What if the Yen falls another 20%?

Financial Mirror (Cyprus) - - FRONT PAGE -

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.

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