Japan’s problem is uncompetitive products

The tug of war between the Bank of Japan and the newly installed government led by Shinzo Abe continues.

The central bank finally yielded to pressure from the administration to voice its commitment to a new 2 per cent target for inflation but did not commit to any deadline beyond “the medium term”. It promised more open-ended easing but that will start only in 2014. The net increase in asset purchases for next year will be a mere Y4tn a month.

Despite the bank’s rearguard action, faith in the short yen/long equities trade remains widespread. But the market may be too optimistic – not in believing that the Abe administration will prevail but in believing that the trade will work for any sustained period.

Mr Abe and the business community in Japan continue to think their main problem is an expensive yen, or more accurately an underpriced Korean won. That may have been true in the past but not today. Even if the yen was to fall significantly, the world’s consumers are not about to abandon Samsung gadgets for those of Sony or Toshiba. The problem is not an uncompetitive currency, it is uncompetitive products.

The latest fiscal stimulus programme is large. Indeed, the Y20tn headline figure is the largest since the second world war, according to JPMorgan. But it, like its predecessors, is unlikely to have a big multiplier effect in stimulating more private investment or consumption.

Meanwhile, Japan’s trade deficits will worsen as the cost of imports rises while the current account will benefit but not enough to compensate. The fiscal deficit is expected to reach a shocking 11.5 per cent this year, JPMorgan estimates.

The yen has already depreciated 15 per cent, leading many to believe the correction is now overdone. Still, some analysts expect the Bank of Japan will soon be forced to embark on a massive programme of foreign bond purchases in an effort to drive the currency even further down, spending a possible Y50tn in the process. It is not entirely clear whether that buying will be targeted exclusively at eurozone debt or US Treasuries as well (as some Fed officials believe may be the case).

If that happens, there may be much worse to come. One reason the yen has remained strong (until recently) is because the BoJ has been much less aggressive in expanding its balance sheet than other central banks. As that changes, the danger that the yen overshoots on the downside becomes higher, with big negative ripple effects both on the Japanese government bond market and the Japanese economy.

The markets today remain oblivious to the threat of massive new supplies of government bonds and developments in the currency market. But foreign investors now hold 9 per cent of the bond market. As the yen goes down, those investors will begin to demand more yield to compensate for their losses on a depreciating yen. What happens then?

One possible scenario is that the Japanese money, which went into Europe and the US in an effort to drive down the yen, decides to come home to shore up the government debt market. No Japanese investor can afford to take capital losses on their holdings of JGBs and the government can hardly risk paying more to service its spiralling debt.

Moreover, the currency could fall much more, given how many hedge funds are betting against it. Many, including David Einhorn at Greenlight Capital, finally made money on their short yen positions in the last quarter of the year. (Indeed, the position was Mr Einhorn’s second most lucrative one for the period.) They will be tempted to add to their positions, especially since the cost of borrowing yen is so cheap.

“The yen has finally begun to weaken. We suspect that there is more to come – possibly a lot more to come. We continue to be bearish,” Mr Einhorn wrote in a letter to investors dated January 22.

Still, for now, optimism prevails. The yield on the 10-year JGB hit a low of 69 basis points in December and is now a mere 74bp. The general optimism will be reinforced come April when Masaaki Shirakawa is replaced at the helm of the Bank of Japan. All the leading candidates for the position are more supportive of Mr Abe than they are of the current governor.

Still, if Mr Abe is wrong and precipitates a vicious cycle of a weakening yen and rising government bond yields rather than an economic revival, Mr Shirakawa’s successor could face even more of a nightmare scenario than the incumbent has done during his contentious tenure.

henny.sender@ft.com