A.G. EDWARDS & SONS, INC.
One North Jefferson, St. Louis, Missouri
314-955-3050
(February 14, 2002) CURRENCIES: The Bank of Japan has been put under political pressure to further expand the money supply. Since Japan is deflating, such a policy seems to make sense. After all, inflation is said to be a monetary phenomenon, and so more money should help raise prices. However, our research suggests that the bank has supplied ample liquidity. The problem seems to lie in the "transmission process."
Japanese Money Supply
Chart courtesy of A.G. Edwards.
This chart shows the yearly growth of M1 and M2 on the upper lines, with the ratio of the two numbers on the lower line. From the late 1970's into the early 1990's, the ratio of M2 to M1 rose steadily, suggesting solid loan demand. M2 represents the residual from the lending process. If a bank takes in funds via open market operations, it lends them to a borrower. Assume the borrower buys capital equipment; that cash goes to another bank as a deposit, which lends them to another borrow, and so on. The wider the ratio, the stronger the lending growth. Since the early 1990's, the ratio has steadily declined, suggesting less "bang for the yen." In other words, the lending that follows the injection of liquidity has become steadily weaker. Note that on the upper lines, the M1 growth rate has been consistently rising faster than the M2 rate, the reverse of the pattern in the 1980's. Essentially, the Bank of Japan appears to be providing ample liquidity; however, the banking system has such an overhang of problem loans that it cannot fully utilize that liquidity to expand the economy.
How does Japan clean up the lone problems? Essentially, there are two paths to fixing this problem. The first is the "path of virtue" which requires a bank to reserve against the loan, and take steps to collect collateral to salvage what remains of the asset. This process tends to lead to painful restructurings, but does reallocate capital to more productive uses in the long run. The other method, the "way of perdition" is to lower the real value of the debt through inflation. It does allow the bank to clean up its problems, but it does not reallocate capital, allowing "dinosaur" industries to remain in their relative place in the economy. And, it leaves an economy with an inflation problem, which can hurt long-run growth prospects.
So far, Japan has not taken decisive steps in either direction. It is our belief that the political structure lacks the discipline to restructure, and so they will eventually try and reflate their way out of their current problems. This should bring a weaker yen. We remain long Euro FX against yen in the March and June contracts. We recommend buying the June 7600 puts at 200 (ob), risking to 100 on the close, with an objective of 550.
Bill O'Grady
www.agedwards.com