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WisdomTree comments that fiscal woes keep the yen weak


ETF provider WisdomTree writes that the yen is poised to remain a structurally weak currency, and calls for added easing on the yen from the Bank of Japan. 

The firm writes: “In coming weeks, yen volatility is expected to rise as short-term market players’ position for potential changes in central bank policy. Here we maintain our call for added easing from the Bank of Japan (BOJ) to be in place by the end of the November 18–19 policy board meeting. More importantly, beyond this short-term outlook, the case for a continued structural depreciation in the yen remains strong because of the dismal outlook for Japanese government finances, in our view.”
The BOJ has scheduled two policy board meetings in a period of four weeks. The first was a one-day meeting on October 30, whereby the main agenda item was the semi-annual revision in the board members’ “central tendency forecast” for inflation and growth. The second is the upcoming regular two-day meeting on November 18 and 19, which will follow the release of the July–September gross domestic product (GDP) report on November 16. WisdomTree writes that investors should expect more pundit commentary and jockeying for market positioning in the run-up to these dates.
“In our view, added easing is likely at the November meeting. Our rationale here is not primarily the continued weakness in Japanese domestic economic indicators—industrial production fell to 1.4 per cent below the April–June quarterly average in July and August, representing a 2.8 per cent drop relative to the January-March average. The real reason is political: Prime Minister Shinzo Abe and his team are very focused on reasserting a coordinated pro-growth policy drive. In our view, a switch in BOJ priorities from de facto Consumer Price Index (CPI) targeting toward targeting nominal GDP—that is, the BOJ explicitly falling in line with Abe’s new JPY600 trillion target for Japan’s nominal GDP (currently approximately JPY500 trillion)—is possible.” 
However, WisdomTree writes that merely changing the target from 2 per cent inflation to JPY600 trillion nominal GDP will not do much in itself. “An increase in BOJ asset purchases is likely, in our view, centering on both exchange-traded funds (ETFs) and adding municipal, regional and “zaito” government bonds to the BOJ’s bond buying options (which are currently limited to national government debt only). If so, the short-term case for added yen depreciation rests on this added quantitative ease” the firm writes.
The more medium-term case for yen depreciation rests on more fundamental economic grounds, they believe. “Japan’s fiscal dynamics appear locked in a vicious cycle of endless budget deficits running around 2 per cent to 5 per cent of GDP in the foreseeable future. Why? To understand Japanese government finances, we have looked at the past 35 years of data on both expenditures and revenues as a share of nominal GDP. This historic perspective shows that increasingly heroic assumptions are needed to escape from permanent deficit financing. Specifically, over the past 35 years, total expenditures exceeded revenues by an average of approximately 5 per cent of GDP.”
In order to understand the difficulty of getting back to a budget surplus, WisdomTree suggests looking at the extremes, the ‘high’ and the ‘low’ both spending and revenues. Expenditures peaked at 22.7 per cent of GDP and troughed at 13.8 per cent, while revenues peaked at 16.4 per cent and bottomed at 7.5 per cent of GDP.
“So to get toward a budget surplus, spending would have to be cut back to within one percentage point of GDP to the historic low, while revenues would have to rise to within one percentage point of the historic high. Given the realpolitik on both the expenditure and revenue sides, these seem like increasingly heroic assumptions, in our view. In other words, prospects are for the budget deficit to remain within 2 per cent to 5 per cent of GDP in the foreseeable future.”
Japan thus faces the combination of both a ‘perma-deficit’ from the government and a structural deficit from the household sector (which is dictated by the demographics—that is, the aging society forcing dis-savings and a negative savings rate currently running at around 1.5 per cent of GDP). The net result is an economy that must attract global capital to fund its domestic savings deficit.
“The necessary adjustment could come via higher interest rates or a weaker currency. In our view, the BOJ is poised to maintain its iron grip on interest rates in general, Japanese government bond (JGB) yields in particular—we do not want to fight the BOJ. In turn, we do expect that the currency will bear the brunt of the adjustment. Japan’s “twin deficits” of both the public and household sectors argue that global investors should hedge their Japan asset exposure, in our view.”

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