A Contrarian Bet Against the Rising Sun

Amidst the rapid decrease of the Japanese Yen since Shinzo Abe won election as Japan’s next prime minister in December 2012, the fundamentals concerning how the depreciation would impact global markets practically have been forgotten.

Attention of market participants has been fixated on Abe-rhetoric, which has driven the yen down 7.2% since December 2012 without any quantitative easing from Japan’s Central Bank thus far. In fact, Abe’s rhetoric has transformed market sentiment more successfully than Japan’s last US$100billion attempt to drive the Yen down in November 2011. Furthermore, market participants see the near future outlook for the Yen weighing towards further weakening due to:

Will the Sun continue to rise this year?

1. Japan Central Bank’s likely stance to utilize monetary easing until an inflation target of at least 2% is achieved;

2. The delay in increasing the consumption tax will add pressure on Japan’s fiscal position and weigh on the yen; and

3. Rumours of a ratings downgrade would likely increase sales of Japanese government bonds and capital outflows, which would depreciate the yen.

However, an examination of the fundamentals suggests that Japan’s devaluation of the Yen will not be allowed to go so far, for both political and economic reasons. Politically, Shinzo Abe’s rhetoric and ultra-nationalism has provoked neighbouring countries China, South Korea and Taiwan. Japan and South Korea’s relations soured over Japan’s decision to celebrate Takeshima Day in February 2013, a celebration concerning the Takeshima Islands or Dodko (as they are known in South Korea), as well as continued issues regarding Japan’s refusal to acknowledge its misuse of Korean comfort women. Japan’s relations have soured with China and Taiwan over its decision to nationalize the disputed Senkaku Japanese) or Diaoyu (Chinese) islands last year. Then there is the added competitiveness between China and Japan as to who is the giant in Asia and the stage is set for political confrontations. On the economic side of the coin, Japan’s major trading partners – China, South Korea, Taiwan, Hong Kong, and Saudi Arabia – all have something to lose in a global marketplace with a weaker Yen. A weaker Yen directly affects these countries’ imports and exports. Furthermore, these countries all compete with each other in global markets. For example, a cheaper yen can slow these countries’ export growth to key markets such as the USA and Eurozone. When one combines the political will of these countries when confronted by Japan along with the economic detriments for them of a weaker Yen, there is incentive to negate Japan’s efforts.

The next question then is do these countries – specifically China, South Korea, Taiwan, Hong Kong, and Saudi Arabia – have the means to resist Japan’s efforts to weaken the Yen. International capital reserves allow governments to manipulate exchange rates – either to provide their country with a more favourable economic environment or to buy domestic currency to protect their country from “hot money”. On the one hand, Japan has the second largest international capital reserves in the world at US$1,321,000 million. However, just considering China’s reserves alone, nearly double Japan’s at US$2,453,550 million, suggests the means to counter Japan’s Central Bank. In addition, Saudi Arabia have the fourth largest reserves (US$418,000 million), Taiwan have the sixth largest (US$360,230 million), South Korea have the eighth largest (US$316,000 million), and Hong Kong have the tenth largest (US$295,000 million). Combined, this is a potent arsenal to arrest Japan’s depreciating yen. My proposition is that they won’t let the repercussions of a weaker Yen last long and therefore a contrarian bet against the Japanese Yen is an attractive play.

The recent slight increase in the Yen’s value to 91.60 against the USD, from a low of 94.99, may just be a market correction. However, it may also signal testing of Japan’s strength and commitment to intervene to weaken the Yen. Once the Japanese Central Bank is installed with a governor conducive to Shinzo Abe’s vision of a weaker Yen and they begin a concerted campaign of unlimited quantitative easing, we may see a concerted effort from China, perhaps with implicit cooperation from other affected states such as South Korea, Hong Kong, Saudi Arabia and Taiwan, to combat their attempts. Although they may be unlikely allies, these countries could be united by a common cause – game theory suggests that cooperation would save them more of their individual capital reserves than if they acted alone. Therefore, be a surfer, watch the ocean, and figure out where the big waves are breaking. And adjust accordingly.