- 2000: Volume 9, No. 3 Japanese Yen: Situation Report

Despite its relatively small land area and limited natural resources, Japan is one of the world's key economic engines. But dependence on trade makes Japan vulnerable to foreign exchange rate risk. It is critical that Japanese exports be competitively priced. When the Asian economic meltdown hit in the autumn of 1997, some of the hardest hit countries were Japan's major trading partners.

As Asian (and world) economies continue to recover from 1997, it would appear that Japan is well-positioned to benefit.

Japanese recovery, however, is not a foregone conclusion. Structural economic problems—aside from exports—remain: the ratio of debt to GDP is high and the inclination to spend more to fix the economy through deficit spending and forex manipulation is deeply ingrained.

Despite these cautionary signs, we are bullish on the economy's long-term prospects, which should eventually lead to higher interest rates and a strengthening yen.

This report is intended as a background briefing to assist traders in their decision-making. It is not a course in international finance. While this information is believed to be correct and relevant, none of the factors described can be regarded as determinative of future price action.

Figure 1

Current Problems and Opportunities for Japan and the Yen

Japan is stuck in an economic rut and having a difficult time moving back toward expansion. If and when the economy rights itself, the yen should strengthen as real interest rates rise. The yen trended higher throughout much of 1999 in anticipation of improved exports as various trading partners increased their demand for Japanese products.

Throughout much of the postwar era, those products have benefited from either the perception of superior quality and an undervalued yen, which made them relatively cheap. Neither of those advantages remains today. Instead, there exists a complex array of issues which can have an impact for good or ill. Some of the more significant ones are summarized below.

Figure 2

Supplementary Budgets

In response to the recessionary wave of the late nineties, Japan has budgeted 10+ trillion yen in each fiscal year 1998, 1999, and 2000 for what is generally termed supplementary budgets.

The exact amount of these budgets is subject to debate. The patchwork of programs may or may not constitute "real water" (actual new spending) as opposed to spending shifted from an existing program to one that appears new. Much political wrangling is expended on the supplementary budget appropriation process and, in fact, it seems to be falling out of favor even with the participating politicians. Standard political rhetoric lately tracks along the lines of 1) no supplementary budget is needed 2) only a small supplementary budget is needed and 3) only one supplementary budget is needed, but 4) we won't need one next year.

Supplementary budgets are, of course, designed to prime the economic pump by maintaining employment and bolstering demand in a recessionary climate. Japan is experiencing the limits of Keynesianism in attempting this policy: as the last runways are paved and subways completed, charges of waste and corruption are beginning to surface. Worst of all, supplementary spending doesn't seem to be jump-starting anything. Look for the fiscal year 2001 budget cycle to incorporate some of previous years' supplementary spending into the regular budget and de-emphasize the entire "supplementary/real water" issue. In the recent past, the yen has tended to react strongly to supplementary news-expect less reaction in the future.

Interest Rates and Easing

Interest rates in Japan are a contentious issue at the moment. The current policy of the Bank of Japan is termed the Zero Interest Rate Policy and, in fact, the unsecured overnight call rate has hovered in the .3 percent area for months. But instead of such an "accommodative" rate stimulating economic activity, it seems to have had no effect.

Critics of the Bank of Japan's policy contend that real interest rates remain too high—that as long as potential borrowers expect deflation they have no incentive to borrow and generate economic activity. What is needed, they say, is "quantitative easing"—adding liquidity to the monetary system.

Bank of Japan president Hayami opposes any such easing, insisting that it is unnecessary and even extra-legal. Nevertheless, minutes of BOJ meetings indicate that methods of "legal" easing are under active consideration.

Any further softening of Hayami's opposition could be expected to send the yen lower.

Intervention

Over the past year, the Bank of Japan has actively sold yen and bought dollars in an attempt to hold the yen down. Their objective is to keep Japanese exports cheap relative to those of competing countries.

The success of the selling is questionable. For the calendar year 1999, there were perhaps eight to 10 rounds of intervention (some are confirmed, some are not) none of which had more than a passing effect on the dollar/yen cross rate.

Such intervention can be characterized as pro forma: designed to prevent traders from getting overly long the yen by reminding them the central bank stands ready to sell. The amounts being spent on intervention have been small and spread over such a long time that the BOJ seems to be tacitly admitting that they cannot reverse the upward trend—only send a message.

Intervention has been a "Japan-against-the-world" proposition. There has been little or no joint participation by the U.S. Fed or European Central Bank, indicating a basic disagreement among the central bankers as to the efficacy of intervention as a solution for Japan's sluggish economy.

The plausibility of intervention was undermined with the mid-1999 resignation of Ministry of Finance official Eisuke Sakakibara. His successor, Haruhiko Kuroda, has threatened intervention so frequently that his credibility has suffered.

There is no longer a consensus even among the host of Japanese finance ministers, that intervention is the best course of action. While most, like Kuroda, remain intervention hawks publicly, others have attempted to downplay the importance of intervention.

Intervention remains a risk to be considered when establishing a position—especially due to the U.S./Japan time differential which results in most intervention occurring during the overnight U.S. session. But by judiciously managing a position, primarily through the use of options, the risk/reward ratio can be held to a reasonable level.

Trade

While Japanese economic success was built on foreign trade, today's finance ministers probably over-emphasize its importance. This emphasis is a natural result of years of growing market dominance by Sony, Honda, Mitsubishi, et al. But this dominance resulted largely from two factors which are unlikely to recur soon.

First, for many of the last 50 years, Japan has had a guaranteed trade-edge: the central banks held the yen to artificially low levels, resulting in comparatively inexpensive Japanese products. Today's international system of floating currency values precludes development of such an advantage in the foreseeable future.

Less quantifiable was the "quality" window which provided a brief (ca. 1965-1985) but important opportunity for Japanese manufacturers to gain market share, especially at the expense of U.S. automakers. International competitiveness is unlikely to permit such an anomaly to reappear.

Immediate prospects: MITI will continue to issue plans and studies. The Ministry of Finance will continue to agonize publicly when the yen rises. But Japan is largely at the mercy of circumstances on trade issues. Continued recovery among Pacific Rim trading partners would be beneficial. A major risk is further devaluation of the Chinese yuan which would severely cut into Japan's regional competitiveness.

Figure 3

Debt

Reasonable economists differ on whether Japan's debt level is high (gross debt 110 percent of GDP) or low (net debt about 38 percent of GDP). The gross debt places them among the highest of G-7 members and their net debt among the lowest. What all do agree on is that both measures have increased rapidly over the past five years.

Many trillions of yen have been borrowed and spent on various schemes to impel the economy back to its previous heights. Whether or not intervention or bank bailouts or supplementary budgets have worked is problematical. Advocates of each claim that Japan's still sluggish performance would be much worse without them.

The reality is that Japan is nearing the end of its borrow-and-spend rope: credit rating services are actively considering whether Japan's creditworthiness should be downgraded. Consequently, this issue holds little future promise as a solution to Japan's problems.

Figure 4

Banking Reform

Widespread bank failures—due mostly to the burst asset bubble have been a persistent, severe drag on Japan through much of the nineties.

The issue has been addressed repeatedly by the government and the Bank of Japan over the last decade. Huge writeoffs of bad loans have resulted in reduced tax revenue. Consolidations and massive capital injections have dwarfed the scale of the U.S. savings and loan bailout of the eighties. "Big Bang" financial reforms targeted issues of profitability and accountability with, so far, limited results. An unintended consequence of reform has been reduced availability of credit under the new rules, further inhibiting economic activity.

And while reforms have been implemented, their enforcement is suspect. Until a consensus develops to truly reform the apparently political system of bailouts and financial cronyism, this will remain a weak link in the economy. More than one government has fallen victim to this issue. Look for the Obuchi regime to continue to take flak as well.

Currency Gimicks

In an apparent endeavor to leave no idea untried, the Obuchi administration has taken to tinkering with the form of money itself. For example:

• Introduction, in July 2000, of the first new currency denomination since December 1958, the 2000 yen note. Currently, the only notes in circulation are the 1,000, 5,000 and 10,000 yen. The government actually talks up the introduction of the new note as a potential economic stimulus.
• Issuance, of "shopping certificates" cash vouchers redeemable only with local merchants. The experiment seemed not to accomplish its goal of stimulating consumer spending. Many of the certificates went unspent.
• Local use of non-government issued currency: An island off the coast of Yamaguchi prefecture recently introduced (with some fanfare) "ecomoney"-- essentially formalized local barter.

These and similar measures are intended to target an increasingly ingrained recession mentality that has kept a lid on domestic demand. Give the administration some credit for effort and imagination—but Japan's economic problems are not superficial and won't be solved by gimmickry.

Tim Zurick is a currency and optionsspecialist at Alaron Trading, Chicago. You can reach him at 800-563-9518 orvia email: tzurick@alaron.com.