March 6, 2013

Whatever it Takes

By David Franklin, Market Strategist, Sprott Asset Management LP
dfranklin@sprott.com

Japan is about to embark on one of the greatest monetary experiments in economic history. The new Prime Minister, Shinzo Abe, has promised to jumpstart the Japanese economy and propel it out of deflation almost entirely through financial measures. This is a tall order for a country that has been mired in a deflationary spiral for the greater part of 15 years.

During his election campaign Prime Minister Abe made his position very clear. He suggested that the central bank should print an "unlimited" amount of yen to help fight falling prices. This sentiment was echoed by Haruhiko Kuroda, who is expected to become the new governor of the Bank of Japan (BOJ) later this month. During his testimony at a confirmation hearing in Japan's lower house of parliament, Kuroda gave some hints at his new policy direction. Being a strong proponent of aggressive monetary measures to kick-start the economy, Kuroda said that he would not set limits on the amount of funds the BOJ would inject into the economy. Kuroda also said that the BOJ's current policies were not strong enough to boost inflation to the government's target of 2%. He ominously stated, "I would like to make my stance clear that we will do whatever we can do..." with a goal to end 15 years of deflation. (this was widely quoted as "Do whatever it takes")

How prevalent is deflation in the Japanese economy? Forbes provided some historical reference from Paul Sheard, chief economist at Standard & Poors, who has also been a critic of the BOJ and current Governor of the BOJ Masaaki Shirakawa. For the 18 years starting from a peak in the second quarter of 1994 to the end of 2012, the Japanese GDP deflator-the broadest measure of the price of goods and services-declined by 17.8%. For comparison, the U.S. deflator rose by 45.3% over the same period, while the U.K. deflator rose by 51.5%. Over the 15 years ending in 2012, the year-on-year change the Japanese CPI averaged -0.2%, compared with 2.4% in the U.S. and 2.1% in the U.K. Given the stark contrast of these numbers, it will take a lot of printing and stimulus for Abe and Kuroda to reverse Japan's deflationary trend.

Investors have already started repositioning their yen bets in anticipation of Japan's new policy plan. The cash 10-year JGB yield fell this week to as low as 0.585%, its lowest point since June 2003. And the yen per dollar exchange rate has depreciated from 82 to 93 yen per dollar over a mere 3 months. This 13% depreciation represents a massive change in the yen exchange rate with the US dollar, and has come about without any new policy actually being implemented yet! So far the entire yen move has been a response to Abe's and Kuroda's comments - or "open mouth-operations", regarding their monetary plans for Japan's future. Deutsche Bank has an exchange rate forecast for the next 12 months of 105 yen per dollar, or another 12% depreciation. Some market commentators have even suggested the BOJ could eventually push the yen dollar exchange rate to 200! If this comes to pass, it will have seismic impact on the Japanese economy and the entire global econo my as a whole. This is big. Potentially THE macro-economic event of 2013, with far reaching implications.

"Abenomics" stands in stark contrast to conventional economic wisdom regarding the soundness of fiscal policy and the independence of central banks. Japan has faced 15 years of deflation and Shinzo Abe has decreed he will end it. We will be listening to the 'open-mouth-operations' coming out of Japan carefully, and watching for new policy indications from the BOJ. We will not have to wait long either, as the next scheduled meeting for the BOJ is April 3rd and 4th, when Kuroda is expected to outline the new policy direction of the BOJ. What is Japan going to do to pull itself out of a 15-year deflationary spiral? Whatever it takes.