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Does Japan’s current account spell danger for the yen?

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Japan ran the smallest current account surplus on record in the 2013-14 fiscal year, data released Monday showed. If the surplus continues to shrink it could spell long-term danger for the yen.

If Japan's current account surplus turns into a current account deficit, the country will have to attract money into its financial markets in order to pay its bills. That may be difficult given that Japan has some of the lowest interest rates and highest debt in the world. Interest rates would probably have to rise substantially, which would worsen the government's finances and could cause a crisis – causing the yen to weaken even further. Hence the outlook for the current account is crucial for the yen's long-term health.

What is the outlook for the current account? The International Monetary Fund (IMF) is predicting that the current account surplus bottomed out last year, both as a percent of gross domestic product (GDP) and on an absolute basis, and will gradually rise over the next several years. However, the market is a bit less optimistic; the market consensus forecast, in green, is that it will fall further this year before recovering in 2015 and 2016 to about the same level that the IMF forecasts. I've also included the USD/JPY rate in this graph. You can see that in the past it roughly followed the general direction of the current account balance, but not so much in recent years.

At the end of the day, the current account is determined by the amount of a country's savings relative to its investment. An excess of savings over investment means a country has no place domestically where it can profitably put its extra money. By necessity, it will export this money to other countries that can use it. This means it registers a capital account deficit (in official accounting, a deficit in this case means an outflow of money). A country with a capital account deficit by definition will have a current account surplus, like Japan does today.

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On the other hand, an excess of investment over savings means a country has a capital account surplus (an inflow of money), in which case it has to run a current account deficit (like the U.S. does). So while on a micro level the current account is comprised largely of exports and imports, trade in services, and inflows of money from overseas holdings of stocks and bonds, on a macro level it's determined by the relationship between the country's savings and investment, not how many cars it exports or how much oil it imports.

Here's how the IMF comes up with their current account surplus forecast. They forecast the economy's total savings and total investment as a percent of GDP, and as I said, the current account balance is the difference between those two.

Investment bottomed out in 2009 and has since been rising slightly. They forecast that it will continue to rise. Savings on the other hand they assume bottomed last year and will start rising, also very slightly. They assume that the gap between the two is going to stay fairly constant, meaning the current account surplus will stay fairly constant, too.

Is this realistic? My big argument is with the savings side of the equation. I just don't see Japan's savings continuing to rise.

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The share of people over 65 in Japan has doubled from 12 percent of the population in 1990 to an estimated 25.3 percent this year and is forecast to rise further to 27.8 percent in 2020. People over 65 tend not to work but rather to live off their savings and their pensions, which are a form of savings. So instead of saving, they're dissaving – they're running down their savings. I don't see how the national savings, which have generally been declining since 1991, are going to suddenly bottom out and start rising under these conditions.

Another way of thinking about the country's demographics is its dependency ratio: how many dependents every 100 workers have to support. That's the ratio of young people below the age of 15 and older people above the age of 65 to the number of working-age people between 15 and 65. The forecast in the chart above is from the World Bank. It's pretty clear that the ratio is just going to continue getting worse and worse. How are fewer and fewer workers who have to support more and more dependents going to increase their savings? Admittedly it happened between 2002 and 2007, but those were good years for Japan. It's not likely to happen again soon, in my view. So my guess is that over the coming years, total Japanese savings will continue to decline.

Japanese investment however appears to have bottomed out and is likely to continue at least at the current level. Companies can't reduce their investment, because the aging and shrinking population means they have to replace labor with machines. So I think savings is likely to decline further and for longer than investment does.

Eventually I expect Japan's investment to exceed its savings, or in other words, for the country to run a current account deficit. And that's going to be a problem for Japan, because then it will have to attract foreign investors into its markets, particularly its bond market. And very few investors outside Japan want to buy Japanese government bonds, because they have not just the lowest nominal interest rates in the world, but almost the lowest in recorded history, while at the same time the government has the worst debt situation in the developed world.

To make matters worse, if the government is successful in its drive to raise the inflation rate, that will only further reduce the real interest rate on Japanese bonds, which is already the lowest of the major bond markets. That's going to be a hard sell and that's why I expect the yen to trend lower over the next several years.

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Of course, the savings rate has been coming down for years and it hasn't yet eliminated the current account surplus. That's probably because the investment rate has been coming down, too. It's possible that Japanese companies could keep cutting back on their investments, although I think it's unlikely. Oddly enough in Japan companies have been net savers too for many years. In most countries the corporate sector is a net borrower of funds. But I don't think this is likely. I agree more or less with this side of the IMF's forecasts.

So that's why I'm bearish on the yen over the longer term: as the current account slips into deficit, it will be difficult for the country to finance itself without higher interest rates, but those higher interest rates would mean a snowballing debt for the world's most indebted government. And that's a recipe for disaster.

The author is the Global Head of FX Strategy at IronFX Global, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.

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