When Japanese prime minister Shinzo Abe and the Bank of Japan set about their audacious bout of quantitative easing to reflate the becalmed Japanese economy early this year, the yen fell far and fell sharply, recent bounces notwithstanding.
As of June 19 the currency was trading at ¥95.07 to the US dollar. While it has strengthened from a low of ¥103.19 on May 20, the yen was still 10.34% weaker than where it had been at the beginning of 2013.
This depreciation has had sizeable repercussions for other economies in Asia, both good and bad.
“It’s a mixed picture,” says Mitul Kotecha, foreign exchange (FX) strategist at Crédit Agricole. “The obvious conclusion would be to say that a weaker yen would have negative consequences for the competitiveness of other countries because it will hit their exports. But at the same time a stronger Japanese economy will mean capital outflows into the rest of the region, and potentially stronger currencies. There are two conflicting views and the impact is not obvious.”
There are sever al mechanisms through which a weak yen impacts other Asian nations.
“Easing in Japan should affect other countries through three channels,” says Sameer Goel, head of Asia rates and FX research at Deutsche Bank. “The first, the most dominant and the most obvious, is trade, in particular in countries where the export baskets are similar to Japan’s. The second is the portfolio aspect; to the extent that the Bank of Japan is committed to expanding its balance sheet and creating liquidity, it begs the question where that liquidity will get deployed. And the third is the supply chain channel; Asian countries which are linked into the Japanese supply chain.”
For countries such as South Korea and Taiwan, which possess similar export focuses, Japan’s currency devaluation has been somewhat painful. They are already retaliating with their own measures, leading to fears of a currency war.
But other Asian countries could benefit from and welcome Japan’s increased economic confidence and capital, particularly if it leads local investors to seek improved returns in other markets and currencies.
Depreciation pain
It’s not hard to find countries that feel threatened by Japan’s sustained policy of quantitative easing and effective currency depreciation; a process that has popularly become known as ‘Abenomics’, after Japan’s premier.
Neighbouring South Korea is the most obvious. Its economy looks most like Japan’s from an export perspective, with electronics, automobile and manufacturing industries dominating outbound product flows.
“In the first four months of this year, if you look at the performance in Asian currencies the biggest loser was the Korean won, because [South Korea’s] export similarity [compared to Japan] was the highest,” says Tan Teck Leng, Asia FX strategist at UBS Wealth Management in Singapore, adding that the Taiwan dollar was the second-worst performer, reflecting the second-greatest export similarity.
Correspondingly, the Bank of Korea has been the most vocal of Asian central banks in complaining about Japan’s behaviour.
Korea has been hit by the yen’s devaluation in several different ways, explains Rob Subbaraman, chief economist for ex-Japan Asia at Nomura.
“Firstly, Korea’s exports in Japan can lose competitiveness because Japanese local firms suddenly have an advantage over Korean ones. Another way it can hurt Korea is through Japanese firms selling into the Korean market; those firms in Korea that compete with Japan are suddenly less competitive. And the third way is indirect: Samsung and Sharp, for example, competing in the US market.”
Numbers clearly show Korean exporters hurting already. Korea’s exports to Japan fell 11.3% year on year in April, and then 22.4% in May. But the impact on the overall economy has not yet been keenly felt. This is partly because exports to other parts of the world have not yet been demonstrably impacted, and also because South Korea has fought back with stimulus, lower interest rates and efforts to weaken the won.
Such efforts have led some economists to predict that the country will rebound. “Our view is Korea’s economy will actually strengthen,” says Subbaraman. “It’s weak at the moment, but we will see a pick-up.”
Beyond the obvious examples of Korea and tech-heavy Taiwan, Singapore deserves scrutiny, although it has not been affected as much.
“You can’t disregard the weakness in the yen because it counts for almost 12% of the trade-weighted basket that Singapore manages its currency against,” says Tan.
Equity impact
While a weaker yen most obviously affects the exports of Japan and its neighbours, it also tends to flow through in stocks too.
“There is a subset of this trade channel which is that competitiveness clears itself out through earnings expectations for corporates,” says Goel. “If you look at 2004 and 2007 – the last periods of major yen weakness – a lot of this competitiveness play came through the relative performance of the equity markets, when there was a very clear outperformance of Japanese corporates and the Nikkei [225 benchmark equity index in Japan] versus Korean corporates and the Kospi [benchmark equity index in Korea].”
The second theme, around liquidity and portfolio flows, is an interesting one because it isn’t yet playing out as many expected. Japan’s quantitative easing has not led to an outflow of funds from the country into the high yielding Australian dollar as might be expected, but a repatriation of capital back to Japan. Similar dynamics may be at work in Asia.
“So far there is little evidence in flow data to show that Japanese money is funding its way into the rest of Asia – or anywhere else, for that matter,” says Kotecha. “There is huge expectation that Japanese life insurers and, in particular, the government pension investment fund could be major buyers of overseas assets in coming months. It’s on the cards. But the evidence is not there.”
Goel adds: “In general Asia has not been, and I suspect will not be, a very major part of the shopping basket for Japan. Most Japanese investment historically has either been in developed markets or the high carry market.”
Where there are portfolio flows, Goel thinks they will benefit Southeast Asian bond markets rather than, for example, North Asian equity markets.
Staying cautious
Why isn’t this money flowing out of Japan? Subbaraman at Nomura – which sees plenty of the flows in question first-hand – believes that “local institutions like the big pension and insurance companies are not fully sold that Abenomics is going to work and that there is really going to be much of a change. They haven’t yet become a lot more risk-taking.”
The weakening of the yen has also effectively increased local investors’ holding of foreign assets without them doing anything, because domestic assets are decreasing in value in US dollar terms. “There is less need to allocate more overseas because yen depreciation has done it for them,” says Subbaraman.
Thirdly, while Japanese government bond yields initially fell they have since backed up as the yen has staged a slight rebound.
Besides, the fact that the money hasn’t flowed out of Japan yet doesn’t mean that it won’t. John Woods, chief investment strategist for Asia Pacific at Citi Private Bank, agrees that “reflation in Japan has been almost entirely internalised: invested in domestic assets like the Nikkei and JGBs (Japan government bonds)”.
But this may not remain the case. “If you are a sceptical domestic investor and believe the Nikkei has peaked, that liquidity will start exiting Japan and look for earnings opportunities offshore,” Woods adds. “That is one reason people are becoming a bit more positive towards Asian equities.”
Tan at UBS says that, to the extent that capital movement does eventually leave Japan, “the high yielders in Asia will benefit the Indonesian rupiah and Indian rupee – assuming the Fed [US Federal Reserve] doesn’t taper off [its own sustained bout of quantitative easing] too quickly.”
And in June the Government Pension Investment Fund of Japan stated that it would increase its allocation to foreign bonds, suggesting that it may only be a matter of time before money does start leaving Japan in search of yield.
“If Japan really does double its monetary base in two years that would be unprecedented, and it creates more scope for outflows to foreign bond markets,” Tan says.
Supply chain benefits
On the flipside there are countries that are most likely to benefit from Japan’s sustained efforts to bolster its own economic growth.
“A stronger, more economically vibrant Japan has a more positive effect on the rest of Asia, particularly those which have a close supply chain relationship,” says Woods at Citi. “In particular I’m talking about Thailand, China and even the Philippines. Obviously it helps them if Japan is on a sustainable growth path.”
Thailand is the classic example of the supply chain theme, as it is responsible for so much of the manufacturing and assembly of Japan’s automotive industry, notably Toyota Motor Corp. Malaysia is another beneficiary, but Thailand has had the most visible improvement: in the first few months of the year the baht strengthened almost 5% against the US dollar as a result of increased demand for automobiles.
In aggregate, these themes together “lead you to conclude that North Asia, being more of a competitor to Japan, stands to have more to lose than some parts of Southeast Asia which will benefit,” Goel says.
Still, even in North Asia, there may be a good outcome from all of this.
“If Abenomics works,” says Subbaraman, “and the Japanese economy comes out of deflation with stronger growth, ultimately it could be very positive for the rest of Asia. After all, Japan is the third-largest economy in the world, and if it comes back the demand effect will be very good for Asian exports to Japan.”
Naturally, Japan is not the only thing influencing Asian currencies. As time has gone on developments in the US have come to be still more influential, as the market attempts to work out just when the Federal Reserve will begin to taper off its quantitative easing programme. Several Asian economies have been substantial recipients of the largesse of this policy, so they have a big interest in when the tap will be closed.
Deutsche, for example, argues that if the falling yen is the defining theme, the currencies most affected are the Korean won, Taiwan dollar and Singapore dollar; if the dominant external policy theme is a recalibration of US quantitative easing, the currencies most at risk of a sell-off are the Indonesian rupiah, Indian rupee and Malaysian ringgit.
“What could end up happening is a mix of both themes playing out,” says Goel. “They do have a common element: a strong US dollar.”
And all of this presupposes that Japan stays the course on its bold reflation strategy – which is not certain, given the controversy in Japan about whether it is the right way to go.
“There are still risks to this policy, in that the next big phase for Japan has to be reform and productivity improvement,” says Kotecha. “I think Japan will get to 2% [inflation], though maybe not as quickly as it hopes; whether it can be sustained depends on these reforms being carried out.”
Upper house elections are coming in July, and the market will be looking closely for guidance from their results.
In the meantime, reading the signals is going to be tricky. “The dynamics are quickly changing every single day,” says Tan.
Japan’s efforts to invigorate its economy will be ongoing from this year into next. Its success or otherwise will have sizeable consequences for the country’s regional neighbours. They will be watching, with either interest or apprehension.