Yen Policy Makes Japan ETFs Even RiskierPosted 11/30/2009 2:22 p.m. EST Open discussion of quantitative easing in Japan signals that the government is serious about weakening the yen, and the collateral damage could be enormous. I warned of Japanese deflation and Japan ETFs earlier today, and the possibility of quantitative easing only reinforces the dire situation facing the nation. After 20 years of on-again, off-again deflation and mild economic growth, Japan is reaching its debt limit. Failed inflationary policies and deficit spending have reduced the country's flexibility and narrowed its range of action. "Demographic winter" has combined with those policies to deplete Japanese savings, to the point where there's risk of the savings rate going below zero. With currently low yields, Japan may need increased interest rates to attract foreign capital. Higher rates would likely push up the value of the yen and exacerbate the deflationary trend. Japan equity ETFs have done poorly this year, with iShares Japan ( EWJ) down 1.7% year to date through Friday. Small gains for other ETFs, such as iShares Japan Small Cap ( SCJ), are the result of a stronger yen. CurrencyShares Japanese Yen ( FXY) has gained 3.9% this year, and WisdomTree Dreyfus Japanese Yen ( JYF) has gained 4.8%. Even if the country is successful in combating deflation, it doesn't mean Japan is a buy. Japan's economic problems will keep equity prices from rallying too much, while the weakening yen erodes any gains. On top of what are likely to be tepid gains at best comes the risk that extreme measures could trigger extreme moves in the market. Japanese credit default swaps increased in price this autumn and signaled that the market is growing more concerned about debt levels. Previous quantitative easing also made the yen the choice of carry-traders and helped fuel the bubble and then burst of global markets in 2008. Investors may find it impossible to avoid the global effects of Japanese policy, but there's no need to increase exposure via Japan ETFs.
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