Japan and Europe Update

There is no good time for a disaster to hit, but this is a particular bad time for Japan. The Japanese economy is fragile, deflationary forces are still evident despite the jump in energy and food prices. Prime Minister Kan and the ruling DPJ party have been torn by internecine struggles and a series of financing scandals. In foreign affairs is a mess as Russia and China have increased their claims on contested territories. The BOJ has injected a record JPY15 trillion in to the banking system and increased its asset purchases under quantitative easing by JPY5 trilion. This appears to have helped stabilize the yen after the dollar briefly fell below JPY81.00.

Japan’s accumulated gross debt, the most among the major industrialized countries, including the periphery in Europe, constrains the use of fiscal policy. However a supplementary budget is likely. The opposition Liberal Democrat Party, which has threatened to vote against the government’s proposal to issue more than JPY44.3 trillion in JGBs in the new fiscal year beginning April 1, has indicated it will endorse spending related to the disaster.

It seems some of the money for reconstruction will be borrowed and perhaps the BOJ can be persuaded to buy those, extending what it called “rinban operations”. Some of the funds will be drawn from unspent funds in this year fiscal year’s budget.

Some observers have opined that Japan might sell some of its $880 bln holdings of US Treasuries. Recall after boosting dollar reserves in its ill-fated large-scale intervention operation in late 2003 and into early 2004, Japan gradually reduced its Treasury holdings by about $125 bln, but it has boosted its holdings steadily through the global financial crisis. In May 2008, the Japan’s Treasury holdings stood at $575 bln and have risen at a rate a little faster than $100 bln a year.

Japan could reduce its Treasury holdings, but the bulk of which are held as reserves and are generally financed with, well, financing bills. Selling US Treasuries would leave the financing bill as an uncovered debt, which is something Japanese officials have been reluctant to do. The DPJ did lose the city election in Nagoya over the weekend, which suggests the disaster may not help Kan regain his political momentum.

Some observers note that after the 1995 Kobe earthquake, the yen rallied around 20% and suggest the same could happen this time. Assuming the dollar was trading near JPY83 when the disaster struck, that would project to around JPY66.

This may be too simplistic. There were other things happening early 1995, including the US Treasury Secretary at the time, Lloyd Bentsen who was threatening a devaluation of the dollar if Japan did not make some trade concessions. Shortly thereafter Robert Rubin replaced Bentsen and announced the strong dollar policy, which was meant to signal a break from the past. There was, ironically, stories in the press about Asia central banks diversifying out of reserves and the possibility that oil would be denominated in another currency.

The dollar bottomed against the yen in July 1995 and proceeded to appreciate by 70% over the next three years. That low the dollar saw in 1995 near JPY79.75 remains the record low. This could risk a bout of intervention that would likely find some sympathy in Washington and elsewhere.

The euro has built on and is consolidating its pre-weekend gains after EU officials agreed to a broad outlines of an agreement that includes boosting the lending capacity of the EFSF and allowing it to buy sovereign bonds directly from governments are in an assistance program with strict conditionality (Ireland and Greece). The euro looks poised to challenge the $1.4035 high form earlier March 7. The pre-weekend recovery as an impressive reversal, illustrating the underlying enthusiasm.

 

Greece also received a 100 bp reduction in the interest rate on the EU assistance program and got the duration extended to 7 1/2 years from 3 years. Apparently this was in exchange for the 50 bln euro privatization program. Ireland in contrast not no concessions as it refused to budget its 12.5% corporate tax rate. (I will be posting a more detailed analysis of the European agreement shortly.)