The strength of the Japanese yen late last month was driven in part by growing expectations of an end to the Bank of Japan's quantitative easing policy, which will ultimately result in less liquidity in the Japanese economy.
There were also expectations that this would then see a rapid move to reduce banks' current account balances at the Bank of Japan (BoJ). However, the risks are that the BoJ will be rather more cautious and the market will be disappointed. In addition, portfolio inflows into Japan are easing back, and may turn negative at the start of the new fiscal year. The risks would seem to be that the Japanese yen gives back further ground in the near future.
The BoJ introduced its policy of quantitative easing in March 2001. This was necessary because Japan's economy had failed to return to a sustainable growth path and was faced once again with a threat of deterioration. Against this backdrop, the BoJ concluded that the economic conditions warranted monetary easing.
In setting this policy, the BoJ also defined the conditions under which the policy would end. Specifically, that the new procedures for money market operations continue to be in place until the consumer price index registers stability at zero per cent or an increase year on year. The exit strategy has been refined to include the proviso that the risk of a return to deflation should also be small.
The current conditions for exit have been met, as consumer prices have been at or above zero for the past four months, and the consumer prices jumped to +0.5 per cent. The recent strength of economic activity measures, and of the equity market, suggests that the BoJ may have confidence that deflation may not recur.
As a result, the BoJ announced that there would no longer be a target for current account balances, but instead sufficient liquidity would be provided to ensure short-term interest rates remain at zero. Some in the market appear to be expecting that excess reserves will be rapidly eliminated. However, there are also good reasons for expecting the BoJ to be cautious about the speed of its exit from quantitative easing.
Demand for funds in March is often high because of end of fiscal year pressures. Hence, to remove reserves now would risk disrupting the markets. Furthermore, the BoJ wants to be absolutely sure that the economy will not weaken before it makes a move away from zero interest rates. Given current market expectations, there would seem to be the risk of disappointment with the speed of BoJ's exit from quantitative easing.
An additional factor that may weigh on the Japanese currency in the short term is the recent weakening of portfolio inflows. Bond flows have already turned negative, while equity inflows have weakened. This suggests that the strength of the yen has been driven by short-term flows and so could unwind. Next month will see Japanese institutions allocate new funds to investment in oversees assets which could turn the net portfolio flow data quite negative.
The period around the end of the fiscal year often sees fairly sharp moves in the yen and the risks for this year seems to be that the Japanese currency will give back some ground, at least temporarily, as expectations about the pace of monetary policy change are revised down.
While there are short-term downside risks to the yen, the long-term outlook is for significant strength. The rise in energy prices over the past two years has added to the Japanese import bill and cut the trade surplus, despite strong exports.
However, the Japanese current account surplus has continued to trend higher because the growth in overseas investment income has more than offset the fall in the trade surplus.
Japan now has a bigger surplus on overseas investment income than it has on trade. With net external assets of ¥200 trillion (40 per cent of GDP), that are growing about 10 per cent per year, the structural Japanese surplus is set to continue rising.
The more US interest rates rise, the bigger the Japanese surplus will become. Japan's position is the mirror image of that in the US. When the US dollar reversal comes, the Japanese yen will again be under intense upward pressure.
What are the long-term implications of this? First, the Japanese net asset position is the largest single counterpart to the US net liability position. According to Bureau of Economic Analysis data, the US has a net liability position of $2.5 trillion, which compares to the Japanese net asset position of $1.7 trillion at current exchange rates. The Eurozone has a net liability position of about $1 trillion.
If the global net international investment position is to stabilise, it will require a fall in the US current account deficit and the Japanese surplus will have to narrow. If exchange rates are to play a part in this, it is the Japanese yen, not the euro, that will have to adjust.