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Yen May Weaken in Wake of Japanese Crisis

Monday, 14 Mar 2011 01:46 PM

By Hans Parisis

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Are we seeing another edition of the “perfect storm” in the making at the start of this week? Could be …

In addition to the still difficult to evaluate human, material, economical and financial disaster that has hit Japan together with the still ongoing nuclear emergency, we also must take notice of a “less than satisfactory” outcome to the eurozone summit over the weekend and the threat of a U.N. led no-fly zone being imposed over Libya while political uncertainties continue to rise in the Middle East and North Africa.

While some think that the Japanese yen could strengthen, as it did after the Kobe earthquake in January 2005, where, by the way more than 6,400 people died, I think that any Japanese yen strength may prove to be short-lived.

Here’s why:

We already know that the financial costs of this still developing catastrophe in Japan will by far outstrip the costs of the Kobe earthquake that caused approximately 10 trillion yen in damage, which represented 2.5 percent of Japan's GDP at the time.

Based on the average currency conversion rate over the following 500 days, the quake caused US$102.5 billion in damage. The cost of the Japanese nightmare, not at least because of the nuclear contamination possibility, could also easily outpace the cost that Hurricane Katrina caused to Louisiana and Mississippi and that has been estimated at more than $150 billion.

This new Japanese tragedy occurs at a moment when we saw a further contraction of the Japanese economy during the last quarter of 2010 and when Japan was already carrying a debt burden equivalent to roughly 200 percent of its GDP, which is by far the worst ratio of all the industrialized countries in the world.

Because of its huge debt burden, Standard & Poor’s cut Japan’s sovereign debt rating by a notch to AA-minus in January, saying that the Japanese government lacked a “coherent strategy” for dealing with its growing debt burden.

Imagine what will come next. I don’t think I’m overly pessimistic when I say we could expect a “negative watch,” if not another negative downgrade, because the government will be obliged to announce a fresh budget that will have to take care of emergency spending to fund rescue and clean-up efforts and, last but not least, will have to resuscitate the economy.

I wouldn’t be surprised to even see more bond issuances to be announced for the next Japanese fiscal year that runs from runs from April 1 to March 31. In clear English, we can expect the current plans of balancing the Japan’s books will be pushed even further out.

Unfortunately, but no wonder either that Moody’s Investors Service already has warned that the earthquake and all what it implies doesn't make fiscal crisis imminent, but Japan could reach the 'tipping point' if the market loses confidence in soundness of government finances as Japan’s earthquake costs will likely halt progress in cutting the budget deficits. The yen will likely remain stable, Moody’s added.

Overnight, the BOJ (Bank of Japan) has announced fresh QE measures. As such, it is really difficult to make a long-lasting argument in favor of strength for the yen.

Yes, there is already talk of capital repatriation and carry trade unwinds. In my opinion, it’s still too early to have prove of that, but nevertheless, a number of important Japanese houses say this morning that expectations of major repatriation of yen is being significantly overstated.

With regard to the unwinding of Japanese yen-funded carry-trades, notwithstanding at first this seemed to me a credible argument, further consideration should be seriously diminished, given the fact that the Japanese yen demonstrated strength between May and September of 2010, it is clear, at least in my opinion, difficult to argue that the Japanese yen has been a, if not “the,” primary funding or carry trade instrument for investments over the past year.

Indeed, there is sufficient proof that when stresses surrounding fiscal and monetary matters where building within Europe as well as in the U.S., it was the Japanese yen that fulfilled the role of one of the preferred safe-haven currencies. All that said, most of available data indicate that the dollar has, to a really very large degree, fulfilled the role of carry trade or funding vehicle of choice over the past 12 months.

Because of all that, I wouldn’t be surprised to see, in the face of the multiple stories of insecurity, the most logical outcome to me will be “a broad retreat from risk.”

Given that and because the dollar hasn’t been one of “the” primary funding vehicle of choice over the past year, it seems reasonable to suppose that the dollar could prove one of the prime beneficiaries of the recent events in Japan, the Middle East and North Africa, and the eurozone where they have reached a “deal,” but where the crisis isn’t over.

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