Yen's Weak for a Reason

Despite Japan's near-record expansion, wages and consumption have failed to pick up.
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Japan's emergence over the last five years from its economic malaise of the 1990s is one of the most important macroeconomic developments within the Group of Seven. Next month, Japan's expansion will reach 58 months, the longest since World War II, surpassing the previous record of 57 month during the Izanagi boom of 1965-1970 (so named because it was said to be a boom unprecedented since the god Izanagi mated with Izanami to create the Japanese islands).

However, this is not a source of optimism -- the expansion cycle is getting long in the tooth and recent data highlight the risks to the economy. From a policy-making point of view, a downturn would be particularly problematic because monetary policy has not yet been normalized and there is little scope for stimulus without resorting to extraordinary and unconventional measures. In turn, this implies that despite the growing current account surplus, the yen may continue to frustrate.

The main challenge for Japan remains the same as 20 years ago -- it needs strong corporate profitability and capital expenditures to spark spending. The principle that a rising tide lifts all boats is failing in practice.

Remember the late 1980s. At the Plaza Hotel, the G-7 agreed to drive the dollar lower. Japan and Europe coordinated interest-rate cuts to increase the chances of a soft landing for the dollar. It was hoped that the lower interest rates would spur consumption, but instead it sparked an investment and speculation boom. Japan's economic malaise was the hangover as the excesses were worked off.

More recently, the hope was that new capital investment would increase the demand for workers, which in turn should boost wages and fuel consumption. Despite the compelling logic of the theory, it appears to be failing in practice.

The ingredients are there: Capital spending has been strong, the fastest in roughly 16 years. Between the fourth quarter of 2001 and the fourth quarter of 2005, investment accounted for 20% of Japan's growth. Corporate profits have been strong. In the fiscal year that ended March 31, corporate profitability rose 35% to a record 20.6 trillion yen (roughly $170 billion).

Japanese companies did hire more workers -- as of last month, unemployment stood at an eight-year low. So far so good, but this is where things break down. Wages fell 0.5% in August. Although it was the first decline in eight months, the gains were hardly impressive. According to Bloomberg data, Japanese wages fell 10% in the last eight years. This decline translates into about 400,000 yen a year, or roughly $3,4000. In the first half of this year, pay increases amounted to an average of 8,700 yen, or about $70.

The sluggishness of wages weighs on consumption. Household spending in Japan fell 4.3% in August and has fallen every month thus far this year. With wages down, Japanese have been spending money that they previously would have socked away for the future. Japan's famed savings rate had fallen from over 10% in the late 1990s to less than 2.5% now.

Unless domestic consumption rises more in Japan, and by extension East Asia as a whole, one cannot realistically expect it to decouple from the U.S. economy. This also would suggest that a reduction of global imbalances will likely prove elusive. However, the implication of this analysis is that the currency market may not be as misaligned as many commentators would have us believe.

It is true, as the perma-dollar bears will quickly point out, the U.S. posted a record trade deficit in August of almost $70 billion. Yet the deficit is not a product of weak exports, which rose 2.3% in August and are up almost 13.5% over the past 12 months. And even this probably understates U.S. export growth.

Civilian aircraft exports rose 11% in August, recouping a good chunk of the 19.2% slide in July, but they are still off. If the dollar was as overvalued by the magnitude that some have suggested, surely exports would not be rising at such a heady pace. That U.S. imports are up 15.3% over the past 12 months is not really evidence that the dollar is weak. Rather, it is a reflection of U.S. demand, buoyed by a 9.4% rise in personal income year-over-year in August.

Many economists still use some derivative of purchasing power parity to determine a currency's fundamental value.

The Economist

magazine has popularized this with it's comparison of the price of a Big Mac in various countries. Theoretically, in the long run, currencies are expected to gravitate around their purchasing power parity level. There is another level currencies gravitate around in the long-run: a long-term moving average.

Using monthly data, the 10-year moving average of the dollar-yen rate is a little above 117 yen. With some minor exceptions, the dollar has traded within 1 standard deviation of its 10-year moving average for the past 10 years. This year, with the exception of May, when the market was reacting to the G-8/IMF call for a weaker dollar, the greenback has been confined to a +/- 0.5% standard deviation band around that long-term moving average.

The yen bulls/dollar bears argue that the fact that Japan's current account surplus is rising (22% year-over-year in August) is evidence that the yen is undervalued. But look closer at the composite of Japan's current account surplus -- only a small part of it can be traced to the trade of goods and services. In August Japan's trade surplus was about 312.5 billion yen, or roughly $2.6 billion. In contrast, the current account surplus stood at 1.477 trillion yen, or roughly $12.36 billion.

The driving force behind Japan's current account surplus is not the trade balance, but its investment income balance. From past investments, Japanese investors earned 1.377 trillion yen in August. It is true that the U.S. semiannual coupon payment boosts Japan's income from its investments, but the July figure of 1.224 trillion yen suggests that this is not a fluke or statistical anomaly.

In September, the Ministry of Finance reported that Japanese investors turned net sellers of foreign bonds for the first time in six months, but it is far too early to call this a trend. First, September marks the end of Japan's fiscal half year and it is not uncommon to see repatriation during the month. Second, since the start of October, interest-rate differentials between Japan and the U.S. and Japan and Europe have widened again.

On the other hand, the early press reports of the investment plans of Japanese life insurance companies suggest a waning appetite for foreign bonds in the second half of the fiscal year that began this month. We need to be careful not to exaggerate the role of Japanese life insurers.

For the sake of the argument, let's agree that the September data may be distorted by the fiscal half year end, so let's look at the August data. In that month, Japanese investors bought a net 2.29 trillion yen of foreign bonds, while life insurers were net sellers of 248.6 billion yen of foreign bonds.

Meanwhile, foreigners have been net buyers of Japanese stocks month in and month out, with the recent exception of May and June, when they turned modest net sellers. The 580 billion yen sold in those two months was more than recouped in July and August, when foreigners bought about 1.1 trillion yen of Japanese stocks.

However, the Nikkei is grossly underperforming the G-7 this year. Its 1.6% gain pales next to the double-digit gains throughout Europe and the 8.75% gain of the S&P 500. The energy-intensive S&P/Toronto Stock Exchange Composite Index is the second-worst performer and it is up about twice the Nikkei's gain. While U.S. earnings growth may be losing some momentum, many are forecasting an outright decline (~6.5%) in corporate Japan's profitability this calendar year.

By the philosophical principle of Occam's Razor (the simpler explanation is preferable), there is no need to cite conspiracies or currency market manipulation to explain the yen's weakness. The fundamentals might be sufficient.

Marc Chandler has been covering the global capital markets in one fashion or another for nearly 20 years, working at economic consulting firms and global investment banks. Currently, he is the chief foreign exchange strategist at Brown Brothers Harriman. Recently, Chandler was the chief currency strategist for HSBC Bank USA. He is a prolific writer and speaker and appears regularly on CNBC. In addition to being quoted in the financial press, Chandler is often a guest writer for the Financial Times. He also teaches at New York University, where he is an associate professor in the School of Continuing and Professional Studies. While Chandler cannot provide investment advice or recommendations, he appreciates your feedback;

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