The fundamental side

Now we have to ask whether the original impetus of the key reversal day, the Chinese float, stood up to scrutiny. The answer is no, it didn’t. For one thing, the Chinese central bank said — and repeated that it was not going to revalue again; the paltry 2.1-percent revaluation against the dollar was going to be the only “big” move, and the rest would have to come from the daily allowable moves. This is why the yen faded downward right after the big day. But other yen-favorable factors were in the news, and the market was willing to use them as substitutes for the lost influence of the renminbi revaluation.

The lesson is that a breakout such as a key reversal day can be based on a false or weak premise, but the move is not necessarily condemned to failure for that reason. The key reversal day itself suffices to raise questions about the previous downtrend, encouraging traders to be willing to look around for other reasons to keep the new move going.

And Japan delivered enough favorable news in the days and weeks following the key reversal day to support the yen. First, traders perceive that August traditionally provides a seasonal inflow of money into Japan, as Japanese holders of foreign bonds collect their interest payments around mid-month. Is it true the yen usually rises in August? Yes, but not consistently. The yen has risen in 10 of the past 16 years. But it has risen every year in the past seven years, which is pretty impressive. The point is that when it doesn’t rise, it falls only a little, but in years when it does rise, it rises a lot — and that’s what people remember.

Next, second-quarter GDP came in below forecasts, but it contained the critical component of high private-capital spending, long the engine of Japanese growth. At the same time, the central bank is now predicting deflation will be whipped by the end of the fiscal year (March 2006), allowing interest rates to be lifted. In the background, the financial sector seems to be cured of its overhang of bad loans, after 10 years of sweat and tears. Third, Prime Minister Junichiro Koizumi kept his promise to dissolve the lower house of the Diet if it refused to pass reform bills privatizing the Postal Service. The announcement triggered five full days of higher highs and higher closes. Calling new elections turned out to be a stroke of political genius, because Koizumi’s approval ratings rocketed higher on his courage in defying the old political hierarchies.

Koizumi’s new popularity is also symbolic of the Japanese people’s willingness to accept deep structural change. The Postal Service in Japan encompasses not only mail delivery, but also the world’s largest savings bank and the country’s biggest life insurance entity. Both the savings and insurance businesses will be privatized (and become taxable), albeit over a lengthy period of time, liberating both sectors from the heavy hand of the state and putting Japan back, it is hoped, on the road to fiscal prudence. As we know from experience in the U.S., free markets create opportunities.

Then there is the acknowledgement by foreign investors that Japan had been “underweight” in their portfolios since the 90s. Japan is the world’s second-largest economy but generally it didn’t hold second place in the country rankings of investment managers. After the Nikkei 225 stock index bottomed in 2003, foreign investors started returning to the market, and the return has become a flood. Ten days after Koizumi called for new elections, the government reported that in the most recent five weeks, foreign investors had bought the largest amount of Japanese stocks in 17 months, a net ¥21.15 billion ($17.6 billion).

It shows the correlation of the Nikkei stock index with the yen. It’s not a perfect one for one relationship, but every foreign investor who buys Japanese shares has first to buy yen.

Finally, we circle back around to the China connection. Chinese Premier Hu Jintao will visit the U.S. in September, and may use the occasion to announce another currency revaluation (as wished by certain members of the U.S. Senate) or some other act indicating acceptance of free-market principles, such as liberalizing merger-andacquisition (M&A) terms for Chinese firms. This may be directed toward the U.S., since it was the asymmetry in M&A conditions that annoyed the U.S. business community in the case of the Chinese oil company CNOOC bidding for America’s Unocal, but Japan will be a beneficiary, too.

Because China is now Japan’s biggest trade partner and the top destination for new direct investment capital, any liberalization of trade and investment terms inside China benefits Japan. In early summer we witnessed the strange occurrence of anti-Japan rallies and vandalism against Japanese property in China — acts which were thought to be instigated by the Chinese government, which then cracked down on them. Murky politics are behind these developments, which may yet come back to damage the Japan-China relationship. Meanwhile, China’s ever-greater integration into the world economy favors the yen more than any other currency. In fact, some advisors say the safest way to play the China card is to invest in Japan. A key reversal day does not always signal a trend change, but when fundamental conditions favor the new direction, as was the case with the yen, it is something we should respect.