This is our second post on Japan’s new economic project.

The newly appointed Bank of Japan (BOJ) Governor Haruhiko Kuroda shocked the market by announcing the “massive” monetary easing at his first policy meeting on April 4, 2013. Consensus expectations before the BOJ policy meet was that Kuroda would under deliver, demonstrated by the appreciation of the Japanese yen before the announcement. However, Kuroda over delivered, announcing a new policy package, including the following:

• Doubling the monetary base in two years (also changing operating target from call rate to monetary base¹)
• Increasing the average maturity of the BOJ’s Japanese Government Bond (JGB) holdings and extending the maturity of bonds, eligible for purchase, from 3 years to 40 years
• Increasing the purchase of risky assets (ETFs & REITs)
• Continuing easing until a 2% inflation target is achieved

Following the announcement, the yen lost more than 5% of its value in just two days.

A return to monetary aggregates and Bernanke’s prescience
The BOJ has somewhat turned back the clock by abandoning interest rate in favor of monetary base as its operating target. None of the central banks of major advanced economies has used monetary aggregates as policy tools since the 1980s. Another interesting aspect of the BOJ’s new measures is their similarity to Ben Bernanke’s suggestion in a famous speech delivered in 1999. His suggestions—higher inflation target, weaker yen, significant increase in money supply and JGB purchases—are now part of Japan’s new economic policy.

Monetary stimulus in major economies since crisis
What has caught the imagination of the market is the BOJ’s commitment to double the monetary base in two years. Surprisingly, this is not very different from what central banks in the United States, the United Kingdom, and the eurozone have done since the 2008 financial crisis. The balance sheets (close proxy for monetary base) of the Bank of England, the Federal Reserve and European Central Bank are now about 5.1, 3.7, and 2.3 times their pre-crisis levels, respectively. The BOJ’s new policy, along with other relatively small bouts of QE undertaken since 2008, will bring its balance sheet to 2.5 times the pre-crisis level. Based on this matrix, the BOJ’s policy is hardly earth shattering. As a percentage of the GDP, however, the BOJ’s actions seem more audacious. While the balance sheet of central banks in the United States, the United Kingdom, and the eurozone stand between 20% and 28% of the GDP, the same figure will rise to about 58% for Japan (from the current 35%) by the end of 2014. The discrepancy arises because the BOJ’s balance sheet still carries the asset accumulated during the unsuccessful policy interventions from the late 1990s to 2006. To highlight the scale of the current policy again, the BOJ will likely purchase assets worth ¥60–70 trillion ($70–$80 billion) per month in 2013, not much less than the U.S. Fed purchase of $85 billion per month at present, in an economy that is one-third of the U.S. economy.

Sources: Bloomberg, IMF

The repercussions of such easing in the United States, the United Kingdom, and the eurozone have not been very dramatic. While their currencies have depreciated, they haven’t exactly fallen off the cliff. Inflation too, barring the United Kingdom, has been below the target in these economies for most of this period. Inflation in the United Kingdom (2–5% since the crisis) has been higher on account of higher VAT and energy prices. This has primarily happened because demand continues to be weak and inflationary expectations are well anchored due to the credibility of central banks in these economies. This experience, combined with the deeply entrenched deflationary expectations in Japan, suggests that the new policy package is not a recipe for hyperinflation or large scale currency debasement, as suggested by a few commentators.

Monetary transmission in Japan – historically
The increasing supply of money cannot create inflation on its own, unless there is a demand for those funds. Deleveraging and risk aversion have ensured that the channels of monetary transmission remain clogged. Balance sheet recession from the 1990s to the early 2000s has sapped any appetite to borrow from the Japanese households and businesses. Deflationary expectations ensure that money is hoarded rather than spent. Thus, broad money² has not grown despite the rapid expansion of monetary base. This is important, because the prices will rise only when base money circulates in the economy and becomes broad money. The evidence on these relationships over the last three decades (1981–2012) in Japan is presented below.

Source: Bloomberg

As we can see, there is no observable relationship between base money and inflation in Japan over the last three decades, even after we account for a one year lag for transmission. We do, however, find a positive association between broad money and inflation. Finally, we can see that there is no apparent relationship between base money and monetary base. Therefore, unless monetary transmission starts working again, inflation is unlikely to respond to the monetary base expansion.

Monetary transmission in Japan – today
This puts the BOJ’s actions in context. The BOJ’s ‘shock and awe’ policy aims “to drastically change expectations of markets and economic entities” conditioned by years of deflation. However, the economy will need to deliver rather quickly over the next one or two years in terms of positive inflation and better growth for expectations to be sustainably changed. Otherwise, the ‘shock and awe’ too will fizzle out, once people do not see any impact on the ground.

Apart from a weak yen and rising market expectations of inflation, exports, consumer sentiment, and domestic lending look slightly positive this year, perhaps showing early signs of the new policies making an impact. Moreover, there have also been some reports of wage increases. On the other hand, an air of pessimism, fed by two decades of deflation and balance sheet corrections, seems to hang over businesses. This is reflected in low credit offtake and a preference for overseas expansion rather than domestic, despite a weaker yen. The sentiment was reinforced days before the BOJ’s announcement of the new policy, when Shinzo Abe admitted, quite uncharacteristically, that the inflation target may not be met in the next two years.

There is concern that monetary transmission may work only via a weaker exchange rate, while private domestic borrowing remains sluggish. This would create a divide between the tradable sectors and the rest of the economy and is, therefore, unlikely to lead to broad-based growth and inflation. Moreover, reliance on a weaker currency to boost exports will limit incentives for innovation, diminishing the long-term prospects of the export sector. The fate of former market leaders such as Sony is illustrative. Therefore, if sluggishness continues in the private sector and monetary transmission via commercial banks does not work, deficit spending by the government would only be able to raise broad money and therefore, increase growth and inflation.

Fiscal vulnerability
This puts Japan’s precarious public finance situation in the spotlight. The BOJ-engineered higher inflationary expectations can potentially raise JGB yields, limiting fiscal space. While both the United States and the United Kingdom have been able to keep yields low, and, at the same time, keep the inflationary expectations significantly positive, recent volatility in JGB is a cause of concern. George Soros recently lamented that the current policy would have been great if it was implemented 15 years ago, when the public debt figure was not so high. While the taboo associated with downgrades has certainly reduced, S&P’s recent downgrade warning reflects the risks associated with the Japanese economic project. If the volatility gives way to higher yields, it would not only signal a failure of the BOJ policy, but would also endanger Japan’s fiscal stability. It would also be catastrophic for large holders of government bonds like banks, insurers and pension funds. Recent anecdotal evidence suggests that Japanese investors are looking to move out of JGBs to the United States, or the Antipodes, or eurozone sovereign debt to escape near-zero yields. JGBs attractiveness to foreign buyers has also diminished due to a depreciating yen. Therefore, it is very important to keep an eye on the performance of JGBs, lest the mother of all monetary stimuli gives way to the mother of all fiscal crises.

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¹Monetary Base/Base Money (M0): This is the currency supplied by the Bank of Japan. It is defined as Monetary Base = Bank notes in circulation + Coins in circulation + Current account balances in the Bank of Japan.

²Broad Money (M3): This includes currency in circulation, deposit money, quasi-money, and certificate of deposits (CDs) issued by depository institutions. It represents the broadly defined liquidity in the Japanese economy.

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This is our second post on Japan’s new economic project and a lot has changed since our first post at the beginning of this year. The international community has largely countenanced the yen’s depreciation; self-imposed restrictions (banknote principle and maturity) have been done away with; institutional reluctance seems to have been overcome; and unlike previous instances, the markets, not BOJ interventions, have driven the depreciation. These developments could now see the yen stabilize at a lower than anticipated level.

A curious phenomenon is currently playing out in the global markets. Improving macroeconomic outlook and continuation of QE by the Fed ideally support assets across classes. This had indeed been the pattern since the onset of the financial crisis, which saw a significant increase in cross asset correlation. However, since late 2012, commodities have been diverging from the broader market trend, especially equities. As risk appetite has reached its post-Lehman high and S&P 500 is treading at all-time highs, commodities have been declining (see Figure 1). Current speculative positioning—as measured by CFTC net non-commercial futures positions—is net short for commodities, such as wheat and copper. Therefore, a turnaround is not being anticipated by hedge funds. What does this say about the current state of the economy? Some might argue that commodities are portraying a more accurate picture, as they represent a demand for real goods, unlike financial assets, such as equities. However, others might counter that the current risk rally is supported by improving growth prospects.

Figure 1

Source: Bloomberg

Impact of dollar

The decline in commodity prices has been pervasive, led by copper, wheat and corn, and to a lesser extent by crude oil. Since all commodity prices are quoted (or denominated) in terms of dollars, the recent strengthening of the dollar can be seen to be an important factor exerting downward pressure on prices. In Figure 2, we can see a high correlation between the inverted dollar index and the commodity index.

Figure 2

Source: Bloomberg

The strengthening of the dollar, however, is clearly not enough to explain the decline, as we also see a change in the shape of the term structure of these commodities in the forwards market. As is evident from Figure 3, both wheat and copper have moved from ‘backwardation’ six months ago to ‘contango’ at the present*, as a result of adverse fundamentals.

Figure 3

Source: Bloomberg

Fundamentals behind weakness

Recent news flow suggests that multiple factors have been at play in depressing commodity prices – increased supply (hence inventory build up), weaker demand and appreciation of the dollar. Global copper inventories are estimated to be at a nine-year high. On the demand side, excluding China’s copper consumption, global demand for copper actually contracted in 2012. The supply outlook of copper is considerably better for 2013; hence, weakness is likely to persist.

The US Department of Agriculture’s report on the build up of grain inventories and a better supply outlook has been behind the recent weakness in agriculture commodities such as wheat and corn. Crude has also been hit by demand substitution towards gas. As a result, natural gas has bucked the trend and the Henry Hub benchmark is up about 80% Y-o-Y. This shift towards gas has become more prominent due to the shale gas boom. All of these factors lend more credibility to commodity prices versus financial assets (such as equity), as unlike commodities, there are no physical demand and supply fundamentals in equities.

Economic prospects

What is important to look at is – what this divergence between equities and commodities says about the state of economy? Recent US economic data has been a mixed bag. Optimism borne out by the positive housing and consumer data has been tempered by weaker PMIs and employment, which, along with sequester, have led to lower Q2 growth expectations. Chinese data has also been uneven. Despite this, it is quite evident that the US economy is on a much stronger footing than it has been since the recession, which may justify the performance of equity markets. Also, events in Cyprus notwithstanding, the situation in the Eurozone, is far away from the dire prospects predicted during 2011–2012.

Commodities such as copper are seen as leading economic indicators due to their multiple uses in different industries, e.g., construction and electronics. However, the divergence between the broader market risk appetite and price trends of commodities is sending mixed signals about the state of the economy. So, do we have the spectre of another downturn looming large on the horizon or is copper in danger of losing its sheen as the bellwether of the global economy? Perhaps growth and employment numbers in the coming months will be able to answer this better.

*Technically contango (backwardation) refers to a situation where future prices are above (below) expected spot prices. However, in practice current spot prices are generally used instead of expected spot prices.

For more on TSC’s RAI performance and outlook, view our recent update.

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More about TSC’s RAI 

Recent efforts by the Japanese government to weaken the Yen, in order to revive the domestic economy have led authorities in South Korea, Russia, Norway, China, Chile, Australia, New Zealand, the United Kingdom, Sweden and some Eurozone countries to raise concerns over a global currency war, prompting a statement from the G7 and making it the main talking point at the recent G20 meeting. However, the G7 and G20 statements—by avoiding any criticism of the policy-engineered depreciation of JPY— have done little to assuage the fears of competitive devaluation. In fact, the JPY depreciated even further in response to the statements. Perhaps the only major implication of the G20 statement is that ‘talking down’ currencies or verbal intervention may become a taboo. On the whole, global policy coordination notwithstanding, a global currency war is well underway.

Currency War

The term ‘currency war’ was coined by the Brazilian Finance Minister, Guido Mantega, in 2010, as quantitative easing induced capital, flooded Brazil and caused its currency to sharply rise against the USD. With developed markets continuing to grapple with the near-zero interest rate and slow domestic demand, external devaluation appears to be an attractive growth avenue. Since it comes at the expense of the growth of other economies, such policies are labelled as ‘beggar thy neighbour’ policies. Over recent decades, China has been considered to be the most successful proponent of this type of strategy. Emerging markets (EM), especially those that rely on exports, have been historically reluctant to accept a nominal appreciation of their currencies, and are expected to counter any significant strengthening.

Source: Bloomberg

The depreciation of the JPY, though seen as a big positive for the Japanese economy (see Figure 1), has been especially problematic for South Korea and Taiwan, as they compete against Japanese products in international markets. This year, the KOSPI has fallen on account of worries over the impact an appreciating currency will have on the export sector. Expectations of retaliation from Korean and Taiwanese authorities have led to the depreciation of their respective currencies against the USD.  Korean authorities are planning to impose taxes to rein in capital inflows and expectations are rising that the Bank of Korea may intervene in the foreign exchange markets. China also seems to have taken the cue, with the People’s Bank of China recently setting the RMB at weaker levels  However, given the apparent desire to rebalance the Chinese economy away from exports, the RMB may not be allowed to fall drastically or even depreciate at all in the medium term.

Changing Policy Paradigm

In the widely accepted ‘Impossible Trinity’ of monetary policies, an economy can hope to have only two of the following three simultaneously:  independent monetary policy, fixed exchange rate, free capital flows. Over the last two decades, the favoured policy prescription has been—independent monetary policy and free capital flows; leaving the exchange rate to be determined by the markets. A prolonged worldwide currency war will change this, with countries looking to manage the exchange rate by direct intervention in the foreign exchange markets, or a looser monetary policy, or by restricting capital flows. IMF’s recent institutional acceptance of limited, conditional capital controls can be seen to be lending legitimacy to such policies.

Direct interventions, most likely unsterilized, could add to inflationary pressures on the already ‘stagflated’ economies (a topic we will cover in our forthcoming blogs) and also create grounds for asset bubbles. Inflation pass-through from a weaker currency would also be an important consequence to be considered.

Brazil has been active in imposing taxes on capital inflows and has also intervened in foreign exchange markets in an effort to manage its currency’s movement. The Brazilian government has tinkered with these taxes as its focus has oscillated between growth and inflation. In this sense, it exemplifies the dilemma that economies face, especially emerging ones, which experience high inflation and slowing growth, while participating in the currency war. This period has seen the BRL trade as high as 1.53 against the USD in 2011 and as low as 2.13 by the end of 2012.

Rising tolerance of looser monetary conditions and lower interest rates, aimed at weakening the currencies is also being observed. Despite still high inflationary expectations, the Turkish central bank recently slashed its overnight rates to restrict capital inflow and in turn prevent the appreciation of the TRY. In Sweden, though the deflation in recent months was reason enough, the central bank cited the strengthening of the SEK as “yet another reason” for a rate cut. Denmark has already experimented with negative interest rates to limit the appreciation of its currency vis-à-vis the EUR. As the currency wars continue, we may see more and more central banks giving higher weightage to currency movements in their rate setting considerations.

Consequences

Similar to Brazil, many emerging markets are likely to face the difficult choice between protecting growth and suppressing inflation or even between preserving the newly earned free market credentials and the stigma associated with managed exchange rates (admittedly diminishing recently). This would, however, increase policy uncertainty and lead to a rise in volatility, as the markets will hang on to every action by the authorities for guidance on the next move of the exchange rate. The recent spike in the volatility of KRW as uncertainty over policy action looms, is a typical case which could be experienced in other countries as the ‘war’ plays out.

A major consequence of the currency war would be the realignment of trade among countries, with those that are more successful at playing the game, gaining a bigger chunk of the global trade pie. Countries unable to participate, perhaps due to high foreign debt or reliance on imports for food/energy, will come out as poorer neighbours in the world of ‘beggar thy neighbour’ policies.

We have had two major worldwide currency wars—1930s and 1970s—until now. The 1930s war was characterised by protectionist trade barriers, which led to a significant decline in world trade, and is not a very relevant guide for the current currency wars. High inflation that followed the 1970s episode though, is an important consequence that needs to be monitored. This time around, the primary consequences could be the realignment of trade and therefore growth, higher volatility in the foreign exchange markets, rising inflation and the possibility of asset bubbles in emerging economies.

Trading Opportunity

A positive interest rate differential, along with the Balassa-Samuelson effect*, leads to a natural tendency for the currencies of growing emerging market countries appreciate, a ‘problem’ compounded by the currency war. Willing and able countries may be able to prevent such an appreciation and their currencies can be good short bets in a hypothetical exchange trade basket. On the other hand, currencies of unwilling or unable participants may turn out to be good long bets.