Weak Yen Could Lead to a Second Asia Crisis: SocGen

Japan has been trying to devalue the Yen (as anyone following the news would know). Many hedge funds have made and continue to make profits shorting the currency. Millions of articles have been penned on Abenomics and related topics. However, Albert Edwards of SocGen notes that the Asian Crisis in the late 1990s was caused by a weak Japanese Yen. He puts forth the argument that current Japanese policy to weaken the currency could trigger another crisis. Below is the full note from SocGen.

H/T Cullen Roche of Pragmatic Capitalism

Our recent trip to Asia has left us more concerned about the vulnerability of the China growth engine with the recent economic data weaker than expected. A sliding yen comes at a time when China’s balance of payments situation has deteriorated and a pronounced real exchange rate appreciation has triggered a reversal in investment flows. To me, this closely echoes the situation in the run-up to the 1997 Asian currency crisis. Noddynomics lives on.

  • Experience has taught me to tread very carefully when talking about emerging markets (EM, see page 4). But after 30 years working in financial markets one increasingly finds that our economic and market conjectures bear a close resemblance to something we had firsthand experience of decades ago. We believe the current conjuncture in Asia increasingly resembles the run-up to the 1997 currency crisis
  • We have just returned from a marketing trip to Hong Kong and Singapore and had some very fruitful conversations with clients. Much of the discussion centred on the likelihood that the Bank of Japan (BoJ) would lose control of the printing press and how a rapidly declining yen would lead to a replay of the 1997 Asian currency debacle. It seems investors may have forgotten that yen weakness was one of the immediate causes of the 1997 Asian currency crisis and Asia’s subsequent economic collapse. We discussed how that scenario might mirror what is happening today.
  • We have noted previously that China has seen a pronounced rise in its real exchange rate in recent years ? mirroring events in Thailand, Malaysia and South Korea in the run-up to the 1997 crisis (and indeed the GIPS prior to the eurozone crisis). In addition, China, and many other key EMs have seen a trend deterioration in their balance of payments (BoP), partly as a result of the repatriation of foreign direct investment ? again echoes of 1997. Hence despite a $128bn rise in China?s first quarter foreign exchange reserves to a record $3.44 trillion, we note the yoy growth rate is still only a paltry 4% (see chart below). And although 4% is an improvement on recent data, it is a far cry from the rapid growth rates of recent years and represents a huge monetary tightening that may help explain recent poor Chinese data.

Growth-in-Chinese-foreign-exchange-reserves-Chart Weak Yen

Over the past week we have been discussing all things Japanese with our Asian clients. It has been a long time since Japan has been at the centre of client discussions ? it was truly like travelling back in time. The salespeople from our regional research partners, JI Asia, were particularly excited. JI Asia has a history of intensive Japanese coverage which they have broadened out recently to the entire region (I suppose the clue to their background is in their web address They, like us, have found limited client interest in Japanese stocks in recent years but things have certainly changed now. Given their deep understanding of Japan it was interesting attending meetings where they contributed to client discussions and enhanced my understanding of the current situation.

Mark Burges-Watson, the CEO of Japaninvest, had some particularly interesting insights. He showed me a chart from the recent Tankan survey in Japan which, somewhat surprisingly, suggests that companies are already short of labour! We reproduce the chart below together with a similar ?capacity utilisation? measure for productive capacity. This suggests that Prime Minister Abe will indeed get his way on a rapid return of wage inflation to boost consumption. Indeed you could argue that with the Japanese trend GDP growth rate having been so low for the last decade, the output gap should close quickly.

labour shortages in Japan Chart

One thing we have been clear about on these pages over recent months is that contrary to what every commentator would have us believe, Japan has tried QE in the past and it has worked! The chart below shows aggressive BoJ FX intervention at the beginning of 2004 to stop the yen rising. It was no accident that property prices subsequently flickered into life. Personally I have little doubt that if Japan had kept printing at that time, it would not be in this dire position today. I am in the camp that thinks the BoJ will lose control of its QE. For if the market really believes that it is committed to the 2% inflation target (and I certainly do), then

Printing money is reflationary Chart

Japanese bond yields will quickly attempt a move above 2%. We showed in our last weekly that the Japanese government is bust ? and that is with 0.5% bond yields! If the JGB yield begins to rise then an unsustainable debt position becomes even more obviously unsustainable, and the government will be obliged to ramp up its QE operations to pin yields at low levels ? that is until higher inflation arrives and tax revenues pick up. I certainly expect accelerating QE to undermine the yen further and the market to anticipate this.

We have been here before. Prior to the 2004 FX intervention, the yen was a pro-cyclical currency. After the 2004 intervention, the yen slid downwards as investors used it as a funding currency ? irrespective of the cyclical recovery that unfolded (see chart below). Once again we should expect money to pour out of Japan as a result of current policies. Who will be a beneficiary of this carry trade ? probably high yield GIIPS bond yields and the euro. And hence the periphery will appear to have been ‘fixed’. Who will suffer? Germany, as the euro soars.

Heavy BoJ FX intervention to stop yen Chart

A weak yen comes at a time when the Chinese and other major EM countries are seeing a deteriorating BoP situation – similar to what we witnessed in the mid 1990s. I studied Asian economies very closely at that time as the average UK pension funds had almost 10% of their assets parked in Asia ex Japan! Hence when I see a sharp rise in China’s real exchange rate (see below) and deteriorating BoP, it rings alarm bells. China is not the most vulnerable of the EM currencies to a weak yen, but this conjunction could easily trigger a currency crisis as growth is crushed. High levels of FX reserves are no protection – if they are sold to prop up Asian currencies this will only impart a further deflationary monetary squeeze. Boom will turn to bust. And although I know my employer will support any call I make, I will not speculate on what the weakest EM domino might be. My history with calling out Asian Noddynomics tells me this might generate considerable EM ire and so more thorough research is needed (see SCMP article overleaf from January 1996). But rest assured Noddy lives on in Asia.

China's Exchange rate Chart

Weak Yen Could Lead to a Second Asia Crisis: SocGen

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