By DAVID REILLY
Yen strength may prove fleeting, even without ongoing intervention to weaken the Japanese currency.
The yen surged in the wake of Japan's natural and nuclear disasters, partly in anticipation of money being repatriated, prompting Group of Seven countries to intervene Friday. Longer term, though, the currency's prospects are clouded by a likely deterioration in Japan's trade balance, potential for the Bank of Japan to buy more government debt, and likely rises in interest rates overseas, which would make the yen look relatively less attractive.
In January, Japan reported a ¥395 billion ($5 billion) trade deficit, its first since January 2009. While that decline was thought to be largely seasonal, the earthquake and tsunami change the picture.
Color China Photos/Zuma Press
As export industries struggle with rolling blackouts and supply-chain disruptions, Japan will have to import materials for reconstruction and energy to make up for damaged plants at home. "If Japan's trade profile deteriorates over the next several months as the country imports more in the rebuilding process, we think this will take an important source of strength away from the currency," analysts at Standard Chartered wrote this week. And the yen could face more downward pressure if the country's fiscal condition deteriorates further.
Japan's about ¥870 trillion in government debt already is about 200% of gross domestic product. Japan has for years been able to carry this seemingly unsustainable load because it sells about 95% of debt domestically. Also, interest rates have been low because of the deflationary slump, which makes the actual annual interest costs manageable.
Barclays Capital estimates reconstruction costs for the government could be ¥5 trillion to ¥7 trillion, equal to about 6% of government spending. Economists believe existing reserves should fund a large portion of this, so there shouldn't be a flood of new bond issuance, although any additional stimulus programs could change that.
Still, while Japan's savings pool is big, it isn't limitless, especially given its aging population. The savings rate climbed to 5% in 2009. But Goldman Sachs forecast earlier this year that it could go negative this year or next.
If there were any difficulty funding additional spending at low rates, Japan would struggle to tap foreigners, who likely would demand higher yields, particularly if interest rates around the world rise. Instead, the Bank of Japan might feel it has to buy more bonds to keep yields down. Even with 10-year Japanese government bonds yielding just 1.2%, interest payments are about 10% of government spending. And banks would share in any yield pain because they are big holders of government debt.
If there are bond-market issues, "then we can expect more quantitative easing to soak up the problem," says Andrew Milligan, head of global strategy at Standard Life Investments.
Persistently low yields on Japanese government bonds may continue to confound bears, as they have for years. But the yen may end up weaker than even the government currently hopes.
Write to David Reilly at david.reilly@wsj.com
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