INVESTMENT VIEW: GO LONG JPY/USD

Most foreign investors are positive on Japanese equities and the Nikkei 225 index has increased by more than 100% since the low of April 2003

By ALI FARID KHWAJA
Feb 27 - Mar 05, 2006

The Japanese economy finally seems to be coming out of its economic doldrums. The economic data released on the 17th of February, showed that the GDP grew at 1.4% in the fourth quarter, taking the full year growth to 2.8%. The Japanese economy has been in a slump for the last 15 years and even loose monetary policy stimulus by the Bank of Japan in the form of zero interest rates had not been sufficient to propel a revival. The recent and ongoing Post Office reforms and restructuring of the financial sector assisted the turnaround in the economic fortunes. The CPI data released in November showed a rise of 0.1%, which was a positive signal after the deflationary pressures had kept inflation at 0% for the last two years. Based on the upbeat prospects of an economic revival driven by restructuring, most foreign investors are positive on Japanese equities and the Nikkei 225 index has increased by more than 100% since the low of April 2003. The growth prospect in the Japanese economy, along with the unsustainable nature of US economic growth, leads me to the recommendation that investors should go long on JPY against the USD.

THE RISE OF YEN:

As I have argued earlier, the Japanese economic indicators are indicating strong growth. In fact the fourth quarter growth in Japan exceeded the fourth quarter growth of the 0.3% growth in the US. Foreign investors have been bullish about the prospects of the economy and most have increased their weighting of the Japanese equities from 10% to 15%. The only exception to this has been Morgan Stanley, which recently changed its weighting to 10% as the Nikkei 225 has increased by 55% in just one year. However, most analysts tend to be in consensus about the revival of the Japanese economy, backed by strong structural reforms.

If the CPI data continues to show further increase, which most observers believe that it would, the Bank of Japan would have to end its quantitative easing policy and an interest rates' increase seems near. A change in the interest rates policy would propel the JPY against the USD and hence I make the case for going long on the JPY. The JPY/USD is expected to increase to near 0.01.

UNSUSTAINABLE US GROWTH

The US economy needs to attract 70% of the world's total investment flows to be able to sustain its growing current account deficit. At present the deficit stands at a record level of 6% of GDP. The total foreign debt of the US economy has increased to 25% of GDP. With the recent inversion of the US yield curve the confidence of foreign investors in the US economy seems to be dwindling. The net foreign inflows in the US economy last month slowed down to USD45bn as compared to the USD60-80bn required to fund the current account deficit. The shortfall indicates that the current account deficit in the US has to adjust, translating into a slowdown in US consumption (and economy) and depreciation in the exchange rate. Some economists like Regoff and Obstfeld, believe that a depreciation of around 50% is required to correct the imbalance. I would further develop on my case on the fragility of the US economy in later weeks.

CONCLUSION:

In my earlier articles published in Pakistan and Gulf Economist, I have presented a case for going long in Euro against the USD. Although over the last three weeks the USD has remained stable, due to the continuation of tight monetary policy in the US, I still support the view that the EUR would outperform the USD in 3-6 months. The Euro zone has shown positive growth over the last three quarters and any positive data would make the ECB raise interest rates. The Japanese economy presents a similar though a much stronger case. In the next 6 months, I expect the JPY/USD to rise to 0.01 as compared to the current levels of 0.00843. The risk to the downside is the GDP deflator data, which shows that the rise in inflation was mainly due to pass through of high energy prices. However, if the Japanese economy continues to grow at these levels, and the consumption growth picks up it would lead to a change in the monetary policy regime and the JPY would strengthen. Data releases would be extremely important guide.

The author is a Rhodes Scholar at Oxford.