How the Japanese can get their exchange rate down
A lot has been made of so-called Abenomics after comments in Japan about forcing the central bank to set and defend a 2% inflation target. Getting a consolidated government balance sheet from a fiscal and monetary agent working hand-in-hand would be a true paradigm shift. Nonetheless, in truth, until we actually see action, this latest move by the Japanese is just another salvo in the ongoing currency wars.
The real goal of incoming Japanese Prime Minister Shinzo Abe is to depreciate the Japanese Yen in order to boost exports. And while the talk about creating a unified monetary and fiscal regime has certainly made the Yen weak, this effect is only temporary. What really drives exchange rates is real interest rates and that means we need to see Japanese interest rates minus inflation sink relative to Japan’s peers. The problem in getting this to happen is that Japan has consumer price deflation, which means that its zero rate policy cannot force financial repression aka negative real interest rates onto buyers of Japanese Government Bonds (JGBs). Meanwhile, negative real rates are the norm across the developed and developing world. The result is that the Yen appreciates.
Up until now, the Japanese have followed the orthodox monetarist approach which favours monetary policy over fiscal policy to reflate the economy. As in the US, where policy makers are using a similar approach, this has had limited success. To the degree the Japanese have used fiscal policy, much of the deficit spending has ultimately only served to support favoured large companies without creating a sustained increase in consumer demand. And as always, there is always discomfort with large scale deficit spending as well, such that the Japanese economy has lapsed in and out of recession.
The approach that Keynesians want Japan to take is that of increasing deficit spending until consumer demand causes the economy to reach full capacity and inflation takes hold. While Abe claims that he wants to use a two-pronged approach of reflationary fiscal policy supported by accommodative monetary policy, it is not clear how much latitude he would have to try this approach. Nor is it clear that Abe actually wants to lean toward fiscal policy as his reflationary tool of choice. Noah Smith, for example, has a good piece out claiming it won’t happen.
Personally, I remain sceptical about claims that Japan just needs to deficit spend until it reaches full capacity and inflation takes hold in order for it to turn the corner. I believe there are structural issues at play in Japan due to the changing demographics. The Japanese economy is aging quickly, and this suppresses consumer demand. Once the prop of deficit spending is removed, would Japanese consumer demand continue to grow robustly? That’s the long-term question. But wat other choices do the Japanese have left? That’s a serious question because price deflation is killing the economy, interest rates have hit rock bottom and repeated cycles of quantitative easing have not yielded sustained results. The Japanese need growth.
As an investor, what we should be looking for is what happens on the fiscal front. I am not concerned about Japan imploding like Kyle Bass because I realise that to the degree foreigners lose faith in the yen as a safe haven currency due to the consolidation of monetary and fiscal policy, this will not result in higher interest rates but rather currency depreciation. A bullish scenario for Japan would be currency depreciation down to 100 or 110 yen to the US dollar, moderate real GDP growth and inflation above 0%. This would be a scenario that would be bullish for stocks and moderately bearish for long-dated JGBs due to rising inflation and interest rate expectations. The only policy response that could produce this outcome is one of yet more deficit spending. And remember, this is the (medium-term bullish scenario.
A bearish scenario for Japan would be continued currency appreciation back to 80 to 85 yen to the US dollar, combined with low or negative real GDP growth and deflation. The toxic combination of deflation and poor growth would imply economic contraction in nominal terms and thus mean that consumer demand continued to sink. The appreciating currency would also cut into export growth and would imply larger government deficits despite the poor growth numbers. This is a scenario that is bearish for stocks and neutral to bullish for JGBs.
The bottom line here is that Japan’s government can continue to deficit spend for quite a while longer without economic Armageddon. But this does not necessarily ensure sustained economic growth even if the government kept at it until employment and industrial capacity reached their limits. Japan is in a deflation that is exacerbated by the demographic challenges of an aging society. Where and how this ends is anybody’s guess. But I don’t expect huge convulsions in 2013.
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