Why JPY is so strong and how it matters to the West
Over two lost decades of economic growth, a public debt to GDP ratio of over 225%, minuscule Japanese government bond yields and a near permanent bear market in Japanese shares hardly seem like strong justifications for a strong JPY. However, USD/JPY currently trades at around 80, compared with around 110 about five years ago.
Since the eruption of the financial crisis, Japan has taken on a safe haven status, and given its financial bubble popped after the 1990s, it's already been through the rehabilitation process the West still has to finish. Japan's economy and financial system has appeared relatively more stable than West's. Also, the country boasts enviable social cohesion and its huge debts are predominantly financed domestically.
Japan has been a big exporter of capital and the income from that has been very supportive of its current account surpluses. Indeed, successive Bank of Japan interventions have been an attempt to counter-act those surpluses in a bid to sap JPY strength.
All these factors are well known, but what's less well appreciated is why Japan has tolerated such a strong JPY, which has resulted in hollowing out its industrial base. Though the BoJ's efforts have been substantial, it should have been even more aggressive, according to Japan's beleaguered exporters. Indeed, the Swiss managed to successfully cap the rampaging CHF through ultra-aggressive interventions and the threat to escalate them if necessary.
Mrs Watanabe likes a strong JPY”
In effect it comes down to Japan's ageing population with many retirees living off fixed income pensions. One of the effects of a strong JPY is domestic deflation, also because of over-capacity and weak demand, but is nonetheless convenient for people living on fixed incomes. When the retired Mrs Watanabe, the mythical Japanese housewife, goes down to the shops, she's not unhappy that the yen in her purse goes further. And crucially older people are also more likely to vote than younger people – a factor politicians are well aware of.
According to the BoJ Japan's dependency ratio was 17% in 1990, the lowest of the G7 countries, but soared to 35% in 2010, the highest in group, and is set to reach 53% in 2030. The BoJ explains that the ageing population is a significant dampener on GDP growth and will increasingly weigh on the economy in the coming decades. It also notes that an older population negatively impacts fiscal balances as seen in Japan with retirees drawing state pensions rather than earning salaries and paying taxes.
The growing band of Japanese retirees and their rising political clout is likely to favour maintaining a strong JPY against a backdrop of weak and indecisive governments. However, the situation in Japan is unsustainable and the government is looking to cut pension payments by 2.5% from October 2013 to April 2015 in line with falls in the Consumer Price Index. If this goes ahead it will be interesting to see if this in any way changes the socio-political dynamics favouring a strong JPY. Also, questions are increasingly being asked by policy makers over whether Japan can afford such a strong currency.
Gazing into a crystal ball
Japan is in the vanguard in terms of the ageing of advanced economies. What is happening in Japan and the performance of asset classes there matters, because Western countries are also starting to age and are likely to experience similar economic symptoms and socio-political dynamics. Nonetheless, the BoJ holds out some hope for ageing societies in finding new sources of growth. It notes that “depending on the creativity of the supply side, there is considerable room left to expand the elderly's spending.” The BoJ says that in a rapidly changing economy, the output gap only captures the shortage of demand in terms of the current supply of goods and services, but does not reflect the shortage of supply against new potential demand. In some respects Japan is a laboratory of how advanced countries adapt to what is one of the most important of all economic mega-trends – ageing populations.