The Japanese economy, policy amid yen strength

With earnings season in sight, one of the main questions is how Japan, Inc is handling the yen strength.

Typically, a strong yen will affect large manufacturers through more indirect channels than in the past, given the globalisation of Japanese businesses, so a stronger yen will create no real incentive to repatriate income from abroad, rather than cripple firms directly through export revenues.  Still, Japan’s large corporations are seasoned currency hedgers – so all else equal, yen-selling flows may be price drivers for USDJPY while smaller exporters might get hit by their lack of similar access to the market.

The market now appears to be eyeing Y105 for USDJPY, though there are some opposing forces at play, including:

– Massive speculative yen long positions, which could wash out given even small surprises;

– Given the BOJ kept its powder dry at its most recent meeting, they may still have some easing up their sleeve;

– Potential for MOF intervention.

On the last point, the recent US Treasury semiannual report does make a difference.  They focused on the “orderliness” of markets and so long as USDJPY moves remain “orderly”, it may be difficult for MOF to step in.  However, if we see a sharp drop in USDJPY in high volatility, MOF may well step in.  Over past years, MOF has tended to favour these types of “smoothing” interventions rather than defending a “line in the sand” as in the Sakakibara years.  So don’t rule out intervention, but consider a greater likelihood if sharp moves, coupled with speculative activity, dominates trading.

Lastly, on the policy side of things (and reaction to yen strength): a strong yen does appear to affect sentiment (take a look at the sensitivity of the Nikkei to yen strength), which means, if deemed to be a reinforcing factor for deflationary expectations, yen strength could influence BOJ policy.  For instance, if markets are expecting the BOJ to act in July, extreme yen strength could favour a June move.

Reaction may not only come via monetary policy – there have been rising expectations for a delay in the implementation of the next consumption tax hike.  There is a big trade off at play here – while a consumption tax hike delay might give rise to some short-term relief to consumers, the message that this sends out about government finances is one of waning credibility of fiscal responsibility, which in an extreme situation could foster fiscal crisis.

As for structural reform, market volatility, deflationary expectations – these are not particularly good conditions whereby to implement structural reform.  The risk here is one of losing policy credibility on all three arrows (where there was only really credibility on one – reflation – before).   The compounding problem here is that reflation was a prerequisite for the other two.