The JPY illusion
It is true that the yen has strengthened against the USD and the euro since April. In recent sessions, a dollar buys about 120 yen, compared to 126 back in April. And one euro costs around 102 yen now, down from April's 114 level. So the yen has strengthened, right?
Wrong! The longer-term picture shows a sustained decline of the yen. Compared to June last year, when the yen was averaging 106 per dollar, the yen is some 13% cheaper today. By the same token, the yen averaged 100 per euro last June. It was down to 89 at some point in the fourth quarter in 2000. This means the yen is about 2% cheaper against the euro in the past year and 15% cheaper over the past 9 months. The point is that the sustained, long-term depreciation is much more important in affecting the economic outlook, and hence foreign exchange policy, than a quick short-term (two-month) rebound.
The Koizumi effect
Crucially, the recent yen strength is not sustainable. The yen's rise since Koizumi san became Japan's Prime Minister in April is mainly due to expectations of a major economic improvement under the new leader. But these expectations are likely to be unmet.
The market is banking on Koizumi san to deliver his election pledges, notably a fast write-down of bad loans and a cut in the fiscal deficit to 30 trillion yen. But a fast bad-debt write-down would push many banks over the cliff. This could set off a chain effect on the economy and lead to a financial implosion. Cutting the fiscal deficit at the time when the economy is weakening would drag it into a recession. All these do not sound like a winning campaign platform for Koizumi for the Upper House election in July. So quick implementation of these measures is not likely.
If Koizumi's government survives the election and his reform plans are implemented, the Japanese system is going to face tough times. If Koizumi and company were defeated in the July election, the LDP's old-liners will rule the government again -- and they will not reform. Even if Koizumi san won, it is still doubtful how far he could push his reform program under the shadow of the conservatives in the LDP. Worsening economic and structural woes won't help his reform plans either.
On the back of a weakening economy, with leading indicators pointing to more bad times ahead, this catch-22 situation for Koizumi – damned if he wins, damned if he doesn't – is negative for the yen. Hence, even if the Bank of Japan doesn't force the yen down, the market will do the job. The political and economic woes are also negative for the Japanese stock market. Thus, the JGB yield curve could flatten further when funds take flight for safety from equities to bonds.
euro abandoned
The smell of stagflation -- inflation plus stagnant growth -- is a big problem hurting the euro. The lack of ECB credibility only rubs salt to the euro wounds. Though short-term interest rate spreads over the USD still favour the euro, bond yields in euroland are not attractive. The emergence of inflation risk suggests that euro bond yields would be likely to rise further, implying potential losses on bonds. So euroland bonds are no good.
Business and consumer confidence have been plunging in Europe, suggesting significant weakening of the domestic sector. If Europeans do not have confidence in their economic outlook, why should foreign investors? One could argue that confidence in the US has also dropped. But recent data shows that the worst of the US confidence decay might have passed, while further deterioration can be expected in euroland. Hence, euroland equities are no good either.
Even if the US economy recovers, its help to euroland's growth may be limited because its domestic sector is weakening. In both Germany and France, inflation has been rising either faster than or at the same rate of wage growth. This means that real income growth is down or flat, dragging on consumption. All this only underscores the perception that US growth outlook is still superior to euroalnd's. The euro bear is still roaring, and the ECB doesn't seem to care. New lows for the euro, anyone?
Chi Lo, regional head of research (NE Asia), Standard Chartered Bank Global Markets, Hong Kong.
