Japan’s massive public debt burden, pundits have called for the demise
of the Japanese yen for years. Are the yen’s fortunes finally changing?
Our analysis shows that the days of the yen being perceived as a safe haven
may soon be over. Let us elaborate.
So many foreign exchange (“FX”)
speculators have lost money shorting the yen that the currency earned the
nickname the widow maker. Indeed, as the yen has had a weak patch as of late,
some are already cautioning the trade might be crowded. But we don’t
talk about a trade; we talk about a fundamental shift in the dynamics that
might finally be unfolding.
To understand the yen, consider the earthquakes that hit New Zealand and
Japan in early 2011: New Zealand’s shaker caused the New Zealand dollar
to fall; Japan’s earthquake, in contrast, pushed the yen higher. In the
short-term, earthquakes disrupt economic growth; conventional wisdom suggests
less growth leads to a weaker currency. However, economic growth and
currencies do not correlate as highly as one might expect. Indeed, everything
appears backwards in Japan, and there’s a reason: historically, Japan
has enjoyed a current account surplus. As a result, Japan does not rely on
inflows from abroad to finance its budget deficit. Despite conventional
wisdom, note that when there’s a shock to the economy, consumers save
more/spend less, a positive to a currency all else being equal (i.e., in the
absence of a current account deficit). In contrast, countries like the United
States, or New Zealand for that matter, have a current account deficit; in
the absence of growth, foreigners are less inclined to invest in the country,
potentially depriving the country of inflows needed to finance budget
deficits and, in the process, putting downward pressure on the currency. One
reason why U.S. policy makers favor growth over austerity is to encourage
inflows to finance the deficit. On that note, the lack of growth in the Eurozone,
where the current account is roughly in balance, may be bad for employment,
but the euro has managed to hold up reasonably well despite the crisis.
In some ways, when a country has a current account
surplus, currency dynamics may be counter-intuitive: the more dysfunctional
the Japanese government, the stronger the yen appears to have been in recent
years. Since 2005, Japan has had seven prime ministers, with another change
likely soon. A government with rotating heads suggests a government that doesn’t
get anything done. Usually a government that “gets things done”
is one that spends money, but Japan could not even get an expeditious
rebuilding effort under way after the earthquake struck.
However, Japan's current account has been
deteriorating in recent years. Consider Japan's seasonally adjusted monthly
current account balance below:
Japan is doing its part to accelerate the demise of
its current account:
- With one of the
world’s highest life expectancies, almost no net immigration and
falling birth rates, Japan’s aging population is often cited as
the key-long term driver of the country’s deteriorating current
account balance. The Japanese retire later than others in developed
countries, cushioning the impact somewhat.
- The main
“achievement” after the earthquake was announcing to abandon
nuclear energy. Increasingly relying on imported energy is bad news for
Japan's current account balance.
- Rising tensions
with China don't bode we'll for trade. Shinzo
Abe, Japan's likely prime minister to be is said to potentially escalate
tensions further. If correct, we expect Japan's current account balance
to suffer as a result.
Why does this all matter? After all, the US has had
a massive current account deficit for years. The size of the current account
deficit represents the amount foreigners need to buy in assets (local
financial assets or real assets) to keep a currency from falling. With a
current account deficit, Japan's debt to GDP ratio of over 200% may suddenly
matter, as Japan may need to offer higher rates to attract foreigners to buy
local assets (e.g., Japanese government bonds). The trouble is that
Japan’s debt might be unsustainable at higher interest rates. To the
extent that Japan has a current account surplus, it doesn't matter whether
foreigners buy the yen, but those surpluses have fallen to deficits recently
and that trend looks set to continue.
Some will argue that it still doesn't matter, as
Japan is currently more concerned with negative rates. Our analysis, however,
shows that the market does care: in recent years, the yen often appreciated
when there was a "flight to safety;" if we use the VIX index, a
popular measure of implied volatility of S&P 500 index options, as a
proxy for the amount of fear in the market, then the yen should show a high
correlation with the index. Below please see the 12-month rolling correlation
of the yen versus the VIX index:
What the chart shows is that the yen isn't the safe
haven it used to be. The yen no longer is the "go to" place when
fear is elevated. There might be many reasons for this, but we like to look
at it in the context of the current account balance, shown in the previous
chart: as the current account has deteriorated, the yen's safe haven status
appears to be eroding.
The one thing still going for the yen is that
Japanese policy makers often don't execute on their talk. For example, Abe's
election rhetoric suggests that the Bank of Japan (BOJ) will lose its
independence as the government may force it to increase its inflation target
of 1% (which it has failed to achieve) to 2 or 3 percent. But the BOJ has
failed over and over again to live up to its promises. A side effect of that
is that in recent years the BOJ's balance sheet has barely grown (the BOJ has
"printed" very little money as one might colloquially say); Japan
did its money printing in the 90s.
However, it may matter little what the BOJ is up to
once the current account deteriorates further. We don't look at these trends
as academic exercises, but rather consider the risk of acting versus not
acting. At this stage, we assess the risk of not acting to be high and are
putting our money where our mouth is.