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Can Japan Assassinate The Yen?

Japan’s Prime Minister Shinzo Abe based his economic plan on “three arrows” of reform and stimulus, but the Bank of Japan seems less inclined to use a bow and is breaking out a bazooka instead.

At the end of October, the Bank of Japan announced a surprise round of economic stimulus that will accelerate its already aggressive campaign. The Wall Street Journal reported that the central bank would expand its annual asset purchases by tens of trillions of yen, rising to around 80 trillion yen total, or the equivalent of about $730 billion in U.S. currency. While lots of central banks, including our own, have spent large sums on stimulus, it is important to recognize that this plan will dwarf the actions taken by the U.S. Federal Reserve and the European Central Bank. By spending over 15 percent of Japan’s gross domestic product each year, the Bank of Japan will make the Fed look downright conservative.

The aggressive monetary moves look particularly timely after this week’s announcement that Japan has slipped into a recession. Gross domestic product slipped at an annualized 1.6 percent in the third quarter, the second consecutive quarter in which national output has declined following an increase in the national sales tax that took effect in April.

The Bank of Japan’s measures will not help produce the structural reforms that Japan badly needs. However, they have made clear that Japan sees another way out of its decades-long slump: weaken the yen. While Abe has denied that the Bank of Japan’s decision was designed to weaken the country’s currency deliberately, the yen fell to its lowest level in seven years following the announcement. The Financial Times reported that it had fallen 20 percent against a trade-weighted basket of currencies as of mid-November, relative to two years prior, before strengthening a bit after the recession was announced.

This raises the question of whether a country really has the power to wreck its own currency. Can Japan kill the yen through internal action, or could external factors keep such a plan from succeeding regardless of how the central bank behaves? There is no clear answer, at least so far.

Why would Japan want to wreck the yen in the first place? There are several potential benefits of doing so. First, Japan has struggled with deflation for an extended period. Though recently the country has managed a small amount of inflation, a falling currency should help spur this trend dramatically. In fact, accelerating inflation to the target of 2 percent in 2015 is the stated goal of Japan’s increased quantitative easing.

Depreciated currency will also make Japanese exports more attractive. Japan’s economy was long export-based, and its net trade surplus exerted natural upward pressure on the yen. It has recently flipped to being a net importer because of the need to import energy in the wake of the country’s decision to power down its nuclear reactors. Now the country is talking about turning the reactors back on. In early November, the governor of the Kagoshima prefecture approved the restart of two reactors at the Sendai nuclear plant, removing the last legal barrier to the resumption of activity. Most observers expect those reactors to power up sometime next year. If this happens, and leads the way to other reactors turning on as well, Japan could quickly flip back to an export economy, and the yen could begin climbing again. By taking pre-emptive measures to knock down the value of the yen, Japan can export more and grow the country’s economy in the meantime.

Japan is also a heavily indebted nation. A depreciated currency could make the country’s debt cheaper to pay off, which is an attractive prospect. And, of course, a large injection of cash will stimulate Japan’s investment markets, at least temporarily. In the immediate aftermath of the Bank of Japan’s announcement, the Nikkei 225 index reached levels it had not seen since 2007.

However, it is important to remember that all currency movements are relative. The yen won’t depreciate in a vacuum. The European Central Bank has also indicated it is open to further economic stimulus measures to combat low inflation which could, by extension, depreciate the euro relative to other currencies. The Fed, meanwhile, has followed through on its plan to wind down its quantitative easing program. The dollar has risen as a result, but the dollar cannot appreciate against other currencies forever. How intensely the yen depreciates in relative terms will depend on how other currencies move too.

It is also not yet certain whether nuclear power will return to Japan. It looks likely that some of the reactors will restart, but we can’t yet know how many and to what extent Japan will see to its own energy needs going forward. If nuclear power returns to Japan, and the country’s economy goes back to relying on exports, upward pressure on the yen may quickly reverse any currency depreciation efforts.

Abe described his three arrows as fiscal stimulus, monetary easing and structural reforms. The third is the most important of the three, and also the one that continues to lag badly behind. I have written before about the various factors that make such reform imperative. It remains difficult for Japanese companies to fire or lay off employees. Entrepreneurs and start-ups still struggle to gain a foothold in an economy that tilts heavily toward established companies. And an aging population, combined with a low birth rate and an intensely restrictive immigration system, means that it is an open question where the engine of economic growth will come from in the next few decades.

At Palisades Hudson, we choose to underweight Japanese equities due to long-term concerns about the country’s demographics and economy. We also prefer to hold shares of multinational companies headquartered in Japan, rather than smaller Japanese firms that rely on local consumers. However, we have never hedged against the yen, for several reasons. Currency movements can be notoriously difficult to predict, and hedging can be an expensive drag on returns. In addition, exposure to foreign currencies can create additional diversification within an equity portfolio, which we would expect to boost returns and lower risk over the long term.

Many U.S. investors are currently buying Japanese stocks and hedging their yen exposure back to U.S. dollars. If Abe’s third arrow doesn’t fly, or if the nuclear reactors don’t come back online, we may decide the yen is not a currency worth holding. But rather than overreact to short-term fluctuations, we are content to wait and see how things develop.

Managing Vice President Paul Jacobs, of our Atlanta office, is among the authors of our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. He wrote Chapter 12, "Retirement Plans"; Chapter 15, "Investment Approaches And Philosophy"; and Chapter 19, "A Second Act: Starting A New Venture." He also contributed to the firm’s book The High Achiever’s Guide To Wealth.

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