Koizumania reached a fever pitch on Sunday as the wildly popular Junichiro Koizumi led his unpopular Liberal Democratic Party to an election victory. The prime minister's win could mean many things for Japan's economy, the most immediate being a weaker yen.
Koizumi's ambitious plans to slash government borrowing and force banks to write off bad loans have investors bracing for a drop in Japan's currency. While the prime minister's strategy could pay off in the years ahead, it's sure to cause economic pain in the short-term, by boosting unemployment and depressing growth.
"The initial impact of any reform is likely to be deflationary," says Steven Saywell, a London-based currency strategist at Citibank.
Continuing decline
That helps explain why the yen had its biggest drop in four months and Japanese stocks slid to a 16-year low following the victory of Japan's ruling coalition in Upper House elections. News that industrial production fell 0.7 percent in June, twice as much as expected, didn't help. It was the fourth straight monthly decline and suggested the economy continues to shrink. It contracted 0.2 percent in the first quarter.
Now it's time for markets to contend with the dark side of the "Koizumi Phenomenon." Investors couldn't care less about the personal charisma, mane of unkempt hair and love of rock and roll music that so endeared the 59-year-old to voters. What they do care about is Koizumi's much discussed, but unimplemented economic reform plan. That they've heard far more about it than they've seen isn't inspiring much confidence. Hence the yen's slide.
Since taking office last April, Koizumi has focused on staying there. With the LDP safe for now, Koizumi will try turning economic vision into reality.
"Now for the hard part," says Anne Mills, senior currency economist at Brown Brothers Harriman & Co in New York. "The LDP's win removes one potential barrier to Koizumi's proposed reforms, but bigger ones remain." The biggest are getting changes past a wall of opposition within Koizumi's party and getting the reforms right. Whether markets think Koizumi will pull it off may matter little in the near term.
The mere expectation of reforms is likely to hurt the yen as investors price in a deeper recession and weaker demand for yen-denominated assets. After all, Koizumi has pledged to implement his programs even if they boost unemployment and cause hardship for Japanese households.
All of this could bring the Bank of Japan back into play.
With interest rates at zero percent, BOJ Governor Masaru Hayami has made further money-printing efforts contingent on concrete action by the government. Those steps include forcing banks to write down loans and getting corporations to reduce debt levels.
Once Koizumi starts down that path, the BOJ will come under pressure to make good on its own pledge to increase Japan's money supply.
Koizumi's economic team has dropped few hints it plans to seek a weaker yen to increase trade. That hasn't stopped Finance Minister Masajuro Shiokawa from indicating he'd be comfortable with a lower yen. He said Tokyo should "remain silent" if the currency were to lose value in global markets.
"With fundamentals headed in only one direction, the market interpreted this a green light to sell the yen," says Mansoor Mohi-uddin, a currency analyst at UBS Warburg in Singapore. He thinks the dollar will rise to ?130 year within three months. It's currently at ?125.09.
Global trends also favor a lower yen. Even though the US economy has slowed markedly, the strong dollar is likely to continue siphoning capital from Asia. Europe's slowdown, meanwhile, may be prolonged by the European Central Bank's reluctance to cut rates this year. For all its problems, the dollar may be a more appealing investment than the yen or euro.
Buying opportunity
For those who think Koizumi will succeed in ending Japan's 11-year recession, a declining yen may present a buying opportunity.
Anyone who calls the bottom to Japan's malaise and puts their money where their gut feelings are could enjoy one of the biggest bull markets in modern history. How many are willing to take that risk is unclear, especially since so many have been burned investing in Japan in recent years.
Keeping investors away is the fear that Koizumi's initiatives won't just undermine yen assets in the short term, but cause a meltdown. A plunge in the yen could exacerbate the losses in the Nikkei 225 stock average, which is at its lowest level since January 1985. It could also destabilize the bond market, boosting yields at a time when Japan needs lower borrowing costs, not higher ones.
If Koizumi has done anything, he's shined a spotlight on Tokyo's potential fiscal crisis. Politicians' attempts to revitalize the economy focused on government spending financed by bond sales. That's left the nation with a debt load a third larger that its entire economy. Any increase could have a catastrophic effect on Japan's financial system.
While Japan's future and Koizumi's roles in it remain impossible to predict, one thing seems pretty clear: The yen won't hold much allure for investors.
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