Japanese paradox

You have probably noticed that the stock market is crashing again in Tokyo. What you might not have considered is that this presents an opportunity for a speculative play on the yen. Bet that it will go up. The Japanese Nikkei dropped I 0% in the 14-day period from Oct. 26 through Nov. 9 as investors noted that the Japanese economy is performing miserably. Contributing to this economic weakness are the severe financial pressures on the big banks. The capital base of many of Tokyo's giant banks suffers as their portfolios of industrial stocks decline in value and as they belatedly own up to staggering losses on their real estate loans.  The balance sheet weakness in turn translates into reduced lending.

The weak Hosokawa coalition government worsens matters. It is under continuing pressure from the Clinton Administration to cut income taxes and all but force consumers to buy more American goods. But its effective paralysis means that it can't deliver. So, there won't be much of a resurgence in consumer demand to recharge the economy, and political pressure from the U.S. will continue. Instead, what we see in Japan now is deflation. The asset bubble has burst. Real estate prices are falling. Other prices-­ stocks, consumer goods--could follow. All this makes for a strong yen rather than a weak one. The contrast between the weak economy and the strong currency may seem paradoxical, but it is not contradictory. Markets have taught us that economic weakness does not necessarily translate into currency weakness, and the current situation is no exception to this rule. ln fact, the yen has performed wonderfully, shrugging off all the bad economic data in Japan. Many very large and well-known speculators have bet heavily against the yen, only to discover that the massive trade and capital flows moving out of dollars and European currencies into the yen can completely overwhelm and reject speculative flows moving the other way. This lesson has been taught repeatedly since 1990, and it has often been expensive, but its message persists. Recently, many players built up quite massive, short yen positions, in anticipation of a trade package between the U.S. and Japan, which, they reasoned, would remove the need for a currency shift. (In favor of a stronger yen) to correct the enormous trade imbalance between these two nations. The premise of these speculators, unfortunately, is ultimately flawed, as the trade imbalance is ingrained in the living habits of both countries. The trade surplus with the U.S. will not be fixed by the Clinton Administration's jaw­ boning. It will be corrected only when the U.S. and Japan dramatically shift their respective preferences for consumption and saving. The Japanese must become much greater consumers and the Americans must become much greater savers. Otherwise, the trade imbalance is doomed to remain stubbornly and dangerously large., and to be a source of continuing political and eco­ nomic tension--and of continuing strength in the yen. Ultimately the value of the yen is determined by trade and capital flows, and they both look set to support the yen for quite some time. The weakness in the Japanese economy, coupled with the increasingly healthy U.S. economy, points to a probable worsening of the trade picture. More and more, the U.S. recovery is becoming consumer led, while Japanese consumption is still declining. That means a growing amount of Japanese export sales will be converted from foreign currencies, such as dollars, back into yen, every month there are over $10 billion worth of these conversations, and they create a constant demand for yen.

When the domestic situation in Japan is healthier. Japanese investors recycle many of these flows abroad by purchasing foreign assets and securities. Currently Japanese investors hold hundreds of billions of dol­ lars' wm1h of U.S. and European assets, and it was these net purchases that prevent­ ed the yen from appreciating more rapidly during the late 1980's and early 1990’s. Now, however, with weak capital bases and severe deflationary pressures continuing unabated, the likelihood of extensive further recycling of the trade surplus is diminished. In fact, if domestic conditions worsen sufficiently, one should expect substantial efforts by the Japanese to protect or even bring home some of their foreign holdings. That means yet more purchases of yen and sales of dollars and deutsche marks. The bottom line is that the yen may be getting ready for another very large appreciation against the dollar and the European currencies. The flows all point that way and increasing dissatisfaction of the U.S. Administration with the pace of the Hosokawa administration's effort to shrink the trade surplus could cause this move to accelerate.