Looming Challenge for Japan

There are two important developments in Japan that may be lost in the shuffle between the heightened uncertainty in Europe now that Italian voters appear to have rejected Brussels/Monti austerity and the US self-inflicted sequester. 

The first is that deflationary forces have tightened their grip on the world's third largest economy. The second are the weekly portfolio flows that warn that the old recycling problem may be back. 

Japan reported inflation fell for the 8th time in 9 months in January.   Headline CPI has fallen 0.3% year-over-year.  It had finished 2012 0.1% below year ago levels.  

Tokyo's CPI for February was also reported.  It tends to catch national trends.  Tokyo CPI fell sharply in February.  The -0.9% year-of-year pace was nearly twice January's 0.5% decline and matches the most acute deflation since August 2010.  

As we have noted, the price of money--in this case the exchange rate-- moves much quicker than the prices of goods and services.  It may be too early to make a firm judgment, especially as administered prices like for wheat, are on the rise.  Nevertheless, it shows that the new BOJ team has its work cut out for itself to achieve 1% CPI let alone 2%.  

Many global fund managers were underweight Japanese equities relative to their benchmark, which makes sense given their poor performance.  However,as the yen began weakening in earnest from mid-November last year, many were forced to chase the Nikkei (or Topix) higher.   

Foreign investors were more important buyers of JGBs in the first half of last year, but with a weakening of the yen, they rotated from bonds to stocks.  However, the equity purchases appear to be slowing.  The most recently weekly purchases were the least of the year and the 4-week moving average (to smooth out some of the volatility of this high frequency series) is JPY254 bln, which, while higher than time in the first 11 months of 2012, is considerably below the JPY400 bln peak in early Jan.  Over the past four weeks, foreign investors have sold an average of JPY197.4 bln of Japanese bonds

The decline of the yen, however, is not spurring Japanese investors to buy foreign assets.  On the contrary, they have turned significant sellers of foreign assets.  Over the past four weeks they have sold an average of JPY851.3 bln of foreign assets.  This is the highest 4-week average net sales since 2002. 

Therein lies the rub.  Previously, Japan had problems recycling its trade surplus.  This entailed selling enough yen to offset the yen that coming into the country as a product largely of its trade surplus.  The yen appreciated when  the surplus was not offset.  Then there was a greater understanding that the investment income surplus (from coupons and dividends and royalties and licensing fees) was a key driver of the external surplus (current account).   Now the new foreign interest adds a new dimension to the old recycling problem.