Kan's Election: Should We Expect A Weaker Japanese Yen?

On Monday, June 8, Naoto Kan formally became the prime minister of Japan. The former finance minister took the reigns from Yukio Hatoyama, who stepped down last week following popular outcry over a U.S. air base.

With Prime Minister Kan in office, good vibrations are beginning to surface. Political leaders have backed the former finance minister, voting by an overwhelming majority in the weekend election.  Of the 477 lawmakers voting, 313 voted in favor of Kan.  The public is also widely supportive of their new leader.  Since the election, Kan’s Democratic Party of Japan administration has garnered a 44% approval rating in public opinion polls.  The figure is a vast improvement from the less than 20% enthusiasm witnessed under Hatoyama’s government.

But is this optimism too good to be true? Japan’s government has been a notorious revolving door when it comes to political leaders, and Kan may not be any different. Additionally, there are foreign exchange implications since Kan, a fiscal conservative, has already voiced displeasure with the level of the Japanese yen.

That should be a big concern for investors, because Kan has a solid history of standing behind his convictions. In a political system where family and class still play a heavy hand in elections, he has always gone against the grain. While former Prime Minister Hatoyama is a fourth-generation politician of a well-known political family, Kan is the son of a white-collar executive in an upper middle-class family. His upbringing led him to question government intentions while sticking to roots grounded in transparency. It came in handy.

In 1996, Kan exposed a government cover-up, releasing documents that showed the health ministry knowingly allowed the public distribution of blood that was at risk for HIV contamination.  The incident solidified his reputation, helping him through a personal scandal linking him to an extramarital affair and missed payments to the national pension system. So while many questioned Hatoyama’s political motives and rather weak commitments to campaign promises, Kan’s “comeback kid” personality and strong political history helped him into office pretty much uncontested.

But he walks into leadership dealing with a country full of problems and no easy solutions.

On the foreign relations side of the card, Kan must address the discontent over Futenma — the Marine air base at the heart of Hatoyama’s departure. At the beginning of the September 2009 campaign, Hatoyama pledged to move the United States Marine air base out of Okinawa — a cause vastly supported by the regional population, especially by local residents. However, after intense discussions with U.S. leadership, Hatoyama allowed the base to stay — giving voters the idea that his administration was weak and unable to deliver on campaign promises.

But even with Hatoyama out of the way, the issue of Futenma still remains. It will continue to be a lingering frustration as Kan looks forward to developing stronger foreign ties with the United States. Those ties are extremely important, too, because of the other problem Kan must deal with — Japan’s shaky economy.

The Rising Sun Has Yet to Rise

Growth has slowed to a crawl for the country — which is still the world’s second-largest economy. Consumer interest is additionally down in the dumps, as deflation continues to cripple domestic investment and spending. Retail sales, a measure of consumer spending, remained negative for all 12 months of 2009 — falling as much as 5.8% in February–March.

Of course, the Japanese government hasn’t just stood by and watched things fall apart. Earlier last year, it injected almost $300 billion in tax cuts and subsidies to shore up the economy following the global financial crisis.  But all that spending hasn’t produced any real results. Overall gross domestic product is expected to rise by 1% percent, one-third the pace of the United States.

Central bank measures have also proved fruitless. Since 2009, the Bank of Japan has lowered rates to near zero, currently at 0.10%, and extended credit lines to ensure liquidity with domestic banks.   So fiscal and monetary policy options are both running thin, creating a rather difficult situation for Prime Minister Kan.

For the foreign exchange markets, the election of Naoto Kan means a continued conservative approach to currency valuation and economic development. Previous prime ministers have merely hinted that high volatility and extreme appreciation for the underlying Japanese yen was undesired. Kan is taking a different approach. Not only has he explicitly spoken against high volatility in exchange rates, he has also openly supported a weaker yen.

At press conferences held during his tenure as finance minister, Kan stated that exporters favored a U.S. dollar – Japanese yen exchange rate of 90. That level insures that Japanese exporters are able to reserve some level of competitiveness when it comes to exports. Should the rate move to 89 or beyond, Japanese products would become more and more uncompetitive as their goods rise in price against other currencies. So Prime Minister Kan will want to do his best in containing any yen strength if the Japanese economy is to recover.

All in all, what can we really expect from the newly elected prime minister? With a fiscal conservative in charge, the country will likely see relatively unprecedented tightening. Taxes may not go up, but spending will definitely be cut. With most programs under duress, including health and pensions, administrative cuts in spending will likely geared towards defense. Additionally, Kan is likely to impose his will on the central bank through his finance minister, Yushihiko Noda. Although Noda has proclaimed his neutrality in central bank decisions, look for Kan to push for anti deflationary measures — like lower interest rates and looser lending practices by banks.

FX market intervention is also a probable scenario as Kan looks to protect the yen from speculative appreciation in the short term.  The probability of any intervention in the currency is likely to keep buyers away from the market, helping the yen to weaken to 100 against the U.S. dollar.

Richard Lee
for The Daily Reckoning