Why the Yen Should Become Stronger, Not Weaker, Japan Government Faces Debt Crisis
Currencies / Japanese Yen Mar 17, 2011 - 09:18 AM GMTBy: ECR_Research
Renate van Ginderen writes: Japan’s Economics Minister Kaoru Yosano stressed that damage from last week's devastating earth quake and tsunami to the country's economy would be limited. However, what he did not mention was that the adverse effects from damaged nuclear plants are likely to be much bigger.
Additionally, Yosano stressed that he does not think that stock and currency markets are in a state of turmoil. This is a rather strange proclamation, given the stock market’s reaction to escalation of the nuclear problems with the Fukushime nuclear plant. Monday’s fall in the NIKKEI was over 10%; something not seen since the Lehman bankruptcy. Financial markets seem to believe the impact on the Japanese economy will be much bigger than as stated by Yosano.
Another peculiar event was the steep rise of the Yen vis-à-vis the American dollar within 30 minutes of trading, as presumably large Japanese financial institutions repatriate Japanese overseas assets, causing a large increase in the demand for Yen. The Ministry of Finance is watching the situation and will order the Bank of Japan to intervene, should the currency become too strong. In the past, the USD/JPY limit was 80. Anything below this level was crucial and thought to hurt Japanese (car) exporters too much.
However, there might be an important incentive for the Japanese central bank to intervene only if USD/JPY reaches even lower levels than 80, even as at these levels exporters are hurt already. Since a current lack of (nuclear) energy has and will - at least temporarily - disrupt parts of many supply chains, it is likely that Japan is not able to export much the coming months anyway. On the other hand, a strong yen in the coming few months would not be such a disaster for the rest of the economy. Japan is completely dependent on oil imports, as it has no own oil supplies. Now that a large part of the nuclear plants is damaged, whereas before the disaster Japan relied for over 30% of its energy consumption on nuclear energy, imports of oil or seaborne coal have to compensate a resulting energy shortfall. Given that the prices of these two commodities have risen rapidly in the past few months, a strong yen makes importing energy less expensive. Therefore, the advantages of a strong currency will weigh heavier than the disadvantages.
The advantages of a strong yen grow with increasing unrest in the Middle-East and when fears of disruption to the supply of oil - most notably in Saudi Arabia - become reality. In other words: the higher the price of oil (and other energy sources imported by Japan), the more Japan profits from a stronger Yen.
Notwithstanding the enormous toll the earthquake and tsunami take on human life and the damage done to buildings and infrastructure, rebuilding efforts starting shortly after the disaster should provide an economic boost. In this respect, the earthquake, tsunami and problems with nuclear plants should on average not hurt the economy. However, given that the government will take on a large part of the losses, any additional spending will imply a greater public deficit and debt. With a public gross debt that will be reaching perhaps even 220% of Japan’s GDP at the end of FY 2011, fiscal stimuli add to the burden. Declining government tax revenues from both firms and households worsen the problem further.
Many analysts have written that a larger debt does not automatically mean that government finances will run out of control. Given that 95% of public debt is in the hands of Japanese residents and its central bank, and given that the private sector has a large pool of savings left in the form of deposits and cash, Japanese government bond yields are not destined to rise within short due to a lack of capital to fund the deficit and rolling-over of old debt.
Nonetheless, the government’s debt was financed increasingly short-term over the past few years, and from the private sector the savings rate of households is already in negative territory and as the population ages, consumers are drawing down on their pool of savings. Additionally, firms will have to rely in the short term more on the built-up reserves to cover the costs from the current disaster.
To conclude, over the coming months less capital will be available to fund a growing public deficit. This is not automatically or necessarily problematic in the short run, but the problem is that nobody know exactly how large private savings are and to what extent the private sector will draw on reserves rather than invest in Japanese government bonds. For now, the Bank of Japan has proven willing to invest about 3 trillion yen more in JGBs than previously indicated, so this will stave off any capital shortfall. Importantly, there will be a point in time at which private sector savings are not sufficient and/or are not transferred into government bonds, and the Bank of Japan has truly reached its limit regarding monetization of public debt. Until this point, government bond yields will stay low. However, past this point, foreign investors have to be persuaded to invest in JGBs and at that moment, yields will quickly rise to historically high levels. The result is a sovereign debt crisis in the 3rd-largest world economy.
By Renate van Ginderen
After having finished a bachelor in International Economics and Finance and International Business at Tilburg University, and a short experience of studying abroad (at Université de Lausanne), I went back to Tilburg University to complete a Master in International Economics and Finance with an average grade of 8 (out of 10). After a six-month internship with ECR Research, I started as a full-time analyst financial markets. Research topics include China and Japan. ECR Research is an independent macroeconomic and financial research company specialised in interest rates and currency rates forecasts.
ECR Research (www.ecrresearch.com) is one of Europe’s leading independent macroeconomic research institutes focusing on the main currency and interest rate markets. The ECR reports reach a worldwide audience of sophisticated investors and treasurers and CFO’s within corporations and financial institutions. ECR offers a wide range of research products which are online accessible and updated on a weekly basis.
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