Sun Rise, Sun Set

The decline of the yen in recent weeks is the most dramatic development among the major currencies. Previously, and frustratingly for Japanese officials and businesses, the yen was the strongest currency. From its summer high through late January, the dollar fell almost 22% against the yen. The euro and sterling’s decline was even more precipitous, falling roughly 34% and 46% respectively against the yen. On a trade-weighted basis, the yen appreciated by 35%. This is an exchange rate shock of incredible proportions.

The good news is that the yen’s bubble appears to have popped. The reversal of the yen’s fortunes is instructive. First, like the financial crisis itself, few could envision the end of the yen’s advance. Yet it has happened and without a clear cause. Some want to link the yen’s decline to Japans horrific fourth quarter GDP report, which revealed that the world’s second largest economy contracted at an annualized pace of 12.7%. However, that report was released on February 15, three weeks after the dollar and euro had already bottomed on January 21st.

Second, although there was some verbal intervention, including a special G7 statement at the end of last year, the market appeared to pay little heed and continued to drive the yen higher. Moreover, the yen turned without material or actual official intervention. The reversal of the yen is a private sector phenomenon.

Indeed in recent weeks, speculators in the Chicago futures cut their long yen positions nearly in half since the start of February. At the same time, Japanese investors have accelerated their purchases of foreign assets. Tabulating weekly Ministry of Finance data shows that Japanese investors bought a total of JPY633 billion worth of foreign stocks, bonds, and bills in December 2008, JPY2.195 trillion in the five week January period, and an incredible JPY4.310 trillion in February.

Economy is in Tatters

Japan’s economy did not appear to have the excess in housing, like the US and UK. Nor does it appear to have the leveraged loan portfolio and emerging market exposure of many continental European countries. Nevertheless, the Japanese economy has been the hardest hit and after the Ministry Of Finance’s Q4 2008 capex survey was released on March 5, there is a clear risk that the initial -12.7% estimate of Q4 GDP is revised lower in the final estimate.

The Japanese economy contracted in the last three quarter of 2008 and early data, including a whopping 10% decline in industrial output in January alone, warns that a further sharp contraction is likely already baked in the cake for the current quarter. In addition to capital investment, which has been falling for seven quarters, the other main leg of Japan’s economy is exports. In fact, Japan’s reliance on exports had increased in recent years to stand at a little more than a fifth of GDP, a significant increase from the sixth it represented a decade ago.

Exports have simply and unsurprisingly collapsed amid the synchronized contractions of the major economies. In October of last year Japanese exports had fallen 7.8% from levels a year before. In November the pace accelerated sharply to more than 25% and then 35% in December. In January, Japanese exports were almost 46% lower than January 2008. Exports to the US

were off more than 50%, while exports to Europe and Asia, including China, had fallen a little more than 45%.

Domestic demand is also poor. Wages, including over-time and bonuses are not just rising slowly. They are actually falling. In January they were 1.3% lower than a year ago. The collapse in demand is occurring faster than the cuts in output, resulting in increased inventories. This will force businesses to meet what little demand there is out of inventories and cut output even further.

Policy Response

No less so than the economy, Japanese politics are in shambles. Since Koizumi stepped down in September 2006, Japan has had three prime ministers, Abe, Fukuda and now Aso, none of whom have had a popular mandate, one of the peculiarities of the parliamentary system. It is not clear at this juncture if Prime Minister Aso, whose support ratings make former US President Bush look like Mr. Congeniality, can hold on to power long enough to lead his Liberal Democratic Party in the polls, which must be held by mid-September this year.

The government’s modest fiscal stimulus measures have been stymied by the Democratic Party of Japan, which controls the upper house of the Diet. Despite campaign financing scandals, the polls suggest the DPJ could capture the lower house in the coming election. Within the context of political paralysis, the Bank of Japan has stepped up. The government and the BOJ have unveiled several measures including the purchases of commercial paper, corporate bonds, and shares from banks, emergency loans, and loan guarantees from the government. In size and scope, there programs have not allowed Japanese officials to get ahead of the curve.

Reserves

However, there is one rather innovative measure. The government intends to tap into its reserves, which are just shy of $1 trillion, to help provide financing for Japanese multinational companies. The Ministry of Finance said it will lend $5 billon from reserves to the Japanese Bank of International Co-operation, which in turn will help companies meeting overseas funding obligations ahead of the fiscal year-end.

Finance Minister Yasano said that this is a “contingent and extraordinary step”. And indeed it is. A little more than a year ago, I wrote an op-ed piece for the Financial Times (attached below) in which I suggested that with interest rates already low and debt levels high, Japan should consider distributing a fraction, roughly 25%, of their reserves to Japanese households. The IMF quickly retorted that it did not think that Japan needed fiscal stimulus and as, the reserves had been purchased with financing bills, distributing them would have left the government with an unfunded liability.

By lending the reserves, officials avoid taking on an unfunded liability. Yet, this refusal means fiscal stimulus remains very limited. And few would argue now that Japan is not in need stronger stimulus. Through the Federal Reserve swap lines, the BOJ could secure the dollar funding its multinationals are seeking. But like the Swiss National Bank who has begun issuing their own dollar-denominated T-bills, the BOJ may want greater flexibility than the swap lines alone.

Traditionally the purpose of reserves was to protect a country from an import surge or a dramatic decline in exports. If nothing else, that is precisely what Japan is experiencing. What pray tell are officials waiting for? The $5 billon that it will lend out is well below the interest that the BOJ can count on its large reserve holdings generate.

This timidity warns that the economic downturn in Japan will be deeper and more protracted than expected. And time works against Japan. With each passing year its demographic predicament, a population that is not just aging, but also diminishing, becomes more acute.

Foreign exchange prices do not necessarily move in the direction which is conducive for policy makers, businesses or investors. Japan needs a weaker yen and insofar that this does not happen in a significant way, the greater the headwind on the Japanese economy. The yen has retreated in recent weeks, with the dollar advancing about 14.5% and the euro recovering 12.3% since January 21st However, JPY100 level and JPY126.50, for the dollar and euro respectively, likely marks a near-term top. Initially the dollar can ease back toward the JPY96.50, where a break would signal risk toward the JPY93.50 area before the yen bears make a stand. If the euro breaks below JPY122, it could quickly drop back JPY120.