The BOJ Debacle, better than Shakespeare

As most of our readers without a doubt have discovered most of the action is taking place in the US at the moment as the credit turmoil has moved from sporadid skirmishes to a full blown bataille. However, the US is not the only place where the sh't is waiting to hit the fan although of course you might say that the fan is already blowing at full force in the US. The issues facing Japan at this point in time are just as much of political nature as they are economic and as always these two issues tend to be intertwined in various ways. On the economic outlook I will be brief in this particular note and hold off my guns until we get a slew of new data at the end of March (see my latest long piece for a reminder). A couple of points would be timely however. Personally, I was surprised by the comparatively small downward revision of the Q4 GDP figures which showed that Gross domestic product expanded an annualized rate of 3.5 percent in the three months ended Dec. 31. That does not indicate that Japan has entered a recession as we have noted here. However, all forward looking gauges firmly point towards a significant slowdown in activity at this point in time. Especially, corporate capex now seems to be entering a new stage where the build up of inventories to reflect an optimistic outlook amongst companies give way to a more modest approach. This will have a very distinct impact on Japan's economic performance moving forward. Moreover, pitch black storm clouds are gathering over Tokyo on the back of the relentless rise of the JPY against all major currencies across the board. Today, the government released a statement in which it carefully noted how the economic recovery was 'pausing' as if it was merely a question of taking a breather; not a very constitutional recovery I would say. The only bright spot seems to come from consumers who are still keeping up appearances even as we enter the slowdown. Recent data from supermarket sales showed a slight increase in spending for February but given the fact that consumer confidence slumped to its lowest level in five years I am not sure how to read this. Finally and epitomizing the perpetual existence of contrarian indicators in the context of Japan the recent release of the 'All Industry Activity' gauge showed a flat reading of 0.

In conclusion, the economic outlook in Japan is steadily and surely deteriorating and the only bright spot remains the Japanese consumer but given the abyss between real data and forward looking sentiment data I am not sure we can expect it to continue. In such times you need authorities and institutions to safely steer the economy through the troubled moment. However, and on top of the persistent lack of economic momentum Japan also lack the political edifice to deal with the most basic functions. The recent debacle surrounding the appointment of a new governor at the BOJ is a dire case in point. Observers have been pointing towards the probability of a stalemate for some time. I first picked up on this when Morgan Stanley's Takehiro Sato mentioned it as an odd point a couple of months back as well as Ken Worsley from the Japan Economy and News Blog also has mused about it. Personally, I have incorporated it in my official outlook for Japan since the end of 2007. Yet, I don't think that even the maestro himself Shakespeare could have conjured a script more riven with intrigue and hidden agendas as the one we are witnessing at the moment. At the heart of the matter lies a split in Japan's bi-cameral system where the leading party (the LDP led by Fukuda) in the lower house has seen its nominated candidates for the BOJ seat been handed the thumbs down by the opposition party (the DPJ) presiding over the upper house. So far, it has thus been a spectacle indeed. For a long while we all believed that Toshiro Muto, LDP's first nominee, would take over Fukui's slot but as the new governor. However, that was not the case and as Fukuda presented his second nominee Koji Tanami it was only a question of time before he also was rejected. The main issue which is being directed to us through the media is one of just how much influence the finance ministry should have in the new BOJ. Consequently, the two first nominees presented by Fukuda (Muto and Tanami) were both rejected on the grounds that their ties to the finance ministry were too strong. This then cuts right across a whole gamut of issues concerning Japan's monetary policy and the problem Japan faces with deflation as well as a public debt of 160% of GDP. Normalising interest rates would thus without a doubt bring more bite and leverage into monetary policy. This seems to be the implicit impetus for the DPJ's rejection of candidates too closely tied to the finance ministry who, on the other hand, would be more inclined to look downwards back into ZIRP. As we know Japan is far from normal and given the level of debt and current inflation pressures (i.e. not driven by economic activity) it is difficult to see how the BOJ would be able to normalise interest rates in any given sense of the word but it does not make the dilemma anymore pressing.

As the 20th of March moves inevitably closer and as the Fukui steps down it seems that the BOJ is forced to opt for a temporary anchor man in the hot seat. This is hardly the best time for such uncertainty. Important decisions need to be made not least in connection with the JPY's flight to the skies as well the economic outlook which now looks decidedly worse. As I have pointed out before the main risk forming on the back of a situation of limbo at the BOJ is that the MOF moves closer to the BOJ decision making process. The DPJ will fight long and hard of course and we may even see a general election on the back of this as well as Fukuda may be forced to step down as it becomes apparent that he cannot, with credibility, act as a mediator. The main risk is thus that the probability for intervention to keep the JPY from flying off as well as a reduction in interest rates must now be considered to be higher than if the transition had been smoother.