The Bank of Japan (BoJ) is embarked on an unprecedented government bond-buying spree designed to double the country’s monetary base to ¥270 trillion ($2.77 trillion) by the end of 2014, slash the cost of borrowing and trigger inflation. The policy has been seized on by Japan’s neighbours, who have accused it of engaging in competitive currency devaluation. But they are also worried that the trillions of additional yen sloshing around in Japan will find their way to their shores.
Large inflows of capital place upward pressure on currencies, fuel inflation and potentially lead to instability in the longer term, as money exits in a rush. Rising currencies also attract speculative inflows, leading to asset bubbles.
“We’ve seen little evidence of the predicted capital outflows; in fact capital has been flowing into Japan,” says Julian Jessop, chief global economist at Capital Economics.
“The coordinated effort to end deflation and boost economic growth will increase the relative attractiveness of Japanese assets, including equities and property, just as much for domestic investors as they have for the foreign investors who have led the rally so far.
“I think that the fact the yen has failed to weaken beyond 100 to the dollar is due to market disappointment that Japanese investors have not responded to monetary easing by falling over themselves to buy foreign assets.’’
Jessop adds that even if capital outflows at a later stage did impact Japan’s neighbours, they would be justifiable on grounds that the benefits for the region of a stronger Japanese economy far outweigh any negatives.
Investors’ optimism is beginning to be supported by the numbers. Figures for March show household spending rose 5.2% from the same period last year, its fastest pace in nine years, while unemployment fell to 4.1%, the lowest level since 2008. Both measures were significantly better than had been forecast.
The point is underscored by the rebound of the yen, signalling that the main bone of contention for emerging Asia, Japan’s devalued currency, may be defused for now. After falling to a four-year low following the BoJ’s monetary easing announcement last month, the yen has strengthened to around 97 to the dollar.
However, Jessop says he still expects the yen to weaken to 105 to the dollar by the end of the year and 120 to the dollar by the end of 2014.
The weakening will be caused by a combination of additional monetary easing by the BoJ in pursuit of its target and a strengthening dollar as asset buying in the US draws to an end.
The latest balance of payments figures available from the Ministry of Finance (MoF) show an outflow of capital of ¥131.7 billion in February, a five-fold drop from the 2012 average of ¥709 billion.
MoF figures for sales and purchases of bonds, equities and money market instruments show Japanese investors were net sellers of their overseas holdings of securities, repatriating ¥9.5 trillion yen, in the 16 weeks to April 20.
Overseas investors sold ¥1.23 trillion more Japanese bonds than they purchased but were overall net buyers of Japanese securities – including splurging a massive ¥112.18 trillion on stocks – to the tune of ¥6.1 trillion yen.
Capital outflows to emerging Asia could occur if the expected pick-up in the domestic economy does not materialize, and is therefore unable to absorb surplus liquidity or provide sufficiently attractive yields.
The most likely Asian recipients would be economies with traditional financial links to Japan such as Malaysia, Indonesia, Vietnam, and Thailand, which already has a trade deficit with Japan. Other strongly performing economies such as the Philippines and India could also benefit, as well as high-beta emerging markets such as Brazil and South Africa.
Analysts say that capital flows may already be occurring but have yet to register in the data. Equity markets and funds may be already responding, in anticipation of the great Japanese rotation, or at least banking on flatter yields in the West, thanks to Japanese government bond-buying, triggering a yield hunt in EM. The Philippine’s PSEi Index surged after the BoJ’s announcement last month, exceeding the 7,100 level for the first time, while the Market Vectors Indonesia Index ETF is up more than 11% this year.
However, Michael Taylor, director of research at Lombard Street Research, says he is sceptical about capital outflows given the foreign capital currently pouring into Japan’s rising stock market.
‘’While the market remains intently focused on Japan, Abenomics, whether it’s working, and the story of a potentially reformed economy, that will continue to be a source of capital inflow.
‘’Clearly, if the equity rally runs out of steam and the issue of the relative interest rate becomes more dominant, then it could trigger capital outflows,’’ warns Taylor.
Asian economies would be potentially the biggest concern, especially if they were to be swamped with capital inflows that pushed up their exchange rate too sharply, Taylor explains.
“There could be significant leakage longer term if there’s large scale selling of assets and replacement with foreign assets. But my instinct is that as the banking system gets going and domestic lending picks up, the QE effect could well be retained predominantly within Japan.”
Taylor and Jessop argue that there is a justifiable economic case for capital flows into Asia’s relatively faster growing emerging economies given the dynamic investment opportunities they present. For the moment, however, the money is staying at home.