Outlook for Japanese Yen

Tokyo is a pressure cooker. We are not referring to the recent ultrahigh temperatures and surge in heat prostration cases, but to the air in any room occupied by economic policymakers. The declining popularity of the prime minister du jour, who is head of a grab-bag of political parties and has to deal with a "twisted parliament," each of the two houses of government being dominated by a different party, are painfully relevant circumstances at a time when the economy is fading, deflationary forces are at large, and the strong yen is crippling exporters.

Last week Prime Minister Naoto Kan summoned the minister of international trade, economy, and industry, and this week will confer with other members of his Cabinet, and possibly also meet with the governor of the central bank. Last week members of the Cabinet and his own party needled the prime minister, urging him to keep in close touch with the BOJ governor. "Close touch" is a euphemism for pressuring the bank to do something about the yen. It is an old political game. Earlier in the week it was expected that the two men would meet on August 23, then it was suggested that a telephone call might suffice. Both the government and the central bank have to keep pundits and the press guessing.

An economic package is expected to be formally announced in September, and is certain to throw some bones to small business, others where they may stimulate employment. Politicians are also worried about the stock market, that is, after all, a leading economic indicator. Probably, 9,000 for the Nikkei Stock Average is a threshold; a lower index than that and political headrolling and more are in the offing. At this time, those worries will hardly be reduced unless the yen strengthens.

The yen has not been as "weak" as 90 since June 23, and economists or businesspersons who expect the yen to be at 90 or weaker during the rest of the year are rare.

On Sunday TV in Tokyo, Koichiro Gemba, head of the influential Policy Research Committee, hinted at a package of ¥1.7 trillion and a supplementary budget to finance it. Since national indebtedness as a long-standing issue has become even more unpalatable after Europe's recent problems and the increase in American national debt, the pressure cooker might blow its safety valve.

So until September and news about management of the economy, the key issues seem to be the US economy and behavior of the US Fed, the outlook for the Eurozone, and the yen.

The Tokyo market and the yen are sensitized to US economic indicators and to that extent are beyond direct influence by the Japanese government and its bank.

In our previous commentary we argued that the yen was in a zone of extraordinary (this attribute used because of the weakness of the economy and low expectations that policy will kick-start it) strength. We mentioned that Japanese individuals were dollar buyers. If they do so to a significant extent, of course it will tend to weaken their own currency. For these individuals, however, given the near-zero interest rates in Japan (a souvenir pen for a substantial bank deposit is probably worth more than the interest to be received for a year; overnight money market rates are 0.1%) the yen is likely to remain strong enough for long enough for them to earn a profit.

We cannot obtain reliable data about their behavior, but we can monitor crossborder flows on a weekly basis. The Ministry of Finance releases data on such transactions, by residents and nonresidents.

What is most important on the residents' side is bonds; the same is true for nonresidents but in trading volume more than net results, and for the latter equities volume is greater than that in bonds, but usually the lesser of the two in net terms.

The next announcement will be on August 26 and can be accessed from http://www.mof.go.jp/english/index.htm.

But what has been going on? Residents were net sellers of foreign bonds in August 8-14 by about double the level of net selling in the previous four weeks. This net selling represents capital outflow. That is, we can take it to represent selling yen into dollars. Net outflow in the week was ¥21.7 trillion. Nonresidents' trading in bonds (and notes, that are likely to have been the instrument favored by Chinese investors recently) resulted in a net inflow, but of only ¥219 billion. For the week, the net inflow of transactions by both groups, in equities, bonds, and money market instruments, was ¥2.15 trillion and this was quite high relative to recent weeks.

The net outflow of money owned by residents doubled in that most recent week, to ¥2.24 trillion, after averaging ¥1.19 trillion in the preceding four weeks.

The Japanese find their own currency to be so valuable in a global context that they are selling it on a large scale, but the diverse unfathomable forces bearing on the market are such that their selling has not changed the direction in which the currency has been headed.

What can the government and its bank do? Leaving the influence of Fed policy and action (a constraint on Japan at this time) for another time, the Japanese financial press has reminded us that the "new operations" of bond buying by the BOJ is one alternative. By this, the government buys bonds (including corporate paper and even commercial paper) for a holding period of three months. This arrangement was adopted in December of last year. The possibility of lowering the policy rate even further, to zero, is unattractive. The toolbox used to include "moral suasion" meaning a kind of jawboning to coax market sentiment, but this seems to be on the wall with buggy whips. The BOJ can also buy more government bonds, but this too is undesirable. Not promising, any of this.

Finally, there is the intervention way to go. In May, the BOJ renewed a swap arrangement with the NY Fed, which provides for the sale of yen to the Fed for a period of up to 88 days. There are swap arrangements with other countries, but this is the key one. Intervention, however, usually just slightly blunts the market forces, and tends to be less effective in the absence of multilateral action. The bank can also buy dollars from financial institutions (and others) that have an account at the BOJ (the US Fed is among them). This removes dollars from the market, replacing them with yen. Then there is a fork in the decision tree: to sell the dollars back (called sterilization) or not. Given the present business environment, in which there is little reason for optimism over future demand for goods and services, it seems that pouring yen into the domestic market will lead to its sloshing about unused. Here, the realistic and concrete nature of the government policy package to support the economy, forthcoming probably next month, becomes critical.

Talk about being between a rock and a hard place. The only good news for Japan government finances lately has been that payments of government annuities to dozens of centenarians whose whereabouts (living or dead) are unknown have been stopped.

Pacific Tax Partners recommendation: This appears to be a good time to cash out of yen. Given the weak economy and near-zero interest rates in Japan (Japan overnight money market rates are 0.1% per year) the yen is likely to remain strong enough for long enough to earn a profit in a foreign currency. Switching currencies should be a winning strategy in any likely scenario: the yen either weakens slowly or stays strong but won't gain much more. We have cited evidence that purchases of other currencies has doubled without weakening the yen. This is a compelling sign the yen is going to stay strong in the near term.

This is an anomalous situation where the strong yen will likely prevail for several months. Timely rebalancing of portfolios with significant yen denominated exposure should also be considered to seize short-term opportunities for greater growth.

For more information on customized economic reports and tailored US-Japan tax advice that cuts to the chase, contact the staff economist and experienced tax professionals at Pacific Tax Partners:

Terry Wilson

US Income Tax, IRS Tax Appeals

Terry Wilson

Terry Wilson has 25 years expertise in international financial planning and trade issues as well as US income tax and tax appeals.

He is qualified as an MBA and US CPA, Certified Financial Planner, Certified Internal Auditor, Certified Fraud Examiner, and is a Certified Computing Professional.

He is a member of the American Institute of Certified Public Accountants (AICPA), the Finance Club of Brussels at the Bourse, and the Institute of Internal Auditors.

He can be reached at terry.wilson@pacifictaxpartners.com.

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