Guest writer: Ms. Malavika Belavangala

Last year it seemed that Japan’s sun was finally rising again. The Yen, seen throughout the world as a safe haven for investors, was one of the most stable and best performing currencies. The optimism with the election of the new government, and in November, Bank of Japan’s 10 trillion yen financial stimulus took the Yen to a 14-year high of 84.82 to the dollar. The political shift signified a positive picture for currency markets because new Finance Minister Hiroshida Fujii was a strong advocate for letting markets decide. This fuelled a rally for the Yen.

WILL POLITICAL CLOUDS DIM THE YEN?
Beginning of 2010, the Japanese government accepted an ailing Fujii’s resignation. Fujii, maintained the principle that government would not intervene to curb the yen’s strength and there need be no fear of export protection. His resignation prompted a jolt in the forex markets and the Yen stopped its rally sending the dollar/yen exchange rate to 92.4.

The appointment of Naoto Kan as new Finance Minister got the response of another drop against the dollar to 93.6. Kan (with less hawkish views than Fujii) vocally and controversially expressed his preference for a weaker Yen as well as intervention. His aim with a weak Yen is to make domestic exports more competitive in the world market. A rebuke by Prime Minister Hatoyama for this statement made Kan back-track his call. However, the currency dropped against the dollar to a four-month low of 93.78. Here is much for us to figure out. We can see undercurrents of a dispute among government officials over currency policy. Then definitely, the export sector is a lot more problematic. And clearly, as of now the government policy itself is unclear!

DEFLATION TALK

Major exporters including Honda Motors complained about the high level of the Yen as they faced poor domestic demand recovery and deflation (prices fell by 2.5% by the end of 2009). In Q4 2009, GDP grew the highest in two years. But not enough for interest rates to rise substantially above 0% or to stimulate consumer spending, which makes about 60 percent of the economy. Well, at least Japan doesn’t have the problem of heavily indebted private households like USA or UK.

Did I speak to soon? Japan’s public debt is projected by the IMF to touch 225% of GDP this year, and 250% in 2014. This is the highest among industrialized nations. In the near future, the new government’s two proposed spending plans and the Y10 trillion stimulus will undermine reigning in public debt. Government may also resort to becoming net seller of JGBs. I see the unsustainable levels as not only an immediate problem. It will expand out to a sovereign debt crisis this year, and add to the risk of a global debt crisis.

SAFETY FIRST

Most of Japan’s problems are in the long term. And pointing toward a possible ‘double-dip recession.’ Despite weak fundamentals, three points convince me of the future. The Japanese people’s savings. Continuing production and exports. And a still cheap and competitive currency.

Coming back to the Yen. Though no longer the lowest-yielding major currency, the Yen continues its safe status on risk-averse investors’ portfolios. This is despite its volatility. The currency is more interesting to see over time. In the chart below, what is prominent is the crucial level of “85” against the dollar. Even about a decade ago the Yen stopped about the 85 mark, similar to Nov 2009.

INTERVENTION YES OR NO ?

The chart is quite interesting. As the world changes all the time one cannot predict the future by looking at prior developments.
No doubt that 85 in USD/JPY means a lot now. Increasing risk reduction the coming months will lead to capital inflow into Japan. Naoto Kan’s comments make me believe there will now be more support for official intervention (last seen in 2004) in determining Yen exchange rates if the currency is set too high. According to Kan this deciding level would be appropriate when at 90 to the dollar. This is a significant political statement.

Naoto Kan will simply be tested, is he around or not with the intervention weapon. I think yes, and the Japanese Ministry of Finance has heavy ammunition. First, they have an unlimited amount of Yen to sell, it’s simply to start the printing machine. Second, they would love to have inflation so they have problems monetary expansion (the excess liquidity will most likely stay in the financial system but Bank of Japan can absorb it through money market instruments – sterilized intervention).
If Naoto Kan takes the fight he will win, so around 85 in USD/JPY it will be time to consider the long-term risk position in JPY.

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