A Yen for Misbehaving

The widening discrepancy between the yen and economic fundamentals raises the risk of market intervention by the Bank of Japan. Officials have made verbal interventions yet the yen proceeds to strengthen versus the U.S. dollar, ignoring the sharp slowdown in Japan’s Q2 GDP growth and instead feeding off the Federal Reserve’s entry to quantitative easing. Export volumes have yet to fully reflect the impact of a strong yen, shrinking only slightly in June, but export values have already tapered off. Q3 exports may show a more pronounced effect as the yen sinks further below the 92 yen breakeven level for exporters, lowering export volumes and local currency revenues and delaying repatriation of Japanese assets overseas. A strong yen also lowers import prices, counteracting efforts to end deflation.

BoJ Intervention in the Offing?

The BoJ will first wait for thin summer trading to give way to higher liquidity. If yen appreciation appears to be more than a temporary phenomenon amplified by low market liquidity, and the yen drags down the Nikkei, the BoJ will ease monetary policy to weaken the yen – as it did after the Dubai shock in December 2009. Though the wealth effect from a stock market decline is small (stocks represented only 17% of household financial assets at the peak of the stock bubble) and the corporate financing effect is minor (Japanese firms raise capital through debt more than equity and are flush with retained earnings), a sustained decline in asset values would strain cross-shareholding relationships between banks and non-bank firms. The plunge in GDP growth to 0.1% q/q in Q2 reveals Japan skates dangerously close to dipping back into a recession. BoJ Governor Shirakawa may need to reconsider his belief that the downside and upside risks to the economy are balanced.

If increasing yen supplies fails to curb appreciation, BoJ may intervene unilaterally in the market. Coordinated intervention to weaken the yen like the G7 did in 1995 is out of the question given other countries are also struggling to sustain export growth. Shirakawa resists meddling in the market, though, as he believes monetary policy is not the answer to Japanese deflation and cannot provide significant stimulus anymore when the overnight call rate is already down to 0.1% yet locals eschew borrowing. Legislators overlook other barriers to Japanese growth. Besides, the effect of unilateral currency interventions tend not to last and, as the Swiss central bank’s interventions earlier this year show, victory is Pyrrhic at best.

See RGE Critical Issues: Will They Won’t They? Is it Time Japan Intervened to Weaken the Yen? and Yen Outlook: Will the Yen Ever Weaken?

Or Fiscal Stimulus to the Rescue… Again?

Expanding the BoJ’s lending facilities may scare off yen investors, but will not counteract the weak borrowing demand that has parried off such attacks on deflation. Many companies don’t need more loans; they sit on a pile of cash or park their retained earnings in government bonds or foreign securities. They just see a regrettable lack of fixed investment opportunities at home and, at the moment, overseas as well.

To help break the deadlock, albeit temporarily, Japan’s fiscal policymakers could step in and extend the deadline on subsidies for eco-friendly cars. Vehicle sales waned before the end of the subsidy program because popular models purchased in July or August may arrive to customers too late to qualify for the subsidy. The end of similar subsidies in Europe caused auto sales to drop at double-digit rates on an annual basis. Toyota and Honda plan to cut output after the subsidy ends September, which will slow production down the supply chain and threaten jobs and overtime pay.

If the BoJ doesn’t budge on the yen, the government might. Injecting funds into the private sector via additional fiscal stimulus would raise yen supplies and inflate the currency. However, the Diet’s focus back on fiscal consolidation suggests that “additional fiscal stimulus” will not actually mean an increase in spending, but merely a reallocation of spending, e.g. diverting a larger share of the 1 trillion yen stimulus fund or the annual budget to prefectures lacking strong local industries.

Also see RGE Critical Issue: Is Japan Undergoing a Credit Crunch?

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