Because of Japan’s massive public debt burden,
pundits have called for the demise of the Japanese yen for years. Are
the yen’s fortunes finally changing? Our analysis shows that the days of
the yen being perceived as a safe haven may soon be over. Let us
elaborate.
So many foreign exchange (“FX”)
speculators have lost money shorting the yen that the currency earned
the nickname the widow maker. Indeed, as the yen has had a weak patch as
of late, some are already cautioning the trade might be crowded. But we
don’t talk about a trade; we talk about a fundamental shift in the
dynamics that might finally be unfolding.
To understand the yen, consider the
earthquakes that hit New Zealand and Japan in early 2011: New Zealand’s
shaker caused the New Zealand dollar to fall; Japan’s earthquake, in
contrast, pushed the yen higher. In the short-term, earthquakes disrupt
economic growth; conventional wisdom suggests less growth leads to a
weaker currency. However, economic growth and currencies do not
correlate as highly as one might expect. Indeed, everything appears
backwards in Japan, and there’s a reason: historically, Japan has
enjoyed a current account
surplus. As a result, Japan does not rely on inflows from abroad to
finance its budget deficit. Despite conventional wisdom, note that when
there’s a shock to the economy, consumers save more/spend less, a
positive to a currency all else being equal (i.e., in the absence of a
current account deficit). In contrast, countries like the United States,
or New Zealand for that matter, have a current account deficit; in the
absence of growth, foreigners are less inclined to invest in the
country, potentially depriving the country of inflows needed to finance
budget deficits and, in the process, putting downward pressure on the
currency. One reason why U.S. policy makers favor growth over austerity
is to encourage inflows to finance the deficit. On that note, the lack
of growth in the Eurozone, where the current account is roughly in
balance, may be bad for employment, but the euro has managed to hold up
reasonably well despite the crisis.
In some ways, when a country has a current
account surplus, currency dynamics may be counter-intuitive: the more
dysfunctional the Japanese government, the stronger the yen appears to
have been in recent years. Since 2005, Japan has had seven prime
ministers, with another change likely soon. A government with rotating
heads suggests a government that doesn’t get anything done. Usually a
government that “gets things done” is one that spends money, but Japan
could not even get an expeditious rebuilding effort under way after the
earthquake struck.
However, Japan's current account has been
deteriorating in recent years. Consider Japan's seasonally adjusted
monthly current account balance below:
(Click on images to enlarge)
Japan is doing its part to accelerate the demise of its current account:
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With one of the world’s highest life
expectancies, almost no net immigration and falling birth rates, Japan’s
aging population is often cited as the key-long term driver of the
country’s deteriorating current account balance. The Japanese retire
later than others in developed countries, cushioning the impact
somewhat.
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The main “achievement” after the
earthquake was announcing to abandon nuclear energy. Increasingly
relying on imported energy is bad news for Japan's current account
balance.
-
Rising tensions with China don't bode
we'll for trade. Shinzo Abe, Japan's likely prime minister to be is said
to potentially escalate tensions further. If correct, we expect Japan's
current account balance to suffer as a result.
Why does this all matter? After all, the
US has had a massive current account deficit for years. The size of the
current account deficit represents the amount foreigners need to buy in
assets (local financial assets or real assets) to keep a currency from
falling. With a current account deficit, Japan's debt to GDP ratio of
over 200% may suddenly matter, as Japan may need to offer higher rates
to attract foreigners to buy local assets (e.g., Japanese government
bonds). The trouble is that Japan’s debt might be unsustainable at
higher interest rates. To the extent that Japan has a current account
surplus, it doesn't matter whether foreigners buy the yen, but those
surpluses have fallen to deficits recently and that trend looks set to
continue.
Some will argue that it still doesn't
matter, as Japan is currently more concerned with negative rates. Our
analysis, however, shows that the market does care: in recent years, the
yen often appreciated when there was a "flight to safety;" if we use
the VIX index, a popular measure of implied volatility of S&P 500
index options, as a proxy for the amount of fear in the market, then the
yen should show a high correlation with the index. Below please see the
12-month rolling correlation of the yen versus the VIX index:
What the chart shows is that the yen isn't
the safe haven it used to be. The yen no longer is the "go to" place
when fear is elevated. There might be many reasons for this, but we like
to look at it in the context of the current account balance, shown in
the previous chart: as the current account has deteriorated, the yen's
safe haven status appears to be eroding.
The one thing still going for the yen is
that Japanese policy makers often don't execute on their talk. For
example, Abe's election rhetoric suggests that the Bank of Japan (BOJ)
will lose its independence as the government may force it to increase
its inflation target of 1% (which it has failed to achieve) to 2 or 3
percent. But the BOJ has failed over and over again to live up to its
promises. A side effect of that is that in recent years the BOJ's
balance sheet has barely grown (the BOJ has "printed" very little money
as one might colloquially say); Japan did its money printing in the 90s.
However, it may matter little what the BOJ
is up to once the current account deteriorates further. We don't look
at these trends as academic exercises, but rather consider the risk of
acting versus not acting. At this stage, we assess the risk of not
acting to be high and are putting our money where our mouth is.
Article Source: 321gold