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Land of the Second Sunrise

By Benjamin Shepherd on December 6, 2012

Earlier this week, investors witnessed green shoots emerging from the Japanese economy when the Ministry of Finance reported that third-quarter capital spending increased 2.4 percent compared to the same period last year, exceeding the expected 1 percent gain.

The Ministry’s measure of Japanese production also showed a healthy jump, rising the most in 10 months and giving hope that the Japanese recession might be coming to an end.

The likely future Japanese government is helping this nascent recovery, albeit in a rather oblique way.

Elections for Japan’s Diet—the equivalent of a parliament—are slated for December 16 and, so far, polling data shows that the country’s Liberal Democratic Party (LDP) is poised to return to power. That means LDP leader Shinzo Abe, prime minister of Japan for a year between 2006 and 2007, is likely to find his way back into the prime minister’s office.

This prospect has been troubling global currency investors over the past couple of months (see graph, below).

The Japanese yen in 2012 remains 25 percent above its value in 2007. In fact, the yen has appreciated by over 200 percent over the past 30 years, and an appreciating currency is never healthy for an export-oriented economy such as Japan’s.

This year, two major factors have been driving this trend.

The first is that Abe has actively militated for curtailing the independence of the Bank of Japan (BoJ), which is widely viewed as the most independent arm of the Japanese government, particularly since it was legally granted more independence about two decades ago.

While the BoJ is highly regarded outside of Japan for not adding to the country’s debt by taking more simulative action, it is a common target for populist politicians eager to stoke pro-stimulus passions among the Japanese electorate. Many Japanese see it as one of the reasons the country has struggled with deflation for the better part of two decades.

Abe had backed off his talk of clipping the BoJ’s wings. But now that his party is leading in the polls, he has again started to wield a cudgel against the central bank, in turn spooking the currency market.

The markets also haven’t been particularly thrilled with Abe’s talk of sparking off a round of inflation in the country. Abe has said that if he wins, he will introduce measures aimed specifically at increasing the country’s inflation rate to at least 2 percent.

While inflation has been the traditional tool for governments looking to reduce their debt burden—they’re basically paying off yesterday’s higher-priced debt with tomorrow’s weaker currency—in the case of Japan that plan could prove counterproductive.

Almost 25 percent of the Japanese government’s budget currently goes towards debt service and that’s with 10-year Japanese government bonds yielding about 1 percent. Annualized inflation in the country is currently running at -0.4 percent.

For argument’s sake, let’s say that Japanese inflation is actually pushed up by the government to an annualized 2 percent. If the yields of Japanese government bonds keep pace, the cost of debt service alone would wipe out the country’s expected tax revenue of about JPY42.3 trillion.

It doesn’t do much good for a country to inflate its way out of debt if it essentially bankrupts itself in the process.

Consequently, the yen’s appreciation has accelerated since mid-November on concerns that Abe might actually find himself in a position to carry out his ill-considered “easy money” plans.

Then again, Abe could be taking a page from US Federal Reserve Chairman Ben Bernanke’s playbook and dabbling in crowd psychology.

Japan’s export sector has been the cornerstone of the country’s economy over the past several years, driving most of its economic growth. But as the yen has appreciated on the view that it’s a regional safe haven currency, Japan’s export sector has faced increasing competition as other nations’ goods become more competitive.

Abe’s push to curtail the BoJ and increase inflation is interpreted by some observers as a backdoor way to prop up Japan’s struggling exporters.

I personally doubt that Abe is becoming a savant at the psychological manipulation of the currency markets; he’s most likely just behaving as a populist politician. But even if the LDP does sweep back to power, Abe still wouldn’t possess the broad powers necessary to make the kind of changes he’s talked about. He may be making the right moves, for the wrong reasons.

Regardless, if he gets Japan’s exporters humming again, Abe might yet prove to be the savior of the Japanese economy. Granted, the yen isn’t low enough yet for that to happen, but it just might get there if Japan’s erstwhile (and perhaps future) prime minister keeps talking.


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