By John Hardy
Special to Newsweek Middle East
The July 10 elections for the Upper House of Japan’s National Diet saw the ruling coalition score a strong victory, giving Prime Minister Shinzo Abe the two-thirds supermajority he needs to reform Japan’s constitution – perhaps his chief political aim.
More interesting for financial markets – and currency traders in particular after the recent yen strength – is how the result provides the Abe coalition with a mandate for more forceful policy action on the economy. The ballot clears a political path towards concerted efforts to boost Japan’s faltering recovery and combat the re-emergence of deflation.
The clarity of Abe’s mandate led many observers to suspect that some form of “helicopter money” could be in the offing along with more conventional central bank stimulus measures.
Helicopter money can take many forms, from supply-side tax cuts to infrastructure spending to direct cash outlays, but the common denominator is that it is an attempt at demand stimulus by the fiscal authority. In a helicopter money regime, the central bank is only there to cover any fiscal shortfalls as money is “dropped” into the economy from above – i.e., by the government.
Why is Japan considering such drastic measures? Because its previous venture into extreme policymaking has failed to produce the intended effects, and so it must now edge further out on the limb. Remember: the Bank of Japan (BoJ) Quantitative and Qualitative Monetary Easing program (QQE) purchases assets worth some 15 percent of Japan’s annual GDP every year, and has still proved powerless against deflation – particularly given the collapse in commodity prices, weakening domestic demand, and aggressive devaluation of the Chinese renminbi.
In fact, the yen is some 20 percent stronger versus the renminbi since the botched BoJ attempt to impress markets with a negative rate policy in January. Not only is the yen up against its regional rival, but the policy statement from the BoJ on July 29 also failed to stem the yen rally that re-asserted itself after Abe’s victory brought the currency down from the precipice.
As it happened, the central bank’s mere tweaking of policy at the July meeting – it left its policy balance rate and monetary base target unchanged while expanding the exchange traded funf (ETF) purchases and USD lending – saw the yen rally farther versus a basket of major currencies, most notably the USD.
All of these developments appear to fly directly in the face of Japan’s intentions for both its currency and its economy. After all, wasn’t this the country that flew former Federal Reserve chair Ben Bernanke in to talk policy with both Abe and BoJ Governor Kuroda in July? The same easing-friendly Bernanke who was so famously critical of Japan’s restrained, late-1990s-and-early-2000s approach?
Japan’s choices are constrained by more than ideology. While the market’s expectations going into the July 29 meeting were intense, the BoJ’s rear-guard actions reflected the fact that BoJ bond-buying is reaching technical limits in Japan and has been blamed for destroying the liquidity of the Japanese Government Bond market. There is also the broader question of diminishing returns familiar to all central banks grappling with the unwelcome byproducts of heavy post-crisis stimulus.
This is why the September meeting is so crucial. Kuroda and company need some time to make to what they referred to in the July monetary policy bulletin as a “comprehensive assessment” of their program and its efficacy. What this means is that the stakes for September are high indeed… but we knew that. The stakes of the central bank stimulus game are high everywhere, and in many ways we are in uncharted territory.
Japan’s structural issues include spiraling debt compounded by a severe demographic decline, and the scale of its money-printing measures requires fiscal involvement and thus a new kind of policy dance with the BoJ and Ministry of Finance as partners. Central bank policy has failed.
Helicopter money – particularly of the cash drop variety – is a powerful new tool, and if employed wrongly or in excess it could suddenly mean Japan lurches from the edge of a deflationary abyss into sudden, aggravated hyperinflation.
Regardless, it looks like the inevitable next step for Japan and it’s very effective in generating inflation – even if is inflation of the corrosive, financially repressive sort (this is so-called “cost-push inflation” where the yen is watered down due to excess systemic supply rather than the more desirable “demand-pull” inflation that results from stronger economic growth).
The yen can head stronger for a while, but if helicopter money is truly on the way, Japan will be “rewarded” with a tumbling yen as it approaches the vanguard of what could eventually prove a new phase of the global currency wars. After all, and should Abe realize his ambition to create a new, less pacifist constitution, some of that helicopter money will likely end up in military outlays, including actual helicopters.
All of these factors are in play between now and September, with the degree of cooperation between the BoJ and the Abe government and the size of the stimulus the key questions. Helicopter shock and awe are needed to slay the deflationary dragon.
Look out below, we suppose — or maybe above.
John Hardy is the Head of FX Strategy at Saxo Bank