What if the Yen falls another 20%?

Japan’s woeful third quarter performancethe economy contracted at an annualised 1.6% rate, pushing the economy into a technical recession-has killed any remaining expectations that the government of Shinzo Abe will proceed with its original plan to raise the country’s sales tax for a second time next year to 10%. In the absence of further fiscal consolidation, this will leave the prime minister’s ‘Abenomics’ policy to revitalise Japan’s economy looking more than ever like naked mercantilism, reliant on quantitative easing to weaken the yen and boost the country’s export sector.

Over the last two years this approach has pushed the yen some 30% lower on a tradeweighted basis, taking the currency from grossly over-valued to somewhere close to fair value today. However, recent events have made clear that Abe is not prepared to settle simply for fair value. The carefully orchestrated announcement at the end of last month of the Bank of Japan’s expansion of its quantitative easing programme, together with a reshuffling of the Government Pension Investment Fund’s portfolio towards foreign assets, indicates that Abe is now planning to push the yen deep into undervalued territory in his attempt to reflate the economy.

So far, his efforts have paid meagre dividends. Although the yen has fallen precipitously, export volumes have risen only sluggishly as exporters have avoided cutting the foreign currency prices of their shipments in order to restore their profitability in yen. They resisted price cuts in much the same way between 2001 and 2006, when the yen depreciated almost 40% in real effective terms. But back then international demand was strong, allowing exports to grow 9% a year in US dollar terms even though Japan’s competitiveness did not benefit from the yen’s decline.

Today, conditions are less benign, and the only way Japan can hope for an economic boost from the export sector is by eating its rivals’ lunch. That means pushing the yen down to a level at which exporters can unleash a price war in the hope of igniting renewed export growth.

As the biggest loser from such a beggarthy-neighbour policy, Korea would be forced to respond with similar tactics. Although aggressive intervention to weaken the won would inject large amounts of liquidity into the domestic financial system-a highly undesirable development in an economy already at risk from high levels of debt-fears about the potential damage from a loss of export competitiveness would outweigh concerns over domestic debt.

The big question is how China will react. The view of Gavekal Dragonomics’ China team is that Beijing will not engage in a sustained devaluation of the renminbi for several reasons: · It would be diplomatically more difficult for China, which runs a large trade surplus, to follow Japan’s depreciation path. · A significant depreciation of the renminbi could trigger large capital outflows. With China’s financial system still fragile, the marginal gains in export competitiveness would be small compared to the threat of domestic financial instability. · Beijing’s policy of internationalising the renminbi requires a strong and stable currency. A devaluation would undermine its credibility.

However, the weaker the yen gets, the greater will grow the pressure on Beijing to follow suit. That’s not so much because Japan and China compete directly in world export markets. The bigger danger is that other Asian countries, which are major export markets for China, depreciate their own currencies in line with the yen. What’s more, the combination of quantitative easing and currency depreciation in Japan set up the yen perfectly as a funding currency for carry trades. In an environment in which Japan is creating a flood of international liquidity, a strong renminbi is likely to attract heavy capital inflows into China; inflows which could prove almost as destabilising as the outflow Beijing currently fears.

In the past, notably during the 1998 Asian crisis and the 2008 global financial crisis, Beijing put a premium on currency stability and withstood pressure to devalue the renminbi. If the yen does fall steeply from current levels Beijing will again seek to avoid any heavy and sustained depreciation of its currency.

However, if confronted with potentially dangerous capital inflows generated by a weak yen, Beijing may well decide-much as it did in the first quarter of 2014-that a greater degree of downside renminbi volatility is needed to restore the market’s equilibrium.