The U.S. dollar has been getting a beating from all sides, but its woes may be far from over – recent developments in Japan, China, Germany and the United Kingdom, not to speak of domestic developments in the U.S., are pointing to a rocky road ahead.
The U.S. dollar has been getting a beating from all sides, but its woes may be far from over – recent developments in Japan, China, Germany and the United Kingdom, not to speak of domestic developments in the U.S., are pointing to a rocky road ahead. Today’s focus is on Japan and, more specifically, how a country on a downward economic spiral can have a strong currency.
Exchange rates are subject to the forces of supply and demand – the flow of funds – of the underlying currencies. While conventional wisdom dictates that a growing economy may attract more foreign investment, a better gauge may be to look at a country’s dependence on foreign investment. A country like the U.S., with a severe current account deficit, depends on foreigners buying about $2 billion worth of U.S. denominated assets every single day just to keep the currency stable. The current account deficit reflects a country’s trade deficit plus any financing requirements, such as government spending that is financed from foreigners rather than domestically. The currencies of countries with significant current account deficits, such as the U.S., Australia and New Zealand, tend to be more volatile during periods when market participants do not have a clear view on whether the economies will experience growth or not.
However, the Japanese economy is less sensitive to capital flows from abroad; instead, if market forces were allowed to play out, frightened Japanese consumers might even save more as their economy continues on its downward spiral. The Japanese yen may perform better the less effective the government is: as the former Japanese government’s leadership became ineffective and the Bank of Japan received no instructions to intervene in the currency markets, the yen was able to rise.
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To further illustrate the point, consider that Federal Reserve (Fed) Chairman Bernanke has repeatedly emphasized that the U.S. emerged from the Great Depression because of a) a guarantee of retail deposits (think guarantee of the entire banking system in the most recent crisis) and b) the U.S. going off the gold standard to weaken the U.S. dollar and allow the price level to rise. Our interpretation is that the Fed wants to have a weaker U.S. dollar to induce inflation to allow home prices to rise and bail out those with debt. Think about it this way: if someone takes half your net worth (purchasing power) away, you may have a greater incentive to work, thus creating headline economic growth and employment. Destroying purchasing power may not be the Fed’s mandate, but this approach may be aimed at boosting employment. By making U.S. assets relatively unattractive, the Fed is, in our view, effectively attempting to weaken the currency. The Fed has been aggressively buying mortgage backed securities (MBS) and government bonds; these securities are now intentionally overpriced and thus may no longer be attractive to rational buyers. We are not just talking about foreigners potentially reducing their appetite for U.S. securities, but domestic buyers as well; we see this as an increasing number of U.S. corporations are hedging their domestic currency risk.
Now think about what happens to a region’s currency when the central bank is not as aggressive. Think euro zone – economic growth in the euro zone may be nothing to write home about, but it may be because the European Central Bank (ECB) has shown more restraint that the currency has been strengthening relative to the U.S. dollar. The forces that have driven the Japanese yen higher are similar to those supporting the euro.
Does it mean all is well in Japan and Europe? No. Quite the contrary, but flow-of-funds issues are more relevant to short- and medium term valuation dynamics than challenges in a country’s balance sheet. In the case of Europe, the banking sector has major challenges still ahead, but the European Central Bank’s approach of providing unlimited liquidity to the sector is likely to keep zombie banks alive; that bodes badly for economic growth, but can support a strong currency. In Japan, the massive government debt is a long-term issue that will become a short-term issue when financing issues arise. In a world where the Japanese banking system is perceived to be one of the safest in the world (what a scary thought!), and the market appears pre-occupied with only the most imminent financial issues, these problems, at least for now, appear to be in the distant future.
Or are they? Long-term challenges can become short-term headaches when someone rocks the boat too much. A new government stirring up dust is a perfect opportunity to have a lingering problem turn into a full-blown crisis. To look into our crystal ball where Japan and the Japanese yen may be heading, let’s look at the newly elected Democratic Party of Japan (DPJ) as it pursues an eclectic policy mix of decentralization, socialism and select pro-business initiatives. Some of the highlights relevant for the currency may be:
•The DPJ wants to take an axe to a system run by bureaucrats– that’s good for change; the party further wants to move power to the regions. However, rather than encouraging a less bureaucratic federal system, the DPJ intends to replace bureaucrats with politicians. Think political appointees at all levels of society. I can’t help but think of the French, where disillusioned citizens vote for change election after election, but get change in a direction they had never imagined or necessarily wished for. The U.S. has similar challenges when it comes to implementing change, but political appointees are not as pervasive (all things are relative…) as they are in France.
•Unions are the main backers of the DPJ; not surprisingly, the DPJ wants to halt the privatization of the Japanese Post Bank. As a refresher to a topic that has been out of the headlines for some time: the Japanese Post Bank has over USD $3 trillion equivalent in deposits, a consequence of what had been a very weak banking system where deposits fled to the one bank with state guarantees. The Post Bank has been instrumental in financing government deficits; we had argued a couple of years ago that a privatization may be inflationary, as a privatized institution might be more risk friendly and deploy its asset base more aggressively. As a result of the policy reversal, this potential boost to economic growth may not materialize.
•The DPJ has numerous populist ideas, from generous child allowances to cancellation of road tolls to generous pension and health benefits. To finance all these programs, “wasteful spending” elsewhere shall be cut. This sounds all too familiar and is likely to be the same as in any other country: expensive.
•The DPJ wants to move power from large businesses to small businesses, from the cities to the regions.
When the yen started to rise in the days after DPJ’s election victory, politicians boasted how this would strengthen domestic purchasing power for consumers. Well, it does, but it also hurts exports. Japan is traditionally one of the world’s best exporters and has the world’s worst consumers. While it is laudable that a government wants to strengthen consumer’s purchasing power, the question is whether the government truly has the willpower to pursue this policy.
From what we can see, the government stayed on course for about a week. When it comes to analyzing developing countries’ currencies, what makes our job traditionally quite easy is how predictable policy makers are. Not so in Japan. The new Japanese government has an array of ideas, but – in our humble opinion – not a clue of what they are getting themselves into. Since the election, the government has
•stated a strong yen is in Japan’s interest;
•stated the exchange rate should be set by market forces;
•denied it said it wants to have a strong yen; and
•threatened to intervene should the yen hurt the economy.
All of this within less than two weeks; so much for consistency of policies. Why do we care about the attitude of politicians with regard to the exchange rate? Because it is a great deal easier to weaken a currency through intervention than to strengthen it.
In the meantime, the markets are not waiting until the new government makes up its mind. One of the consequences of a less predictable policy environment is that speculators are staying away from funding their bets using yen. Commonly referred to as the carry trade, speculators have in the past borrowed money cheaply in yen, then sold the yen to buy higher yielding assets elsewhere. As the credit crisis erupted, the carry trade was largely unwound, causing the yen to rise. Thinking about it another way, the Japanese are one of the largest international investors, and when they got spooked and wanted to hide all their hard-earned cash under the mattress like everyone else, where did they get there money from? Well, they had to pull it out of international markets and back into the yen, putting upward pressure on the yen in the process.
However, now as the world is once again awash in money, the yen is no longer the preferred funding currency for speculators. Instead, the U.S. dollar seems to be taking its place. Given that U.S. policies seem more predictable – a determination to print and spend money, as well as a commitment to keep interest rates low for a considerable time – speculators have more confidence to borrow cheaply in U.S. dollars, and then sell those U.S. dollars to buy higher yielding assets elsewhere.
On a short-term basis, the yen may have benefited from the hope that the new government will help induce domestic economic growth, while reducing the risk of currency intervention. After all, it is marginal demand that pushes a currency higher or lower. To round out factors affecting the yen in the short-term, Japan has also allowed the tax-free repatriation of profits earned abroad by corporations, giving the yen a short-term, but non-lasting boost.
What do we make of all of this? While the new Japanese government is settling in, aside from some short-term profit taking, the yen may continue to benefit despite a continued downward economic spiral. However, the yen may be becoming an increasingly risky proposition because of the unpredictability of Japanese policies and potential Bank of Japan intervention. The yen is likely to continue to be considered a safe haven during times of crisis. And while that’s a topic for a different analysis, we do not think the global financial crisis is over and there may be funding issues in the weeks and months ahead. In case you are not confused, you have not paid attention. But that’s the nature of trying to understand the dynamics in Japan and that’s why Goldman Sachs suggests the yen should be trading closer to 200 to the dollar, while we would not be surprised if the yen strengthened to 85 or even 80 should market forces be allowed to play out. Instead, we can be assured that policy makers will do their best to keep everyone confused – including themselves. The result is likely to be an array of policies that may ultimately be very expensive.