A big country in the East is going to be in big trouble!

Xingtu Financial Research Institute

2024-05-10 16:51Posted on the official account of Jiangsu Suning Institute of Finance

A big country in the East is going to be in big trouble!

Recently, the rapid depreciation of the yen has attracted a lot of attention. On the morning of April 29, the yen even broke through the 160 mark against the dollar at one point, and although the transaction was likely to be an oolong index, it still caused great panic in the market, and the yen plummeted.

In order to save the precarious yen, the Japanese authorities may have come to the rescue twice. According to the calculation of the account of the Bank of Japan, the Bank of Japan may have spent 9 trillion yen for this, equivalent to 1.52% of Japan's nominal GDP in 2023, and the intervention is not small.

The Fed's interest rate meeting in May was a surprise, and although the policy rate remained unchanged, the slowdown in balance sheet reduction was tantamount to substantial easing, the dollar index corrected significantly, Asian currencies rallied, and the yen breathed a sigh of relief.

However, due to the accumulation of heavy burdens, the yen is still prone to fall and difficult to rise, and there are great hidden worries under the short-term calm.

The key to the continued depreciation of the yen is the widening interest rate differential between Japan and the United States.

If the current U.S. economy is in an atypical stage of high growth, high inflation, and high interest rates, Japan can almost be said to be on the opposite side of the United States, in a word, low growth, low inflation, and low interest rates. While Powell was worried about suppressing high inflation, Bank of Japan Governor Kazuo Ueda was worried about the downward trend of domestic inflation.

In order to get rid of the country's deflation for more than 30 years, the Bank of Japan has successively implemented QQE (qualitative quantitative easing) and YYC (yield curve control) since 2013. It was not until March this year, when the CPI and core CPI were higher than the policy target of 2% for 23 consecutive months, and the salary of Chundou rose by more than 5%, that the Bank of Japan announced the end of the YCC policy, raised the benchmark interest rate from -0.1% ~ 0% to 0% ~ 0.1%, and canceled the purchase plan of Japanese stock ETFs and REITs, but still planned to maintain the scale of government bond purchases.

Despite the tightening of the overall pace, the dovish attitude of the Bank of Japan exceeded market expectations, and the yen fell sharply in response to the positive outburst, falling by 1.14% in a single day. In the next two months, although the interest rate of 10Y Japanese bonds rose slightly, the 10Y US bond rose significantly faster, and the interest rate spread between Japan and the United States further widened, reaching a maximum of more than 380BP. Against this backdrop, market expectations of a weaker yen continue to self-reinforce, carry trades become more emboldened, short positions in the yen increase rapidly, and the yen enters a positive feedback depreciation channel of a downward spiral, which intensified after the Bank of Japan's surprise dove release on April 28.

Japan's means of dealing with the depreciation of the yen are very limited and passive.

For Japan, the quickest way to stabilize the yen exchange rate is for the Ministry of Finance to sell dollars and buy yen in the foreign exchange market. However, this has great limitations: if the Ministry of Finance does not intervene enough, it will not be able to reverse the expectation of market depreciation, and eventually the previous gains will be lost, and if the Ministry of Finance intervenes vigorously, it will excessively consume valuable liquidity, which in turn will lead to more unscrupulous attacks by international bears.

More importantly, the depreciation of the yen is the result of the interest rate differential between Japan and the United States, and reflexivity will lead to the continuous self-reinforcement of this process, and the intervention of the Ministry of Finance is just to stop the boiling, which may have some effect in the short term, temporarily amplifying volatility to repel the most aggressive group of bears, but in the medium and long term, it is difficult to change the general trend of the carry trade leading to the depreciation of the yen.

To narrow the interest rate differential between Japan and the United States, either the Bank of Japan will raise interest rates or the Federal Reserve will cut interest rates. The Fed is obviously not going to take into account Japan's interests, and is primarily concerned about the US economy and inflation. For Japan, the only viable way is for the BOJ to revert to its hawkish stance and start a cautious and gradual process of raising interest rates, but this will undoubtedly be a very difficult choice.

The Japanese government's highly leveraged ratio makes it difficult to afford the rising cost of debt. According to the Ministry of Finance, the stock of general government bonds in fiscal 2023 will reach 1,068 trillion yen, of which interest expenses will be 8.5 trillion yen, accounting for about 7.4% of fiscal expenditures, and the average debt service rate (the ratio of interest expenses to outstanding balances) will be only 0.796%. Such a low cost of debt is obviously related to the large purchase of government bonds by the central bank and the implementation of YCC in the past. In such a situation, even a small increase in interest rates would become an unbearable burden for the Japanese government, and if the average debt service rate rises to 2%, interest expenses alone will increase by 10.2 trillion yen. For comparison, Japan's military spending in 2023 will only be 10.16 trillion yen, which is a 75% increase from 2022.

Japan's economy is still fragile, and a rash tightening could undo all the gains made. For the Bank of Japan, it is necessary to carefully consider the policy scale, so that the hard-won imported and cost-based inflation in the future can be transformed into demand-based inflation. The largest increase in wages since 1991 has greatly strengthened the BOJ's confidence in achieving a wage-inflation spiral. However, the ensuing inflation and employment data disappointed the Bank of Japan, with the CPI and core CPI falling by 0.1% and 0.2% month-on-month in March, while the unemployment rate climbed further to 2.7%. In terms of 2023 data, private consumption and capital investment will continue to be a drag on growth, mainly supported by the increase in exports due to the depreciation of the yen. All this shows that there is still great uncertainty about Japan's economic recovery and inflation recovery, the transmission path of import prices upward to inflation inflation expectations of households and enterprises has not yet been fully opened, and the risk of economic recession and re-deflation makes the Bank of Japan afraid to tighten suddenly.

The mainstream theories of exchange rate mainly include purchasing power parity theory and interest rate parity theory. Among them, investors prefer the theory of interest rate parity, mainly because it provides theoretical support for the carry trade and is more in line with the reality of investment, while the theory of purchasing power parity is too idealistic and difficult to verify in reality.

However, interest rate parity has its own problems, and the theory can only calculate the relative depreciation of the two currencies, but cannot measure the absolute level of exchange rate depreciation. Theoretically, as long as the interest rate differential between the United States and Japan exists, the yen will continue to depreciate against the dollar, which is certainly not possible in reality. This is because when the yen depreciates to a certain extent, purchasing power parity will come into play, and the increase in the value performance of yen assets will attract foreign capital inflows, which in turn will push the yen exchange rate towards an equilibrium level.

Japan, as a very developed capitalist country, is unlikely to experience a vicious situation of currency collapse and depreciation like Thailand, Argentina, Zimbabwe and other countries. In the future, the yen is likely to depreciate in small steps, and may briefly rebound when it encounters a key level of 160, and may squat down when the Fed's interest rate cut expectations cool.

The yen did maintain this trend. As of May 9, the yen has risen against the US dollar for four consecutive years, regaining its foothold at the 155 mark, after the results of the Bank of Japan's intervention on May 2 have been digested by the market, and even the threat of interest rate hikes issued by Bank of Japan Governor Kazuo Ueda on May 8 has been ignored by the market, and the yen is still firmly depreciating downward.

Does the Bank of Japan really dare to raise interest rates? I'm afraid that it is not likely, Kazuo Ueda probably still wants to release the news of interest rate hikes to avoid the market forming a consensus expectation of yen depreciation, and there will be a rapid decline at the end of April again. But as we talked about earlier, the state of the Japanese economy is so severe that the threat from the Bank of Japan looks hollow, and the market is still betting on a fall in the yen with gusto.

Recession or depreciation is a good question for Japan.

[Note: The market is risky, and investment needs to be cautious.] In any case, the information or opinions expressed in this subscription account are only an exchange of views and do not constitute investment advice to any person. Unless otherwise noted, the research data in this article is supported by Straight Flush iFinD]

This article was originally written by "Xingtu Financial Research Institute", and the author is Wu Zewei, a researcher at Xingtu Financial Research Institute

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