As in other major economies, production in Japan is on a recovery course driven by inventory adjustments. However, Japan's production recovery is not showing its usual high sensitivity to the global economy in this cycle. It is lagging major Asian economies by a significant margin, which is reflected in Nikkei equity underperformance. Yen appreciation against Asian currencies is one of the explanations for Japan's slower production recovery. In particular, the yen is still up about 40 percent against the Korean won despite some easing. Yen strength against the won and other Asian currencies saps competitiveness from Japanese goods and is holding back the export and production recovery. For example, production sensitivity to JPY/KRW has risen noticeably for products that compete aggressively against Korean products in export markets. Ministry of Finance (MOF) studies show that for autos and electronic components, each 10 percent yen appreciation against the won results in a 6.9 percent production decline. A yen correction against Asian currencies should enable Japan's export/production recovery to make up ground and bring late mover advantages for its equities. Such corrections would ease Japan's extremely tight financial conditions and are crucial for restoring Japanese beta and sustaining Japanese economic growth.
Production is recovering. Industrial production rose 1.4 percent MOM in September (+1.6 percent in August), rising for the seventh month in a row. In addition, production grew sequentially for the second consecutive quarter, rising 7.2 percent in July-September (+8.3 percent in April-June). October-November production plans, announced at the same time, suggest that production will continue growing at a pace of 5.9 percent. There appears to be a sharp pickup recently in the pace of recovery in IT-related industries, such as electronic components/devices fueled by progress in inventory reduction (Source: METI).
A pickup in the production/inventory cycle is beginning to move from an unintentional inventory buildup phase to an intentional inventory buildup phase. On the contrary, employment-related indicators remain weak. The unemployment rate has improved for two months in succession, but still stood at 5.3 percent as of September (August 5.5 percent), while the number of unemployed increased 920,000 YOY (August an 890,000 increase). The job offers/applicants ratio, which is a close reflection of current labor supply/demand, remains close to its low at 0.43X.
In the Outlook for Economic Activity and Prices (Outlook Report) issued at this week's Monetary Policy Board meeting, the Bank of Japan (BOJ) partially revised its FY2009-10 GDP growth to +2.1 percent and the CPI inflation forecast is a third year of falling prices at -0.4 percent. The combination of a lower potential growth rate and higher real growth rate leads to the expectation of gradual narrowing in the output gap. Among the risks is a damper for expectations that the BOJ will increase outright purchases of Japanese Government Bonds (JGBs). As the current deflationary phase extends, a departure of the quantitative easing policy is unlikely any time soon.
The BOJ's quantitative easing policy fundamentally comprises three components: 1) the policy duration effect of leaving the policy interest rate near zero for a long while, 2) quantitative easing through conventional asset purchases, chiefly JGBs, and 3) quantitative easing through non-conventional asset purchases, including commercial paper, corporate bonds and stocks. The BOJ has decided to end the non-conventional asset purchases when its commercial paper and corporate bond operations reach maturity in December. However, it will need to maintain or strengthen the first two components of its quantitative easing policy. With debt service increasing, in part due to the earlier fiscal stimulus package, and interest payments reaching 26 percent of tax revenues, we can see that the BOJ is even more constrained with regard to adhering quantitative easing.
The key takeaway here is that the recent rise in the JPY against both the USD and Asian currencies are having a complex impact on its recovery by: a) hurting exports and slowing the recovery, b) that it is being countered by a production or inventory recovery, yet c) leaving the BOJ in a position to keep easing, but with no JPY depreciation to help exports makes us believe that the recent rise in the JPY could be subdued and that 86-88 might be the strongest we see the yen for some time.
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