Abenomics: Where the Rubber Hits the Road

On Thursday in Tokyo, before the Prime Minister Abe has lunch, he will formally nominate the new Bank of Japan management team.  Former MOF and now Asian Development Bank head Haruhiko Kuroda has now been widely tipped to get the nod for governor and the main opposition party informally has indicated its approval.  

As we argued earlier this month,  Kuroda was the superior candidate among the frequently cited names.  He has the strongest international standing and while a critic of the BOJ, did not advocate, as far as we can tell, the purchase of foreign bonds or changing the BOJ's mandate.  The main concern was about leaving the ADB post.  However, our contacts report that at the recent G20 meeting China seemed to indicate it would not contest the completion of Kuroda's term by another Japanese candidate.  

When he was at the MOF, Kuroda did oversee large scale unilateral intervention.  However, on this side of  G7/G20 meeting, we see Japanese officials respecting the spirit of the "rules of engagement" as they have evolved in recent years.  Officials have shied away from commenting directly on the foreign exchange market and have not suggests bilateral targets in at least three weeks.  

Along with Kuroda, two deputies will be named.  The first and likely to be the deputy governor is Kikuo Iwata, Like Kuroda he has advocated buying more longer-dated government bonds as the thrust of the asset purchase program.  Currently, the BOJ buys government bonds with up to three-years maturity.  The two agree that flooding the market with newly printed money can end deflation. 

The other deputy is expected to be Hiroshi Nakaso.  What he may bring to the table is not so much about the formation of policy but understanding the BOJ as an institution and other central banks. 

The appointment of the new BOJ management team may mark the end of the Abe government honeymoon.  The supplemental budget has already been put into place and tomorrow the monetary team will be.   We suspect the next phase will be the investors looking more closely at Abenomics with a more critical eye.

In several ways we suggest the Abe government got lucky and its luck may be running out.  It got lucky in the sense that as it began to talk the yen down, the desire for safe haven was waning.  The deterioration of Japanese external accounts was hardly of Abe's making, but that also weighed on the yen .  Abe also benefited from the herding effect--by that we mean that many portfolio managers were underweight the Nikkei and as it rallied in the face of the weakening yen, they were forced to chase it or under perform their benchmarks. 

Over the last few months, investors were content to go with the flow, so to speak.  Now, however, as the Italian election results renew concern about systemic risk from Europe and Bernanke's commitment to continuing QE3+, resulting in roughly a 15 bp decline in the US 10-year yield, the virtuous cycle is going in reverse.  Investors are taking profits on the Nikkei and covering short yen positions. 

In some ways, sentiment follows the price action.  The 3-4% recovery in the yen will encourage observers to begin questioning the likely success of Abenomics.  The LDP government is unlikely to be spend the supplemental budget by the end of the fiscal year--March 30.  Nor is monetary policy likely to prove much more effective.  Interest rates are already extremely low in Japan.  Is pushing the 10-year yield lower from the current 66 bp annualized going to make much of a difference ? 

To the contrary the risk is to the extent lower yields are engineered, it will exacerbate the deflationary pressures in Japan.  We argue the source of deflation is excess capacity and over-investment in key industries.   Interest rates are the return on capital.  The only way the return on capital can be so low is if the supply of it is in excess of demand.  Providing cheaper capital will not overcome the "pushing on a string" phenomenon. 

Abenomics is the traditional LDP economic policy on steroids.  It distracts from the kind of structural reforms that are necessary to boost Japanese growth capacity.   Increasing labor market participation, by making it easier for the famous Mrs Watanabe, the proverbial Japanese housewife that manages household finances, to bring her skills to the market economy.  Opening up parts of the economy to greater competition, easing barriers to entry and exit is important.  Redeploying Japanese savings, which are buried in the postal saving systems earning practically nothing, to reinvigorate innovation does not appear to be under consideration. 

The dollar's push to almost JPY94.80 on Monday seemed to complete the multi-month advance.  The JPY90 level seems to be the key to whether there is a broad side ways consolidation of a outright correction.  A correction can see the dollar slip back to the JPY88.00 area and possibly JPY86.00.  This would be broadly consistent with a protracted period of political uncertainty in Europe and soft US yields.