'Abenomics' puts the yen on alert

The phrase 'regime change' has had violent connotations since the Iraq war of 2003, but these are the words many in the Japanese financial sector have started to use in recent weeks. The combination of a new prime minister, Shinzo Abe, and a new Bank of Japan (BoJ) governor, Haruhiko Kuroda, holds out the promise of a radical overhaul of fiscal and monetary policy.

And Japan needs change. The country has been locked in a largely unbroken cycle of deflation for about two decades, discouraging consumer spending and corporate investment alike. Mr Abe and Mr Kuroda have signalled their determination to raise inflation to 2% in two years, compared with -0.2% at the latest reading. No one is under any illusion about the difficulty of achieving this target – inflation has reached 2% for only four months during the past 20 years.

The effect of these policy statements, though, and the strategy dubbed 'Abenomics' on investor sentiment is clear. The yen, which was as strong as Y77.6 per dollar before Mr Abe’s election in December 2012, had fallen to Y96.5 per dollar by mid-March 2013. As increased purchases of Japanese government bonds (JGBs) by the BoJ are on the cards, yields on these instruments have tightened. And in the hope of fresh economic growth and inflation, plus the benefits of public infrastructure investment on construction-related industries, the Nikkei stock index has rallied by almost 27% since Mr Abe’s election victory.

“Japanese investors are looking both internally and externally to diversify their investments in response to Abenomics, and there is some strong momentum to look outside Japan in expectation of yen weakness,” says Takashi Maruyama, head of equity fund management at $154bn investment manager Nikko Asset Management.

Risk of disappointment

Japan has been here before. Quantitative easing (QE) – buying government bonds to bring down interest rates and divert bank liquidity toward companies and consumers – is now the tool of choice for the US Federal Reserve and Bank of England, but it was a Japanese invention in 2001. Aside from a short period at the height of the eurozone sovereign debt crisis in late 2011 when it was overtaken by the European Central Bank (ECB), Japan’s central bank balance sheet has consistently represented a higher proportion of gross domestic product (GDP) than those of the ECB or the Fed.

Much of that balance sheet build-up, though, was in the early 2000s, when the US and European economies were in good health. The other major central banks have expanded their balance sheets much more rapidly than the BoJ since the 2008 crisis. The BoJ’s balance sheet grew by just over a half, from about 22% of GDP to just under 35%. By contrast, the US Fed's balance sheet has more or less quadrupled in the same period, from 5% to 20% of GDP, representing a much larger stimulus proportionately.

Historically, the BoJ focused on buying JGBs with remaining maturities of three years or less, to match the typical duration of bank credit in the economy and maintain a flexible balance sheet, as the assets will roll off relatively quickly. Under its previous governor, the BoJ has already widened its mandate to include corporate bonds and asset-backed paper, and there is widespread expectation Mr Kuroda will increase buying of longer-dated JGBs with maturities up to 10 years or more.

The size of the BoJ balance sheet, though, is apparently already causing operational difficulties. Officials are concerned about taking on excessive corporate credit risk and wary that BoJ purchases in certain corporate, asset-backed and even some JGB maturities risk reaching levels where they might distort the market.

To offset this risk, the BoJ has now gone further than any other central bank to include fund-based assets, such as real estate investment trusts and Nikkei exchange-traded funds in its asset purchasing. In theory, there is no limit to purchases of these funds, because their values would simply rise and the BoJ would reassure investor sentiment. Officials, however, have already noticed investors attempting to speculate on what the BoJ might buy next, which is hardly conducive to normal market functions.

It is all potentially unsettling for an institution traditionally known for its caution. Alongside Mr Kuroda, Mr Abe has nominated two deputy governors, Hiroshi Nakaso and Kikuo Iwata. Mr Iwata has echoed the Abenomics line, but Mr Nakaso is more neutral, at best. Markets could be overestimating Mr Kuroda’s room for innovation, signalling a possible rebound in the yen if the next policy board meeting on April 4, 2013 disappoints.

“Even if Mr Abe has appointed two dovish leaders for the BoJ, six of the nine policy board members still have a record of conservative policy statements, so this is not a radical change in the composition of the board,” says Atsushi Mizuno, vice-chairman of Credit Suisse Securities in Japan and a member of the BoJ policy board from 2004 to 2009.

Change of message

But Japanese investors are already beginning to feel the difference. Hiroki Tsujimura, chief investment officer for Japan at Nikko Asset Management, was particularly moved by the new BoJ governor’s speech to the Japanese Diet (parliament) in March 2013.

“Last year we heard Mario Draghi saying the ECB would do whatever it takes to save the euro. Now Mr Kuroda has effectively said he will do whatever it takes to achieve the 2% inflation target in about two years. I have never heard a BoJ governor make such a strong commitment,” says Mr Tsujimura.

There is a widespread feeling that communication as much as action will form the heart of the BoJ’s new regime. One possible option would be to combine QE with the BoJ’s money market operations, known as Rinbans, which are carried out to smooth seasonal fluctuations and maintain money supply growth consistent with long-term economic trends. The Rinbans purchases of JGBs are limited to the amount of banknotes in circulation and this has given the impression among investors that the entire QE programme is also capped – a belief Mr Kuroda is keen to dispel.

Chris Scicluna, head of economic research at Daiwa Capital Markets Europe, says the previous BoJ administration undermined its own asset purchasing programme by openly casting doubt on its effectiveness and projecting continued deflation.

Change of mindset

Mr Kuroda is much more in tune with the Abe government, which has pitched in with its own increase in expenditures equivalent to 2% of GDP for the fiscal year ending in March 2014.

“We estimate the actual spin-off effects of this to add around 0.8% to GDP growth, which is significant considering our previous forecast was for growth of just 1%. But once the base effects fall away in 2014 and the planned consumption tax hike kicks in, it will be much harder to sustain that growth and push Japan out of its deflationary cycle,” says Mr Scicluna.

Consequently, it is not clear whether JGB purchases and a weaker yen will be enough to sustain growth and inflation. The yen was much weaker than it is today during Mr Abe’s previous term of office in 2006 to 2007. Shigemitsu Sugisaki, vice-chairman of Goldman Sachs in Japan and a former deputy managing director of the International Monetary Fund, points out that exports constitute less than 15% of Japanese GDP, compared with more than 40% for South Korea.

“In reality, the health of our economy, and especially the automotive sector, nevertheless depends on that of major trading partners. Greater confidence in the export sector will stimulate increased capital investment and wage rises, which will cause domestic expenditure to accelerate and so establish a virtuous circle,” says Mr Sugisaki.

Even without taking monetary policy into consideration, Mr Mizuno believes fundamentals point to yen weakness, especially against the dollar. The Abe government is embarking on large fiscal expansion driven by infrastructure spending and post-earthquake reconstruction, just as the US is adopting a more austere fiscal stance. Moreover, shale gas could lead to the US becoming a net energy exporter in the coming years.

By contrast, Japan is becoming a much heavier energy importer, especially since the March 2011 earthquake and Fukushima nuclear plant disaster that led to a sharp increase in petrol and natural gas imports. As a result, says Mr Mizuno, a weaker yen is not automatically positive for Japanese exporters, because their cost of energy will rise as the yen weakens.

“The economy is still heavily influenced by automobile exports, but at the moment Japanese manufacturers are not able to pass on the higher cost of their inputs. That means lower profit margins and little chance to raise wages,” says Mr Mizuno.

This all makes the forcefulness of the BoJ’s message even more important for restoring confidence. Japanese savers hold Y800,000bn on account, the largest retail cash pool in the world, says Mr Tsujimura.

“There is no country in the modern era that has emerged from such a long period of deflation, so we have no exact idea what will happen if the popular mindset changes. But we can assume people will start looking for yield, seeking to protect the value of their savings, and that means buying equities and real assets,” he says.