’s simply a matter of selling it on the open market and because it’s your own currency, you can manufacture an unlimited supply. In contrast, supporting your currency requires selling other currencies and often borrowing them from foreign governments.

Carry Trade

Fourth, the yen has been the darling of the carry trade because of Japan’s liquid currency market and low interest rates. Speculators borrow yen at low rates, convert the funds to higher-yielding currencies and profit from the interest-rate spread. Australia, with persistently higher rates, has often been on the other side of the carry trade. Of course, if the yen strengthens against the Australian dollar, speculators can lose part or all of the carry-trade profit, but if it weakens, they make money two ways.

This dynamic has been on display this year, at least until very recently, with the Mexican peso up 3 percent against the yen, the U.S. dollar up 3.3 percent, and the South African rand down 0.3 percent, the Brazilian real down 5.1 percent and the Australian dollar down 1.2 percent.

Nevertheless, other major central-bank rates have fallen close to zero in recent years, so the yen is no longer unique as a carry-trade funding currency, and the narrow rate spreads largely eliminate carry-trade profits versus the dollar, the pound and the euro. Since September 1995, the Bank of Japan’s overnight interest-rate target has been generally around 0.4 percent or less and never higher than 0.7 percent. Today, the two-year Treasury note yields only 0.18 percentage point more than the comparable Japanese government debt.

The Bank of Japan surprised markets in February by expanding its asset-purchase program by 10 trillion yen to 65 trillion yen ($81 billion) to stimulate economic growth. It also set an immediate inflation target of 1 percent and a 2 percent or lower goal in the longer run to counter chronic deflation. Just imagine, congenital inflation-worrying central banks cheering for inflation. But then, in 2011, the consumer-price index fell again, by 0.3 percentage point, and inflation rates of 1 percent or more have occurred in only nine months since 2002, all largely caused by spikes in crude-oil prices.

BOJ Loans

More recently, the BOJ announced a 2 trillion-yen to 5.5 trillion-yen boost for its loan program for high-growth sectors, such as renewable energy, medical treatment and nursing care. The program, introduced in June 2010, will run until March 2014 and lend to private banks for one year at 0.1 percent interest. As part of the total, the BOJ will offer 1 trillion yen in U.S. dollar-denominated loans.

Last August, the Japan Bank for International Cooperation set up the “Emergency Facility to Deal With the Strong Yen” to lend U.S. dollars cheaply to Japanese companies for foreign acquisitions or to buy foreign resources. The initial $100 billion was increased to $130 billion, which the program borrowed from Japan’s $1.3 trillion foreign-currency reserves. JBIC finances as much as 60 percent of overseas mergers and acquisitions and 70 percent of purchases of foreign assets. Borrowers are expected to obtain elsewhere the additional dollars to complete their deals and thereby boost the dollar against the yen.

Clearly, the independent BOJ is acting in concert with the government to stimulate the economy, but some believe it’s also buying government securities to finance huge deficits. “Monetizing the debt” in this way is taboo among major central bankers because it can encourage profligacy. Yet it’s being done under one guise or another in the U.S. with recent quantitative easing and, more recently, in the euro area, where the European Central Bank loaned 1 trillion euros ($1.2 trillion) to at least 800 banks at 1 percent interest for three years. The banks, in turn, used much of the money to buy their governments’ sovereign issues. Through the end of this year, the BOJ plans to spend 38 trillion yen in its asset-buying program, roughly equal to all the planned new government bond issues.

(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the first in a five-part series. Read Part 2 and Part 3.)

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