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Confusion is currency of the day
By Axel Merk
The US dollar has been getting a beating from all sides, and its woes may be
far from over. Recent developments in Japan, China, Germany and the United
Kingdom, not to speak of domestic developments in the US, point to a rocky road
ahead. Today's focus is on Japan and, more specifically, how a country on a
downward economic spiral can have a strong currency.
Exchange rates are subject to the forces of supply and demand - the flow of
funds - of the underlying currencies. While conventional wisdom dictates that a
growing economy may attract more foreign investment, a better gauge may be to
look at a country's dependence on foreign investment.
The US, with a severe current account deficit, depends on foreigners buying
about US$2 billion worth of US-denominated
assets every single day just to keep the currency stable. The current account
deficit reflects a country's trade deficit plus any financing requirements,
such as government spending, that are financed from foreigners rather than
domestically. The currencies of countries with significant current account
deficits, such as the US, Australia and New Zealand, tend to be more volatile
during periods when market participants do not have a clear view on whether the
economies will experience growth or not.
However, the Japanese economy is less sensitive to capital flows from abroad;
instead, if market forces were allowed to play out, frightened Japanese
consumers might even save more as their economy continues on its downward
spiral. The Japanese yen may perform better the less effective the government
is: as the former Japanese government's leadership became ineffective and the
Bank of Japan received no instructions to intervene in the currency markets,
the yen was able to rise.
To further illustrate the point, consider that Federal Reserve chairman Ben
Bernanke has repeatedly emphasized that the US emerged from the Great
Depression because of (a) a guarantee of retail deposits (think guarantee of
the entire banking system in the most recent crisis) and (b) the US going off
the gold standard to weaken the US dollar and allow the price level to rise.
Our interpretation is that the Fed wants to have a weaker US dollar to induce
inflation to allow home prices to rise and bail out those with debt. Think
about it this way: if someone takes half your net worth (purchasing power)
away, you may have a greater incentive to work, thus creating headline economic
growth and employment. Destroying purchasing power may not be the Fed's
mandate, but this approach may be aimed at boosting employment.
By making US assets relatively unattractive, the Fed is, in our view,
effectively attempting to weaken the currency. The Fed has been aggressively
buying mortgage-backed securities and government bonds; these securities are
now intentionally overpriced and thus may no longer be attractive to rational
buyers. We are not just talking about foreigners potentially reducing their
appetite for US securities, but domestic buyers as well; we see this as an
increasing number of US corporations are hedging their domestic currency risk.
Now think about what happens to a region's currency when the central bank is
not as aggressive. Think euro zone - economic growth in the euro zone may be
nothing to write home about, but it may be because the European Central Bank
has shown more restraint that the currency has been strengthening relative to
the US dollar. The forces that have driven the Japanese yen higher are similar
to those supporting the euro.
Does it mean all is well in Japan and Europe? No. Quite the contrary, but
flow-of-funds issues are more relevant to short- and medium-term valuation
dynamics than challenges in a country's balance sheet. In the case of Europe,
the banking sector has major challenges still ahead, but the European Central
Bank's approach of providing unlimited liquidity to the sector is likely to
keep zombie banks alive; that bodes badly for economic growth, but can support
a strong currency.
In Japan, the massive government debt is a long-term issue that will become a
short-term issue when financing issues arise. In a world where the Japanese
banking system is perceived to be one of the safest in the world (what a scary
thought!), and the market appears pre-occupied with only the most imminent
financial issues, these problems, at least for now, appear to be in the distant
future.
Or are they? Long-term challenges can become short-term headaches when someone
rocks the boat too much. A new government stirring up dust is a perfect
opportunity to have a lingering problem turn into a full-blown crisis. To look
into our crystal ball for where Japan and the Japanese yen may be heading,
let's look at the newly elected Democratic Party of Japan (DPJ) as it pursues
an eclectic policy mix of decentralization, socialism and select pro-business
initiatives. Some of the highlights relevant for the currency may be:
The DPJ wants to take an axe to a system run by bureaucrats - that's good for
change; the party further wants to move power to the regions. However, rather
than encouraging a less-bureaucratic federal system, the DPJ intends to replace
bureaucrats with politicians. Think political appointees at all levels of
society. I can't help but think of the French, where disillusioned citizens
vote for change election after election, but get change in a direction they had
never imagined or necessarily wished for. The US has similar challenges when it
comes to implementing change, but political appointees are not as pervasive
(all things are relative ... ) as they are in France.
Unions are the main backers of the DPJ; not surprisingly, the DPJ wants to halt
the privatization of the Japanese Post Bank. As a refresher to a topic that has
been out of the headlines for some time: the Japanese Post Bank has over $3
trillion equivalent in deposits, a consequence of what had been a very weak
banking system where deposits fled to the one bank with state guarantees.
The Post Bank has been instrumental in financing government deficits; we argued
a couple of years ago that a privatization may be inflationary, as a privatized
institution might be more risk friendly and deploy its asset base more
aggressively. As a result of the policy reversal, this potential boost to
economic growth may not materialize.
The DPJ has numerous populist ideas, from generous child allowances to
cancellation of road tolls to generous pension and health benefits. To finance
all these programs, "wasteful spending" elsewhere shall be cut. This sounds all
too familiar and is likely to be the same as in any other country: expensive.
The DPJ wants to move power from large businesses to small businesses, from the
cities to the regions.
When the yen started to rise in the days after DPJ's election victory,
politicians boasted how this would strengthen domestic purchasing power for
consumers. Well, it does, but it also hurts exports. Japan is traditionally one
of the world's best exporters and has the world's worst consumers. While it is
laudable that a government wants to strengthen consumer's purchasing power, the
question is whether the government truly has the willpower to pursue this
policy. From what we can see, the government stayed on course for about a week.
When it comes to analyzing developing countries' currencies, what makes our job
traditionally quite easy is how predictable policymakers are. Not so in Japan.
The new Japanese government has an array of ideas, but - in our humble opinion
- not a clue of what they are getting themselves into. Since the election, the
government has stated a strong yen is in Japan's interest; stated the exchange
rate should be set by market forces; denied it said it wants to have a strong
yen; and threatened to intervene should the yen hurt the economy.
All of this within less than two weeks. So much for consistency of policies.
Why do we care about the attitude of politicians with regard to the exchange
rate? Because it is a great deal easier to weaken a currency through
intervention than to strengthen it.
In the meantime, the markets are not waiting until the new government makes up
its mind. One of the consequences of a less predictable policy environment is
that speculators are staying away from funding their bets using yen. Commonly
referred to as the carry trade, speculators have in the past borrowed money
cheaply in yen, then sold the yen to buy higher yielding assets elsewhere. As
the credit crisis erupted, the carry trade was largely unwound, causing the yen
to rise.
Thinking about it another way, the Japanese are one of the largest
international investors, and when they got spooked and wanted to hide all their
hard-earned cash under the mattress like everyone else, where did they get
there money from? Well, they had to pull it out of international markets and
back into the yen, putting upward pressure on the yen in the process.
However, as the world is once again awash in money, the yen now is no longer
the preferred funding currency for speculators. Instead, the US dollar seems to
be taking its place. Given that US policies seem more predictable - a
determination to print and spend money, as well as a commitment to keep
interest rates low for a considerable time - speculators have more confidence
to borrow cheaply in US dollars, and then sell those US dollars to buy higher
yielding assets elsewhere.
On a short-term basis, the yen may have benefited from the hope that the new
government will help induce domestic economic growth, while reducing the risk
of currency intervention. After all, it is marginal demand that pushes a
currency higher or lower. To round out factors affecting the yen in the
short-term, Japan has also allowed the tax-free repatriation of profits earned
abroad by corporations, giving the yen a short-term, but non-lasting boost.
What do we make of all of this? While the new Japanese government is settling
in, aside from some short-term profit taking, the yen may continue to benefit
despite a continued downward economic spiral. However, the yen may be becoming
an increasingly risky proposition because of the unpredictability of Japanese
policies and potential Bank of Japan intervention.
The yen is likely to continue to be considered a safe haven during times of
crisis. And while that's a topic for a different analysis, we do not think the
global financial crisis is over and there may be funding issues in the weeks
and months ahead.
In case you are not confused, you have not paid attention. But that's the
nature of trying to understand the dynamics in Japan and that's why Goldman
Sachs suggests the yen should be trading closer to 200 to the dollar, while we
would not be surprised if the yen strengthened to 85 or even 80 should market
forces be allowed to play out. Instead, we can be assured that policymakers
will do their best to keep everyone confused - including themselves. The result
is likely to be an array of policies that may ultimately be very expensive.
The good news is that other regions in the world are - in our assessment - far
more predictable.
Axel Merk is manager of the Merk Hard and Asian Currency Funds,
www.merkfunds.com. His book Sustainable Wealth: Achieve Financial
Security in a World of Debt and Consumption, will be published October
26. Merk Insights provide
the Merk perspective on currencies, global imbalances, the trade deficit, the
socio-economic impact of the US administration's policies and more.
(Copyright 2009 Axel Merk.)
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