Are a weak pound and yen here to stay?

Published: Apr 2013

Let’s start with the UK. Like the US, the UK has seen rampant indebtedness in recent decades against soaring asset prices. Once the bubble burst, asset prices plunged right away and a number of British banks needed large-scale government bailouts. This in itself was bad news for the financial sector. On top of this, the economy required fiscal stimulus.

As a result, the public finances did deteriorate so much that the rating institutes threatened to downgrade the UK’s credit rating. (They have done so once). The British government’s response was to tighten its fiscal policy, whereas it was obvious that the weak UK economy could barely cope with this.

To compensate, the central bank has pursued an ultra-loose monetary policy. However, this has not been very successful. Real growth never emerged and stagnation is the order of the day. Especially as:

  • Most UK consumers think they have taken out more than enough credit and many want to save up for their old age – not least because UK pension funds have large deficits.
  • The UK economy is very open. Wages have soared in the boom years, which is now a big problem, as the country has a large current account deficit. Presently, wages are not rising as fast as inflation, which means consumers are losing purchasing power. Plus the rest of Europe, which is in recession, is the UK’s main export market.
  • The UK’s financial sector comprises an important part of the total economy. However, this sector was – and is still being – reorganised.

In other words, the UK too is caught between a rock and a hard place. To stop the economy from going further down the drain, the authorities are taking the following steps:

  • The Bank of England (BoE) has launched a funding for lending programme. This implies that the central bank lends money cheaply to the banks, provided they use this for lending (except to the financial sector). Until now, this scheme has mainly helped to supply more mortgages, so it has not been very effective. Recently, the focus has shifted to other types of loans. This now appears to be working.
  • There is constant pressure on the BoE to open the money faucets further, in order to send asset prices higher and drive down sterling.
  • As to the latter, the central bank is struggling because inflation is high. This restricts its elbow room when it comes to flooding the system with liquidity (to offset the adverse effects of fiscal austerity and boost growth through asset inflation). It is hoped that a depreciating pound (GBP) will help the export sector. This would boost growth but the problem is that many other countries are also trying to weaken their currencies – for the same reason.
Chart 1: UK Real GDP versus budget deficit

The UK has emerged from its double-dip recession last year but the deficit remains a major concern

Chart 1: UK Real GDP versus budget deficit

Source: Thomson Reuters Datastream/ECR

Japan: from deflation to inflation?

In Japan, the elephant in the room is deflation, which increases the debt burden. At first glance it would seem that Japan has plenty of latitude to open the monetary floodgates. This is misleading as its public finances are spiralling out of control, while the country has a large national debt and budget deficit. Nevertheless, the Japanese administration intends to expand its budget deficit in order to kick start the economy. This is a dangerous strategy, especially as the population is ageing rapidly, which will undermine the public finances.

In other words, there is a high risk that the markets will think that Japan is monetising its budget deficits. Such a policy amounts to a deliberate erosion of the purchasing power of the yen (JPY) at home and abroad. As a result, borrowing costs could start to skyrocket, which would be calamitous to the government finances. Fortunately, things have not reached that point yet; lately, interest rates have dropped. In the immediate future, we can expect the following factors to influence Japanese interest rates:

  • The Bank of Japan (BoJ) will purchase more bonds and, in all likelihood, longer-dated bonds as well.
  • The external value of the JPY will not quickly be eroded, as many other countries want cheaper domestic currencies as well.
  • The same goes for the internal value, due to persistent deflation. The government wants to achieve 2% inflation as rapidly as possible but virtually no one thinks wages in Japan will rise substantially. As a result, higher prices will eat into consumer spending power. Such a drag on the economy will cap inflation.

Of course, everything will change if the Japanese start to borrow against rising asset prices. As in the US, it would be much better if Japan would quickly implement structural measures, so growth could improve on a permanent basis. However, this is unlikely in view of the systemic failure of politics in Japan, where a stalemate has been in place for years. Like the UK, Japan is putting all its money on one horse: the depreciation of the JPY. The other side of the coin is that Japan needs to import most of its raw materials – this will become more expensive as the JPY continues to weaken.

At the time of writing, both the JPY and GBP have shown a substantial decline against the dollar (-10% for the JPY; -8% for the GBP). After an upward correction, both currencies are expected to depreciate further against the dollar as a result of more monetary stimulus and subdued growth prospects due to high debt levels. In addition, the dollar should strengthening further.

On a relative basis, US growth prospects are better than those in Europe or Japan. This will attract more capital inflows to the US. Furthermore, the Federal Reserve will face growing pressure to tighten monetary policy to avoid a surge in inflation. This will contribute to an expected rise in USD/JPY toward 120 and a fall in GBP/USD to 1.35.

Chart 2: UK trade balance and bank assets

UK economy vulnerable as competitiveness is declining while size of banking system remains worrying

Chart 2: UK trade balance and bank assets

Source: Thomson Reuters Datastream/ECR

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