A Few Quick Thoughts on the U.S. Dollar and Japan

I recently participated in a webinar where I was asked a few questions regarding the U.S. dollar and Japan, which I think are on many people’s minds right now. I wanted to pass along my thoughts on both subjects.

What are the chances of the U.S. dollar losing its reserve currency status and what might replace it? 

If you look at the IMF COFER survey, which is the survey of global central banks, about 60% of their reserves are held in dollars. That has actually been on a slight upward trend over the last five years. The problem is that there is no alternative to the dollar – and if our view of a bullish dollar materializes, there will be even less incentive for central banks to diversify into other currencies.

If you look at the euro, which is the number two alternative currency, there are a lot of global central banks genuinely concerned that it could implode or disappear as a currency altogether. Why risk your money holding euros beyond the current allocations?

Now, when you look at some of the other currencies, whether it’s the yen, sterling or those of other AAA-rated countries like Norway, Sweden, Australia or Canada, the problem is that those currencies are way too small. When you look at a country like China that has $3.5 trillion in reserve, or the Bank of Japan that has $2 trillion, they could buy a lot of these countries many times over. It’s not practical for them to increase those currencies as a percentage of their basket.

Now, what about the longer term – the next 10 to 20 years . Do we see an alternative out there? Perhaps, and that could be the Chinese renminbi. The problem in the near term that prevents the renminbi from becoming the chief competitor to the dollar or as a replacement to the euro as the alternative currency, is that it’s not fully convertible. And as long as the currency is not fully convertible, global central banks will be reluctant to add it.

What’s your take on Abenomics (the economic policies advocated by Shinzō Abe, the current Prime Minister of Japan) and what do you think it means for the yen over the short- and long-term?

People have been pleasantly surprised at how aggressive Prime Minister Abe has been implementing badly needed reforms, which have become commonly known as the “three arrows.”

• The first arrow is to push the Bank of Japan to implement aggressive monetary easing, and that is well underway. They’re likely to hit many of their targets in the next two years.

• The second arrow is on the fiscal side. Their debt to GDP ratio is exceeding 200% and that’s worse than Greece, which is at 160%. They need to rein in this deficit. The consumption tax, which takes effect in April 2014, is part of that effort to bring the deficit down.

• The third arrow is structural reforms and this is the one that I think will determine if Abenomics succeeds or fails. Japan doesn’t need more monetary easing or cutting back on fiscal spending. They need to figure out how to boost GDP. From my view, their attempt at structural forms has been disappointing, but it’s too early to determine if we’re going to see a backpedaling of these reforms.

Overall I would say that Abenomics is off to a great start. I think at this time next year we’ll have a pretty good sense if Abenomics is going to succeed, or if Japan is going to be stuck in this deflationary vortex that they’ve been in more or less since the early 1990s.

What Does This Mean for the Yen?
When you look at how aggressively they’ve been implementing monetary policy, the U.S. dollar is bullish against the yen, and– right now we’re trading above 100, around 102. We think we could be at 120 within two years. In terms of the euro, it remains to be seen if the Japanese pattern can be used for the ECB. If there’s a risk that the ECB falls into deflation – and they’re not in deflation yet then this could be a model that the ECB could follow.

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