Forex Medium-Term Outlook

1 May 2015

Mizuho Bank, Ltd. Forex Division

Medium-term Forex Outlook Mizuho Bank Ltd. 1

【Contents】 Overview of outlook ・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・・P. 2

USD/JPY Outlook – Cannot categorically predict a weak-JPY scenario for 2016 JPY supply-demand situation – Risks to weak-JPY scenario surface ・・・・・・・・・・・・・・P. 3 U.S. currency policies now and going forward – USD strength being tolerated for the moment・・・・・・・・・・・・・・・・・・・・・・・P. 5 U.S. monetary policies now and going forward – From “when will it be implemented” to “how many times can it be implemented” ・・・・・・・・ P. 12 Fundamental scenario-related risks – Not discounting the 2016 JPY weakness scenario ・・・・・・・・・ ・・・・・・・・・・ P. 13 EUR Outlook – Continued outlook for short-term weakness and medium/long-term strength ECB Monetary Policies Now and Going Forward – Emphasizing credit function improvement・・・・P. 13 Supplementary Discussion: The Greek Problem, Now and Going Forward – Will for Solvency Improvement? ・・・・・・・・・・・・・ ・・・・・・・・・・・・・・・P. 17

Medium-term Forex Outlook Mizuho Bank Ltd. 2

Overview of outlook Regarding USD/JPY, at least for the current fiscal year, a weak-JPY scenario is forecast to continue from the supply-demand and interest rate perspectives. The trade balance improvement trend is a risk factor, but at the present stage, it may simply cause a release of JPY selling pressure while not strong enough to warrant talks of an increase in JPY purchasing pressure. Rather, within the fiscal year, given the gap between the U.S. and Japanese monetary policies and Japanese government policies, one would like to assume that the acceleration in foreign securities investment will shift the basic supply-demand balance in favor of JPY selling activity. My USD/JPY forecast of 130 within the year is still based on the expectation that the BOJ will implement additional monetary easing within the year, and while there may be room for arguments regarding the level of JPY going forward, the direction (JPY weakness) itself is relatively more certain. However, a different scenario may become necessary for next fiscal year. Foreign securities investments by Japanese investors require that there be a gap between U.S. and Japanese monetary policies, but “noise” over the USD strength is clearly getting louder in the U.S. It is likely that the focus of U.S. monetary policies related to rate hikes for the next fiscal year is shifting from “when rate hikes will start” to “how many times they can be implemented,” and not many people are brimming with confidence in this regard. Thinking of it this way, it may become necessary to reconsider the outlook for many currency pairs next year based on monetary policy gaps vis-à-vis the U.S. As a result, we may also need to consider a scenario that does not involve an out-and-out USD strength. EUR, having hit a year-to-date low in March, is now experiencing a lull. The gap between the FRB and ECB monetary policies continues to be too large to do anything about, and given that the Greek problem seems likely to continue for some time, EUR will inevitably be top-heavy. If one takes into consideration that the Greek situation is another problem to add to the FRB’s normalization process this summer, we may be entering a phase where parity could, once again, come into view. However, as I have persistently pointed out in this report, so far as the fundamentals go, the current EUR weakness is something that should be described as “epic speculation” and its sustainability is questionable. In the near term, though speculative EUR selling accumulates, the real rate has not fallen considerably, and the presence of a large current account surplus cannot be ignored as one of the reasons for this. The Euro zone current account surplus has already surpassed that of Japan in the past, so the real demand for EUR purchase is likely to be quite high. For instance, one must watch out for a roll back in speculative positions immediately following the first rate hike by the FRB, amid the sense that all speculative fodder has been exhausted. This report’s prediction of a reactionary rebound in EUR toward the second half of the forecasting period is based on such a view Forecast table summary

USD/JPY 115.86 ～ 122.04 117 ～ 125 118 ～ 127 120 ～ 130 121 ～ 131 120 ～ 130

EUR/USD 1.0458 ～ 1.2170 1.07 ～ 1.15 1.05 ～ 1.13 1.04 ～ 1.13 1.06 ～ 1.15 1.10 ～ 1.18

EUR/JPY 126.94 ～ 145.30 128 ～ 138 129 ～ 139 131 ～ 141 133 ～ 143 135 ～ 145

Jan-Apr 2015 2015 2015 2015 2016 2016

(124)

(Actual) May-Jun Jul-Sep Oct-Dec Jan-Mar Apr-Jun

(119.62) (122) (124) (125) (126)

(140)

(1.1210) (1.11) (1.09) (1.10) (1.11) (1.13)

(134.15) (135) (135) (138) (140)(Notes) 1. Actual results released on 1 May 2015 around 10am TKY time. 2. Forecast rates are quarter-end levels Exchange rate trends & forecasts

70

80

90

100

110

120

130

140

07/1Q 08/1Q 09/1Q 10/1Q 11/1Q 12/1Q 13/1Q 14/1Q 15/1Q 16/1Q

USD/JPY

Medium-term Forex Outlook Mizuho Bank Ltd. 3

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

07/1Q 08/1Q 09/1Q 10/1Q 11/1Q 12/1Q 13/1Q 14/1Q 15/1Q 16/1Q

EUR/USD

85

95

105

115

125

135

145

155

165

175

07/1Q 08/1Q 09/1Q 10/1Q 11/1Q 12/1Q 13/1Q 14/1Q 15/1Q 16/1Q

EUR/JPY

USD/JPY Outlook – Cannot categorically predict a weak-JPY scenario for 2016 JPY supply-demand situation – Risks to weak-JPY scenario surface Demand-related risks to weak-JPY scenario surface As I argued in last month’s edition of this report, JPY’s changing supply-demand situation is being closely watched as one of the factors that could heighten risks for the USD/JPY outlook going forward. Japan’s March Trade Balance, which was published in April, was +JPY 229.3 billion, the first trade surplus in 33 months, since June 2012. The trade balance has been improving owing to both export growth and import decline, and it seems that the YoY decrease in imports against the sharp fall in crude oil prices continues to have an effect. Although the shift to a trade surplus is promoting the ongoing intensification of cheering for the “JPY depreciation → export volume growth” scenario as evidence for the effectiveness of government policies, as explained below, the export volume index is not rising as much as the real export index. The export growth appearing in GDP statistics is simply the result of the upward tugging of export volume owing to growth in real exports that reflects the rising level of export product added value, and there is a need to take extreme care in evaluating the effect of such export growth on the real economy. Having said that, regardless of background factors, when it comes to forex forecasts, the diminishing JPY -depreciation pressure due to the supply-demand situation cannot be ignored. Since March 2011, professional voices have been inclined to assert that “the supply-demand situation will tend to promote progressive JPY depreciation going forward.” The recent improvement in the trade balance against the backdrop of the sharp fall in crude oil prices since last autumn should probably be considered a risk scenario (I have discussed all the risk factors in a single section toward the end of this report). YoY pace of improvement seems excessive The Trade Balance is improving at an extremely rapid pace in YoY terms, but its sustainability is doubtful. Looking at figures by country, the U.S. contribution to improvement in the March trade balance is overwhelmingly conspicuous. If one considers the outlook for improvement over a longer time frame, however, it is important to note that most of Japan’s trade deficit is in trade with the Middle East (see graph). As mentioned above, the logical basis for attributing Japan’s trade surplus

-3,500

-3,000

-2,500

-2,000

-1,500

-1,000

-500

0

500

1,000

1,500

2,000

07/01 08/01 09/01 10/01 11/01 12/01 13/01 14/01 15/01

（Bill yen）

（Source）Datastream (Note) Bold line refering to the TB's 6 month average

Japan's trade balance progression

-6

-4

-2

0

2

4

6

8

10

12

1H 2012 2H 2012 1H 2013 2H 2013 1H 2014 2H 2014 JAN-MAR

（Tril yen, YoY change）

（Source）INDB

Trade balance development（by country & region, YoY change）

Others Middle EastEU Latin AmericaUS Asia excl ChinaChina Overall

Medium-term Forex Outlook Mizuho Bank Ltd. 4

to the export-boosting effect of JPY depreciation is weak, and it should be understood that the surplus is primarily resulting from a fall in exports owing to the crude oil price drop. Moreover, as mentioned, Japan’s imports during the January-March 2014 quarter surged due to accelerated demand, causing a particularly strong trade balance deterioration, so the kind of large-margin improvement trend shown in the graph should not be expected to persist going forward. Basic JPY supply and demand In this publication, I continue to see the direction of USD/JPY as matching the direction of the basic supply and demand balance 1 (hereafter “basic supply and demand”) – this is an original indicator computed by myself, and I use it as a guide when formulating the outlook. As I have pointed out many times, except during the phase between 2005-2008, when the basic supply and demand was at the mercy of an expansion/contraction in carry trades, there is the strong impression that its direction has been consistent with that of USD/JPY by and large (only the direction, not the level). As the chart shows, the basic supply and demand trend has begun to look up slightly since mid-year last year, which is contrary to USD/JPY, which rose steeply during the same period (portion inside the solid square in the chart). Looking back at past trends, one gets the impression that USD/JPY has followed in the footsteps of the basic supply and demand with a time lag, so, when formulating predictions for JPY rates, the supply and demand trend of the recent past is a clue. The basic supply and demand trend remains at or below zero as before; in other words, the balance of supply and demand continues to be characterized by JPY sale > JPY purchase, but going forward, depending on the domestic and foreign securities investment trends or trade balance trends based on crude oil prices, the basic supply and demand could become positive again, giving rise to possible scenario of JPY sale < JPY purchase. No revival of a virtuous cycle without export volume index growth There have been scattered comments in the markets attributing the turnaround to a surplus for March to an international competitiveness improvement induced by JPY depreciation along with an associated rise in export volume, but it is too early to justify such comments. The principal export volume concept indices designed to account for the effect of price changes are the export volume index and the real export index. The desired volume concept is essentially “export value ÷ price” concept, and the difference between the two indices directly stems from the difference between the “price concepts” that they employ. The export volume index associated with customs clearance basis trade statistics is based on calculations of unit product prices in each product category, and it is calculated as “customs clearance-basis export value ÷ export prices.” This index is appropriate for use when one is seeking a so-called ‘intuitive quantification’ of export volume. In contrast, the real export index prepared by the BOJ is calculated as “customs clearance-basis export value ÷ export product price index.” The export product price index is designed to “adjust any difference between the old and new sample prices using the quality adjustment method so that the index reflects pure price changes.”2 This means, for example, that if a personal computer’s price is held steady while its performance is doubled, then the real price level would be halved. In other words, even when the actual volume of export transactions does not change, because the elevation of performance levels will cause the export price index to decline, the real export index will rise. In the case of the export volume index, the export of one personal computer unit is counted as one export unit regardless of whether it is an old unit or a new unit with improved performance.

1While balance of payments statistics are a sum of current account balance, direct investment, and outward/inward securities investment unassociated with depositary financial institutions and government entities, the statistics are adjusted to calculate the fundamental demand-supply balance by excluding investment income that remains overseas in the form of foreign currencies. Essentially, the fundamental demand-supply balance focuses on only the items that are likely to have a direct impact on forex to provide an image of the demand-supply situation. Excluding the “JPY depreciation bubble” period of 2005-2007, when JPY carry trade transactions and other speculative transactions surged to their peak, the direction of changes in the fundamental demand-supply balance have generally corresponded to the direction of changes in USD/JPY. 2 Bank of Japan, “Corporate Goods Price Index (CGPI, 2010 base)”

70

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100

110

120

130

140 -25

-20

-15

-10

-5

0

5

10

15

20

25

2000 2002 2004 2006 2008 2010 2012 2014

（USD/JPY）（Tril yen）

（Source）Bank of Japan & INDB （Notes)） Bold line designates basic supply/demand quarterly average.The latest Jan & Feb are compounded togetherSubject:Life insurers, pension funds & individual excluding banks & government sectors

Basic supply/demand balancereflected in balance of international payments

Inward securities investmentOutward securities investment (others)Direct investmentCurrent account balance（excluding re-invested profit）Basic supply/demand balanceBasic supply/demand balance（4-quarter MVA）USD/JPY（right axis, reversed scale）

Period where USD/JPY remained unafflectedby basic supply/demand ＝JPY carry expansion ＆retraction？

JPY long↑↓

JPY short

Medium-term Forex Outlook Mizuho Bank Ltd. 5

As has been noted since last year, there has indeed been a recovery in the export volume index, and it may be that this reflects the effect of JPY depreciation. Regarding the level of the index, however, it should be noted that the export volume index has not recovered to its pre-financial-crisis level, and this must be considered disappointing in light of the dramatic degree of JPY depreciation that has taken place since the crisis. On the other hand, the real export index has risen considerably, attaining a level comparable to the pre-Lehman-shock level (see graph). This has directly led to the current growth in real exports in terms of GDP statistics, which are calculated based on the same kind of concept as the real export index. Because of the differences between the definitions of the indices, the high-value-added index (calculated as “real export index ÷ export volume index”) has risen to all-time record high levels. In this way, while the rising level of export product added value is a welcome development, the government’s reflationary policies were designed to elevate the export volume index and induce an associated rise in manufacturing activities with the objective of initiating a virtuous cycle of “employment increase → earnings increase → consumption increase → product price increase.” So long as the rise in real exports is sustained, GDP growth will tend to depend on economic conditions that promote overseas demand, but to the extent that the rise in export volume targeted by the JPY depreciation policy does not occur, it would be difficult to theoretically justify efforts to employ monetary easing-centered policies to promote economic recovery and a general rise in price levels

BOJ monetary policies now and going forward – An autumn of trials awaits the BOJ Deadline for price stability target pushed back half a year At the April 30 BOJ Monetary Policy Meeting, the Policy Board decided by a majority vote to keep the monetary policy unchanged for some time to come. Policy Board Member Takahide Kiuchi, continuing from the previous Monetary Policy Meeting, proposed that the Bank conduct money market operations and asset purchases so that the monetary base and the amount outstanding of its JGB holdings will increase at an annual pace of about JPY 45 trillion, rather than the present JPY 80 trillion, but the proposal was defeated by a majority vote. The key phrase related to the timing for reaching the price stability target was changed to, “Although the timing of reaching around 2 percent depends on developments in crude oil prices, it is projected to be around the first half of fiscal 2016, assuming that crude oil prices will rise moderately from the recent level” – the change was consistent with what BOJ Governor Haruhiko Kuroda told the Diet beforehand. The definition of “first half of fiscal 2016” is not certain, but interpreting it literally, one can reason that it indicates “by the end of September 2016.” Note that with regard to the timing of target attainment, Policy Board members Kiuchi and Takehiro Sato maintained that the 2% target cannot be reached by fiscal 2017, and Policy Board Member Sayuri Shirai proposed widening the time-frame to something like “in or around fiscal 2016,” but the proposal was rejected. Naturally, at the press conference, a reporter asked, “Why was there no additional monetary easing even though the target has not been reached within the 2-year time-frame you assumed?” Mr. Kuroda dealt with the question with his usual responses, “The basic trend is steadily improving,” “The supply-demand gap has improved to around 0% and will continue to improve,” and “Inflation expectations are increasing.” In addition, the fact that the base pay scale this year had been raised to a greater extent than last year was also emphasized. Mr. Kuroda was able to avoid disappointment by saying, “(If the fundamental trend changes), we will adjust our policies without hesitation,” but it remains unclear exactly what indicators show the “fundamental trend” in the first place, making it difficult for market forecasts to be formed. Therefore, the BOJ will probably continue to have to deal with anxiety over how to handle additional easing speculations once every three months. With the release of the official statement and the Outlook Report, USD/JPY fluctuated severely for a while, but ultimately returned to the level before the meeting. One could say that the BOJ was able to skillfully pass the test this time.

0.7

0.75

0.8

0.85

0.9

0.95

1

1.05

1.1

1.15

50

60

70

80

90

100

110

120

130

98 00 02 04 06 08 10 12 14

（Year 2010=100）

（Source）INDB(Note) Right axis: Real exports index devided by export volume index

Real exports & export volume progressionReal exportsExport volumeHigh-value-added index （right axis）

Medium-term Forex Outlook Mizuho Bank Ltd. 6

How to read the weak outlook for FY2017 Taking an overview of the details of the Outlook for Economic Activity and Prices (Outlook Report), the price forecasts of policy board members (median value, CPI excluding fresh food and the impact of the consumption tax hike; hereafter “Core CPI”) for both FY2015 and FY2016 were downgraded compared with the forecasts as of the January interim assessment, from +1.0% to +0.8% for FY15, and from +2.2% to +2.0% for FY2016 (see chart). As mentioned above, the timing for achieving the 2% target was pushed back from “in or around fiscal 2015” to “around the first half of fiscal 2016.” Note that the price forecast for FY2017, newly published this time, was +1.9%. Growth forecasts, though slightly downgraded from +2.1% to +2.0% for FY2015, and from +1.6% to +1.5% for FY2016, remained strong. Growth for FY2017, however, was projected to slump to +0.2%. The projected slump in prices and growth rates for FY2017 is mainly due to factoring in consumption tax hike (from 8% to 10%) in April of that year, but it also seems to be taking into account the cyclical economic downturn coinciding with that period (the Outlook Report mentions that “cyclical deceleration” is one of the reasons for the predicted economic slowdown.) Though they have not drawn much attention, the weak forecasts for FY2017 are important for considering the outlook going forward. My frank impression is that, first of all, if a cyclical economic contraction phase coincides with a consumption tax hike, one naturally wonders whether the reversal will be merely to the extent forecast by the Outlook Report. Also, the fact that the BOJ itself considers FY2017 to be a phase of cyclical economic slowdown (quite aside from the impact due to the consumption tax hike) signifies that, even at the earliest, there will not be an exit from the current accommodative monetary policies before the second half of FY17. In other words, it does not seem likely that a stable 2% price growth rate will have been attained even as late as the second half of 2017. Ultimately, therefore, the present policy of “2% in two years” may take all of Mr. Kuroda’s term in office (2013 – 2018) to achieve. Irrespective of any rationale that may exist in the background, this is a scenario very different from what the markets had imagined originally. The next move may be to go back from “quantity” to “interest rates” As even the BOJ has repeatedly explained, the reason the deadline for the 2% target has been pushed back is the sharp decline in crude oil prices since last Autumn. The reason Mr. Kuroda has repeatedly been saying that prices will accelerate this autumn onward is because that is the exact period when the downward pressure on CPI due to the sharp fall in crude oil prices will begin to dissipate (of course, that is not the only reason – there is also the assumption that the supply-demand gap will have contracted over the same period). One of the footnotes in the Outlook Report says, “this contribution is expected to fall further into negative territory for the time being, followed by a narrowing in the negative contribution in the second half of fiscal 2015; in the first half of fiscal 2016, the contribution is estimated to be around 0 percentage point.” In other words, unless crude oil prices fall another notch this autumn or later, the CPI can be expected to return to the ideal (i.e., 2%) growth rate path envisaged by the BOJ. Looking at it a different way, if the inflation rate has not become more buoyant as of autumn, the BOJ will be unable to avoid a monetary easing at that time. It still cannot be said, therefore, that a monetary easing within the year is impossible. In addition, there has always been the concern that sustaining the present framework of JBG purchases itself will become difficult next fiscal year onward, so irrespective of whether one desires it or not, there will be an automatic contraction of the purchase amount, which could lead to suspicions that the BOJ is implementing tapering. In this regard, there was a question on April 30th press conference: “Is there a likelihood that the purchase of JGBs will become difficult in fiscal 2016?” Mr. Kuroda responded to it saying: “We do not believe a problem will arise going forward,” but at some point, it will become difficult to continue with the planned purchase amount. There are more than a few who point out that, even if, thanks to the Government Pension Investment Fund (GPIF) portfolio reshuffling, the purchase amount can be maintained during the current fiscal year, a technical limit will be reached during the next fiscal year. In other words, this will be a setback for the strategy of using “quantity” to work on expectations. The BOJ will probably feel the need to take action before suspicions of tapering really begin to surface.

-1.0～-0.8<-0.9>

-0.6～-0.4 2.9～3.2 0.9～1.2<-0.5> <2.9> <0.9>

1.5～2.1<2.0>

1.8～2.3<2.1>

1.4～1.8<1.5>

1.5～1.7<1.6>

0.1～0.5 2.7～3.4 1.4～2.1<0.2> <3.2> <1.9>

（Source）Bank of Japan （Note） ＜＞ is the median estimate by policy board members

Major outlook by BOJ policy board members (% vs previous year)

Real GDPCore CPI

（ex fresh food）Context in which tax exemption

impacts are ignored

FY 2014

Outlook as of Jan

FY2015

Outlook as of Jan

FY2016 1.2～2.2<2.0>

<2.2>Outlook as of Jan

FY 2017

0.82.8

0.4～1.3<1.0>

1.5～2.3

0.2～1.2<0.8>

Medium-term Forex Outlook Mizuho Bank Ltd. 7

-1.2

-0.7

-0.2

0.3

0.8

1.3

1.8

80

100

120

140

160

180

200

220

13/01 13/04 13/07 13/10 14/01 14/04 14/07 14/10 15/01

（％）（JAN 2013=100）

（Source）Bloomberg (Note) CPI core: excluding impact after consumption tax increase

Japan's base money & money supply（≒lending）growth

Base money (BS) Money supply (MS) CPI core（right axis）

What could happen at such a time? Simply speaking, a return to “interest rate” operations can be envisaged. Given that there was speculation about the elimination of interest rates even at the time of the January meeting, and that, subsequently, the circulation of government bonds at negative interest rates has become the norm in the Euro zone, there is no need to pursue “quantity” simply out of a desire to keep interest rates strictly at or above zero. It is quite conceivable that the BOJ would allow some level of negative interest rates, thereby avoiding suspicions of tapering and continuing its strategy of working on market expectations. As Mr. Kuroda himself has said that the bank would do whatever it can to achieve the price stability target at the earliest, there is no reason to be fixated on “quantity.” Regarding the timing of a monetary easing, going by the current logic, it seems likely that monetary policy will be kept unchanged at the July meeting, so the October meeting seems more likely. For the BOJ, it may be an autumn of trials. Two years since the introduction of QQE: BM, MS and prices Incidentally, with April, a full two years have passed since the BOJ Monetary Policy Meeting (April 4, 2013) that decided to introduce the quantitative and qualitative easing (QQE) policy. During the past two years, base money (BM) has expanded +100% from approximately JPY 150 trillion to approximately JPY 300 trillion. (These figures are based on statistics for the period from March 2013 through February 2015.) During the same period, however, the money supply (MS, M2 + CD) grew only +6.5%, from approximately JPY 840 trillion to approximately JPY 895 trillion, indicating that lending has not grown in step with the expansion of BM. Essentially, a huge amount of BM has simply been accumulated as excess reserves, and there has been a continued disconnection between the financial system and the real economy. The accumulation of excess reserves indicates “exit strategy difficulty,” since financial institutions face a lack of demand for their loan offerings that is being compounded by the approach of technical limits regarding the accumulation of excess reserves. From the very beginning, this course of developments has inspired a tendency toward skepticism regarding reflationary monetary policies on the part of this article and other observers. However, the Kuroda-led BOJ has been aiming to employ an overwhelming volume of BM to increase inflation expectations and thereby induce a rise in actual inflation, so the strategy can roughly be described as a “policy aimed at moving expectations.” For this reason, so long as prices rise, the exit difficulty and technical limits of asset purchases can be overcome, and it will be possible to view the “increasing prices with money power” mission as successful. As shown in the graph on the previous page, however, after two years of QQE, the rate of growth in the core consumer price index (CPI) excluding fresh foodstuffs and the effects of the consumption tax rate hike fell to the neighborhood of zero in February. Given that growth in core CPI immediately after the introduction of QQE (May 2013) was 0%, one may conclude that “two years of QQE have brought us back to the starting point.” Result of “moving expectations” Of course, it can probably be argued that inflation “expectations” have been affected. That is why the BOJ has adopted the view that “inflation expectations appear to be rising on the whole from a somewhat longer-term perspective.” However, in the “Comments on the Price Rise” section of the BOJ’s most recent “Opinion Survey on the General Public's Views and Behavior” (March 2015), the share of those who chose the “rather unfavorable” response reached 83.7%. This is a higher share than the 80.3% share of those choosing that response two years ago in the March 2013 survey. Moreover, the Cabinet Office's “Economy Watchers Survey” and other surveys clearly show an eruption of discontent with JPY depreciation and price increases,3 and there are zero signs of the budding of an incipient virtuous cycle spurred by inflationary expectations. Essentially, it appears that the attempt to increase prices has become disliked by the public.

3 Please refer to the March 12, 2015, edition of this article, entitled “Will there be an additional BOJ monetary easing? – The possibility cannot altogether be ruled out.”

Medium-term Forex Outlook Mizuho Bank Ltd. 8

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

70 71 73 74 76 78 79 81 82 84 86 87 89 90 92 93 95 97 98 00 01 03 05 06 08 09 11 12 14

（％）

（Source）The Japan Institute of Labour Policy & Traning （JILP）

Japan's structual unemployment rate

Total unemployment rate（①）

Equilibrium of unemployment rate （②）

Unemployment rate resulting from a labor demand shortfall （①-②）

How has the real economy changed? Even if there has been no increase in the inflation rate of inflationary expectations, it would still be possible to muster a positive appraisal of the QQE policy so long as it has had a positive effect on the real economy. In this regard, measuring the real economy in terms of real GDP is the simplest approach and, looking at the seven quarters from the April-June 2013 quarter to the October-December 2014 quarter, one finds that real GDP growth QoQ averaged 0.0% – essentially, the economy has continued to be flat. A simple comparison of demand components at the start and end of that time period shows that real GDP declined from JPY 528 trillion to JPY 526 trillion and that the key personal consumption expenditure item decreased from JPY 307 trillion to JPY 299 trillion. Private sector capital investment edged up from JPY 69 trillion to JPY 71 trillion, while exports increased from JPY 9.8 trillion to JPY 11.9 trillion. In particular, it is the increasing robustness of exports that may, to a certain extent, be recognized as reflecting a beneficial effect from JPY weakness (as mentioned above, this is not an increase in the export volume index). However, given that this degree of growth has come at the cost of exposing the financial markets to huge side effects, it is debatable whether it has been worth it. Results of QQE? – Stock prices and employment/wages situation So far, it may appear that QQE (as the core of Abenomics) is completely without positive aspects, but there are two areas in which it has decisively produced improvements. One of these is stock prices, and the other is the employment/wages situation. The stock price rise does not really require confirmatory statistics, but the Nikkei stock price average rose from about JPY 12,300 in April 2013 to JPY 20,000 in April 2015 – an increase of over 60%. In November 2012, when the strong reflationary orientation of Abenomics was being discussed, Nikkei average was approximately JPY 9,000, and it has more than doubled since then. There is no leeway for doubt that the rise in stock prices is the greatest result of QQE, and other asset price changes (sharp JPY depreciation, sharp drop in interest rates, rise in real estate prices) can be considered another conspicuous result of QQE. As noted above, however, even with those asset price changes personal consumption expenditure on a real basis has not risen (it has actually decreased), and there are no signs of the asset effect propelling improvement in economic conditions. Of course, there are no economic entities facing difficulties stemming from high stock prices, so it is good to see stock prices rising, but it would be misleading to overemphasize the associated benefits. Supply-demand regarding employment clearly becoming tight The supply-demand situation regarding employment/wages has clearly become tight and, as recognized by BOJ Governor Kuroda, Japan is moving close to a full employment situation (see graph below).4 Since, monetary easing is being sustained despite the recognition of full employment, and since there are no signs of a move toward monetary tightening, one would ordinarily expect the economy to face supply constraints (excess demand). In fact, there are some signs of problematic personnel shortages in non-manufacturing industries (restaurants, retailing, etc.) that may be considered symptoms of supply constraints. Furthermore, moves to shift from the use non-regular employees to the use of regular employees are frequently been seen. The non-regular employment ratio peaked late last year and has been declining, but even amid this situation the total number of employed people is not declining. It seems that, rather than using non-regular employment as an adjustment method, companies are dealing with supply constraints by beginning a shift toward the hiring of stable, regular employees. In addition, the March BOJ Tankan survey indicates that companies of all sizes are encountering labor shortages. One phenomenon that is clearly reflecting the tight employment/wages situation is the incidence of annual wage increases larger than normal, and this was an unexpected trend for the many observers (including the author of this article) who are skeptical about the reflationary policies. As can be seen from the current, historically low levels of the real wage indicator, however, price increases are eroding the value of nominal wage hikes, and this is a factor preventing signs of personal consumption growth measured on a real basis. Of course, the effects of the consumption tax rate hike have diminished since April and, since the

44According to Japan Institute for Labor Policy and Training (JILPT) data, the unemployment rate generated by insufficient demand is only 0.09% as of last December.

Medium-term Forex Outlook Mizuho Bank Ltd. 9

1,900

1,950

2,000

2,050

2,100

2,150

2,200

2,250

2,300

2,350

2,400

3,100 3,200 3,300 3,400 3,500 3,600 3,700 3,800 3,900

（Wage, yen）

（Labour productivity, yen）

Correlation of wage per hour and labour productivity per hour

(Source) Cabinet Office, MIC, Ministry of Health, Labour& Welfare & INDB(Note) Real labour productivity per hour =(nominal GDP÷total labour hours)×GDP deflator÷100

impact of the crude oil price drop is projected to depress prices going forward, there is a high likelihood that robust nominal pay hikes may lead to a clear trend of increase in real wages. At the BOJ monetary policy meeting this week and on April 30, it is highly likely that the tightness of the employment/wages environment will be cited as a reason for maintaining the status quo. Wage and price increases dependent on labor productivity improvement The above sections of this article indicate that the impact on the real economy from the unprecedented monetary easing initiated two years ago has largely been concentrated on the employment/wages aspect of the economy. Although it is intuitively apparent that, rather than the effects of QQE, the employment/wages situation has been greatly influenced by government, labor, and management actions exemplified by the government’s demands for wage increases, it is undeniable that QQE’s promotion of JPY depreciation and stock price rises has also played a role in providing companies with the resources (profits) needed to respond to the wage hike demands. If this year’s trend of relatively strong wage hikes is sustained, a permanent trend of improvement in income would naturally have the potential to boost personal consumption going forward and prices can also be expected to rise. (Although the target of boosting the inflation rate to 2% by March 31, 2016, seems unlikely to be attained.) However, the problem relates to the question of whether those trends can be sustained. The precedence of wage increases will pressure companies to realize subsequent productivity improvements, and there is some basis for characterizing the wage increases seen so far are merely being government induced moves. The incentives for corporate productivity improvement in a world where halting wage hikes is easily accepted are clearly different from the productivity improvement incentives in a world where constant wage hikes (and associated price increases) are considered natural. However, Japanese companies have not been paying wages that are unreasonably low in comparison with productivity – one gets the strong impression that wages have been set in line with productivity (see graph). In this regard, while there is some basis for the abovementioned concept of “productivity improvements realized in response to preexisting cost (wage) increases,” it is more likely that the causal relationship is better described as “productivity improvements have been followed by cost (wage) increases.” If the latter description is true, then it is questionable how long a government-controlled wage increase campaign can be sustained. In any case, two years after the start of (the initial commitment to) QQE, it appears that the factors affecting the fate of price increases are gradually moving away from the central bank’s discretion and becoming determined by the private sector – price increase projections seem to be becoming wagers on the kind of productivity improvement companies can achieve. The process going forward may not be quite as simple as “corporate productivity rises enabling the realization of wage/price increases.” However, compared with the confused effects of a crude oil price increase and currency depreciation, it would clearly seem that the corporate-productivity-rise approach is the sounder and more-desirable route toward realizing price increases.

Medium-term Forex Outlook Mizuho Bank Ltd. 10

0

20

40

60

80

100

120

140

80859095

100105110115120125130

93 95 97 99 01 03 05 07 09 11 13 15

（Jan 1997=100）（Mar 1973=100）

（Source）FRB,、Broad base

USD/JPY rate （nominal・real） progression

Real effective dollar20yr average （real effective）Nominal effective dollar （right axis）20yr average （nominal effective, right axis）

Dec 2014 :Over 20yr average since Apr 2009

Mar 2015：Over 20yr average since Apr 2009

U.S. currency policies now and going forward – USD strength being tolerated for the moment The point of the U.S. Semiannual Report on International Economic and Exchange Rate On April 9, the U.S. Department of the Treasury published the latest edition of its Semiannual Report on International Economic and Exchange Rate Policies (hereafter, simply “the Report”). The points one can take away from the Key Findings section at the start of the Report are (1) overall, a stance of tolerating USD strength is discernible, and (2) there are strong calls for fiscal mobilization. Both are the same as in the October Report. It cannot be said that the U.S. currency authorities’ stance has changed dramatically compared with last time. The conclusion seems to be that the strength of USD since last year reflects the strength of the U.S. economy in contrast to the weakness of other economies. There seems to be no feeling that USD has been unjustly forced to appreciate as a result of the accommodative monetary policies adopted by the ECB and other central banks. In this regard, considering that JPY fell sharply after the October 31 Halloween easing implemented by the BOJ soon after the publication of the previous issue of this Report, and that EUR fell sharply following the ECB’s implementation of quantitative easing (QE) on January 22 this year, one gets the impression that the Report’s tone is extremely calm. This time again, no country has been labeled a currency manipulator, and there seems nothing in the report that could lead to a serious problem. It was, however, mentioned that “balanced approaches to macroeconomic policy are particularly needed in large surplus countries, notably in Germany, China, Japan, and Korea.” Looking at the section Analyses of Individual Economies, the most space has been devoted to China (as usual), followed by Japan, the Euro zone, and South Korea in that order. However, the order in which a summary of the analyses of individual economies has been introduced in the Key Findings section is first the Euro zone, followed by Japan, China and then South Korea. Perhaps, rather than “more space devoted to a country = stronger awareness of a problem,” it may be better to assume that the order in which the summaries are introduced reflect the priority ranking in terms of which countries the Report wants to underscore. Be that as it may, it is hard to comprehend why Japan has been mentioned as a country with a large surplus. As one can tell by reading the Key Findings section, the amount of current account surplus and its ratio in terms of the GDP have been mentioned for all the countries/regions mentioned above with the exception of Japan. In the case of Japan, the Report merely states that weak domestic demand “is an ongoing concern.” As I will explain below, the remark’s intent seems to to be to suggest that Japan should complement its weak domestic demand by mobilizing fiscal policy in addition to monetary policy. Perhaps it should be read as implying that a policy that single-mindedly pursues weak JPY is not appropriate. The feeling that USD is “still not too strong” comes through clearly First, with regard to (1) the stance of tolerating USD strength, the section The Dollar in Foreign Exchange Markets is usually useful. Having said that, very little space is devoted to this section, which mainly explains the extent to which USD has appreciated since last year. The October 2014 issue of this Report said, “U.S. economic growth is expected to exceed Euro zone and Japanese growth by 1 to 2 percentage points through 2016, making U.S. assets relatively more attractive for investors” – a clear indication of tolerance regarding USD strength, but this time, a similar description cannot be seen. When it comes to the overall tone of the Report, there is no change in the stance of accepting the strength of USD, but perhaps, from the perspective of the currency authorities, the scope of further increase that can be permitted has decreased significantly. Having said that, the section ends with the statement “The broad trade weighted dollar remains well below its peak in the early 2000s,” so it seems the Report’s intent is to express that USD is still “not too strong.” As the chart on the previous page shows, last month, the real effective USD rate finally rose above the (20-year) long-term average for the first time since April 2009, so from forex rate levels, a completion of the monetary policy normalization process seems to have already been factored in.

Medium-term Forex Outlook Mizuho Bank Ltd. 11

Analyses of Individual Economies – The assessment of the Japanese economy and JPY rates As described above, the Analyses of Individual Economies, which forms the core of the report, devotes a lot of space to Japan. The section begins by pointing out that “the fall in private spending after the tax hike was more persistent than the government expected” and that “domestic demand in the fourth quarter of 2014 was about 1.5 percent below its level in the fourth quarter of 2013,” training the spotlight on the weakness of domestic demand. It goes on to say, “Going forward, the government needs to pursue a balanced macroeconomic policy approach to avoid excessive reliance on exports and support a recovery driven by domestic demand while redoubling efforts to promote meaningful structural reforms necessary to raise long-term growth in Japan.” Taken together, the remarks seem to imply that Japan should not simply supplement the insufficient portion of domestic demand with foreign demand. There is a sense that Japan’s single-minded pursuit of JPY weakness through its QQE policy is not seen in a very positive light. There is no overt criticism of the QQE policy – rather, it has at times been appreciated, but clear disapproval of the country’s contractionary fiscal policies comes through, such as in the remark: “With zero growth in real GDP in 2014, the contractionary effects of fiscal consolidation before recovery has durably taken hold are concerning.” Moving on to forex rates, which are of the most relevance here, no clear opinion has been expressed about the JPY rate level, but some amount of concern regarding its excessive weakness is discernible in some places. Specifically the following passage:

● In its last Article IV Consultation Report for Japan from July 2014, when the yen was at ¥102, the IMF assessed the yen’s real effective exchange rate to be broadly consistent with the economy’s medium-term fundamentals, while noting the very large uncertainty about its assessment given the major changes to Japan’s economic policies and lags between exchange rate moves and the variables that influence the IMF’s assessment. Since then, Japan’s trade weighted real exchange rate has depreciated 9 percent.

The Report does not go on to say what it thinks of this 9% depreciation, but given the opinion expressed above, it could be that the Treasury Department is concerned about the discrepancy that has arisen compared with the level “broadly consistent with the economy’s medium-term fundamentals.” Note that the section of the Report dealing with Japan ends with the remark: “Agreement on the Trans-Pacific Partnership (TPP) would be an important step to lead to internal reforms such as deregulation in areas including agriculture and medical services that could support growth.” In light of the increasing tendency in discussions to link agreement on the TPP to U.S. currency policies, this line may contain an important hint for Japan going forward. The vexing interpretation that “the U.S. itself is the source of its currency’s (USD’s) strength” As described above, so far as the recent issue of the Semiannual Report is concerned, there are no clear indications that the U.S. Treasury Department is concerned about USD strength at the present time. As I mentioned at the start, the conclusion seems to be that USD strength is simply a reflection of the relative strength of the U.S. economy, and there seems no feeling that it is being unjustly buoyed up. If we consider that USD strength is due, in large part, to actions taken in response to the FRB’s normalization process, the origins of the USD strength can be found in U.S. macroeconomic policies, so there are limits to how far the accommodative monetary policies of other nations can be denounced. The economies which get denounced could retort with, “If you dislike USD strength so much, speak to the FRB about it,” so the U.S. Treasury Department is probably a bit vexed at the situation. If one assumes that the Treasury Department’s stance is probably to quietly monitor the situation until the start of rate hikes in an effort to preserve the FRB’s honor, the tone of the Report may show a clear change from October onward, if rate hikes have begun by that time. Again, if we consider that the demands from U.S. industry circles may become more shrill leading up to the presidential elections to be held next fiscal year, U.S. currency policies at that time could conceivably become less tolerant of USD strength.

Medium-term Forex Outlook Mizuho Bank Ltd. 12

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

74

94

114

134

154

174

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

（％）（Yen）

（Source） Bloomberg

Federal funds rate & USD/JPY rate

USD/JPY rateFederal funds rate （right axis）

U.S. monetary policies now and going forward – From “when will it be implemented” to “how many times can it be implemented” The important question is not “when will it be implemented,” but rather “how many times can it be implemented” Regarding U.S. monetary policies, the phrase “can be patient” with regard to the monetary policy normalization process was deleted from the official statement of the March FOMC meeting. With this, the focus of monetary policy debates has finally shifted to rate hikes for the first time in ten years. However, the statement of the next FOMC meeting (April 28-29) assessed current economic conditions as “economic growth slowed during the winter months, in part reflecting transitory factors” – a clear downward revision. Notice the transition (below) in the phrasing of this part of the official statements issued since the beginning of this year: ●January: economic activity has been expanding at a solid pace ●March: economic growth has moderated somewhat ●April: economic growth slowed during the winter months, in part reflecting transitory factors The transition shows that things have recently been difficult for the FRB as the imminent start of rate hikes coincides with a downgrading of the economic assessment. Of course, there is still the possibility of a rate hike in June if the FRB falls prey to its own strong desire to normalize monetary policy by implementing a rate hike while it still can, but it is extremely small, given the consistent message that a hike would depend on incoming economic data. I, therefore, see no reason to change my assumption in this report that the timing of a hike may be June at the earliest, but December in the natural course of things. However, the important thing when considering the forex outlook for the next one year is not the timing of rate hikes. At this point, it can be said that the very fact that the FRB has begun a dialog about normalization is a reason to normalize, so the question of the timing aside, the consensus in the market is that at a rate hike will be implemented at least once. Even though the question of “when it will be implemented” is drawing attention at the present time before the rate hike, once rate hikes have begun, the debate will shift to “how many times can it be implemented.” With regard to this question, there is the opinion that, if things progress smoothly, rate hikes will continue for a period of about three years at the pace of once every quarter, but there is also some concern that the rate hikes could end after the first time. Given that, in the present climate, the timing of the first rate hike is at the mercy of the incoming economic data, even if the process does not end with the first hike, the majority of market participants may be imagining a scenario closer to the latter than the former. If that were, indeed, to be the case, one may even start hearing about a QE4. If one considers that the forex outlooks for the key currencies have always been prepared based on the gap between the monetary policies of the U.S. and the country in question, “how many more times can the interest rate be hiked” is an important question. In particular, if the U.S. monetary policy normalization process is interrupted, it is very likely that EUR rate trends, which have been formed on the basis of speculative short positions that provide for factors that could result in the appreciation of key currencies, could be forced to undergo a reversal. Historically, a rate hike ≈ USD sale Given concerns of USD strength even before the start of rate hikes, USD appreciation could accelerate once rate hikes have begun, thereby derailing the normalization process – there is some logic to this line of thinking. In formulating forex outlooks, the easiest scenario to understand would be if USD were to continue appreciating as rate hikes progress. This would make it easy to formulate forecasts too. However, reality is more complex. As I have said many times in past issues of this report, historically, there has been the anomaly of USD sale accelerating immediately following the start of rate hikes (see exhibit on previous page). Given that the dollar index has been battling at a high level since the start of April, the aforementioned scenario is quite possible. Considering this anomaly of “rate hike ≈ USD sale,” plus concerns of a U.S. economic slowdown immediately following a rate hike, accompanied by a narrowing of the gap between U.S. and Japanese monetary policies, even if the current weak JPY/strong USD phase holds out until the end of the year against the BOJ’s additional

Medium-term Forex Outlook Mizuho Bank Ltd. 13

What could come in the way of JPY weakness/USD strengthRisk factors Remarks

1 Historical anomalyHistorically, USD has tended to drop sharply justfollowing a FF rate increase

2 Deterring action by the U.S.FRB begins to be concerned about USD strengthand drop in crude oil prices

3 U.S. economy's setbackRate hikes end after first round due to the negativeimpact on housing market, etc.

4Improvement in Japan's terms oftrade/current account

Continuous improvement in terms of trade andcurrent account against backdrop of crude oilprice drop?

5 Deterring action by JapanJPY weakness as a tenuous currency policy –response if oi l prices were to rise?

Other 6 OtherDiverse geopolitical risks and other unpredictableevents generally lead to windbacks of JPY shortpositions

Source: Compi led by Karakama

U.S.

Japan

monetary easing and other factors, it is very likely that, from next year onward, a storyline different from that of the past three years will be called for. Of course, if the BOJ were to be drawn in by the government’s currency policies and make a complete about-turn, thereby switching to a stance of distancing itself clearly from additional monetary easing, that “different” storyline may be brought forward, and my outlook for JPY rates this year may have to be revised to limit the scope of its further depreciation.

“Fundamental scenario-related risks – Not discounting the 2016 JPY weakness scenario” Risk factors becoming increasingly relevant As previously, because the fundamental supply-demand environment continues to be characterized by net JPY selling, this article’s main scenario, at least for the current fiscal year, is for JPY weakness/USD strength. As explained above, however, because risk factors are clearly beginning to become more prominent, it will be important to continuously monitor the items in the chart on the right. While these factors were not so significant at the end of last year, at this point, particularly items (2), (4), and (5) are attracting a growing amount of close examination. For example, CEA (Council of Economic Advisers) Chairman Jason Furman’s March 10 “the strong dollar is undoubtedly a headwind for the U.S. economy” statement was considered a market-moving factor that spurred a sharp drop in USD. As noted above, however, the latest edition of the U.S. Semiannual Report on International Economic and Exchange Rate Policies (released in April) seems, if anything, to be expressing acceptance of USD appreciation, so it still cannot be said that risk factor (2) has become a reality. Despite this, as already explained, there is a possibility that USD appreciation can be accepted from the perspective of currency policies based on consideration of the fact that monetary policies are currently in the process of being normalized, so there is a possibility that this accepting stance may be modified if the next edition of the report released this October is subsequent to an interest rate hike in September. (In addition, as explained below, there is a possibility that there will be greater consciousness of currency policy changes during the period immediately before and after the U.S. presidential elections next year.) Objectively viewing the situation, it appears that the amount of noisy speculation regarding USD strength is undoubtedly increasing, and this can be considered to reflect rising risks associated with the weak-JPY scenario. The problem relates to items (4) and (5). Since risk factor (4) has already been discussed I will not go into details here but, as reflected in Japan’s restoration of its trade surplus in March, there are certainly signs of changes beginning to take place in the JPY-related supply-demand environment. At the current stage, however, the changes appear to be causing only a “decrease in JPY-selling pressure” and to have not yet spurred a change to a degree that would cause people to refer to “rising JPY-buying pressure.” People have tended to note that Japan’s trade balance through March has benefited from a sharp drop in imports stemming from the crude oil price plunge, and there is a possibility that the pace of improvement in the trade balance will slacken during the next few months. However, the crude oil price plunge has halted the trend of decrease in the average level of JPY exchange rates theoretically suggested by the terms of trade (export prices ÷ import prices), and one should not overlook the fact that that average level has begun rising recently. This article has been pointing out that the sharp JPY depreciation seen since the advent of Abenomics has led to a convergence between real JPY exchange rates and the rates suggested by the terms of trade – the divergence between real effective JPY exchange rates and the terms of trade has been considerably diminished, and there has recently been clear movement in the terms of trade that is promoting the elimination of that divergence (see chart). There is naturally

60

80

100

120

140

160

180

200

85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15

（Year 1985 average=100）

（Source）Bank of Japan(Note) export price/import price JPY dominated base

Real effective JPY rate & terms of trades progression

Terms of trade

Real effective JPY rate

Better↑

Terms of trade↓

Worse

Strong↑

JPY↓

Weak

Excessively strong JPY is almost disolved by Abenomics in comparison with terms of trades

Medium-term Forex Outlook Mizuho Bank Ltd. 14

a possibility that a renewed rise in crude oil prices could cause movement in the terms of trade to flatten out or decline but, at least so long as the terms of trade are maintained roughly at the current post-crude-oil-price-plunge level, it will be important to note that such a situation will suggest a halting of the effects of a theoretical basis for JPY weakness. More worrisome is risk factor (5). Since last year, this article has felt concern about the possibility that the government’s currency policy stance of seeking to avoid JPY weakness might have an impact on the BOJ’s monetary policy stance of seeking to attain the “2% in two years” inflation target. Since the start of 2015, this risk appears to have become half-way realized, and it can be said that the government has “thrown in the towel” with respect to the BOJ’s QQE policy. The problem relates to whether or not the BOJ will pick up this towel and completely restrain its desire for easing. As I have reiterated each month, this article’s “JPY 130 within this year” outlook is conditional on the BOJ’s undertaking additional easing in line with its “Halloween Logic.” As explained above regarding this point, this autumn will be the showdown period for the BOJ, and it cannot yet be said that the budding results of easing have been for naught. In the case that risk (2) and risk (5) both become realized, then the currency policy interests of Japan and the U.S. will become aligned in a way that is extremely rare from a historical perspective. This can be said to the worst scenario with respect to the JPY weakness/USD strength outlook. Not completely discounting the 2016 JPY weakness scenario As last month’s edition of this article pointed out, while the JPY scenario is expected for fiscal 2015, it appears that another scenario will be needed for next fiscal year (see chart). Although the supply-demand environment this fiscal year is expected to be characterized by net JPY selling stemming largely from accelerating growth in outward securities investment, the changes in fund flows associated with changes in the portfolio management policies of the Government Pension Investment Fund (GPIF) and other pension funds are expected to become less significant by sometime this autumn, and it is assumed that subsequent outflows will gradually peter out. Given the effects of these trends along with improvement in Japan’s trade balance, it will probably become difficult to justify additional JPY depreciation next fiscal year based on supply-demand factors. (However, the assumption of improvement in the trade balance is entirely dependent on the assumption that the level of crude oil prices will be generally flat.) General image of fiscal 2016 outlook

Item Comment Directionality

U.S. (1) Monetary policyShift from “when will they” to “how many timescan they”

JPY strength/USD weakness

(2) Currency policyLimit to acceptance of USD strength? Focus onperiod before/after presidential elections

JPY strength/USD weakness

Japan (3) Monetary policyRealistically impossible to rule out givenprospective April 2017 consumption tax rate hike

JPY weakness/USD strength

(4) Currency policyUpper House elections in July 2016. Difficult toput up with real wage decline?

JPY strength/USD weakness

(5) JPY supply/demandOutward securities investment convergence andtrade balance improvement

JPY strength/USD weakness

Other (6) Other disrupting factorsGreece-related chaos, ECB exit strategy, crude oilprice plunge, etc.

Depending on the situation

Moreover, regarding the outlook for USD/JPY along with all other USD-related currency pairs, it is generally understood that the FRB’s policy normalization will cause a “disparity between the monetary policies of the U.S. and other countries,” and fiscal 2016 will be the year when the robustness of that disparity’s effects will be tested. Since even the amount of USD appreciation occurring prior to an initial interest rate hike (half of it spurred by the U.S. itself) has led to difficulties, many people are frankly inclined to doubt whether a sequence of interest rate hikes would be feasible. As already explained, when considering the forex outlook for the year ahead, the most important factor is not the timing of the interest rate hike. Setting aside the issue of the timing, the market consensus is that “they will definitely hike rates once.” The “when will they do it” issue is in the spotlight at this point, prior to an initial rate hike. After the initial hike, however, the focus will shift to the “how many more hikes are feasible” question. As mentioned above, many people are inclined to be bearish on this issue. Moreover, while the U.S. currency policies appear to be accepting USD strength at this point, we must take into account what U.S. industries are likely to be saying before and after the presidential elections and give due consideration to the risk that there will be a change to that posture of acceptance. Besides the changes in the supply-demand environment during fiscal 2016, regarding U.S. monetary policies, since we cannot have great confidence in our ability to predict the answer to the “how many more hikes are feasible” question, we should probably maintain a general image that USD/JPY is liable to have a increasingly heavy upside potential.

Medium-term Forex Outlook Mizuho Bank Ltd. 15

-60

-40

-20

0

20

40

60

80

07 08 09 10 11 12 13 14 15

(％ point)

(Source) Datastream

Bank lending inclination & demand for loans in Euro zone

Credit standards Demand for loans

Tightening↑

Lending inclination↓

Easing

Increase↑

Demand for loans↓

Decrease

EUR Outlook – Continued outlook for short-term weakness and medium/long-term strength ECB Monetary Policies Now and Going Forward – Emphasizing credit function improvement Nothing new besides the intruder The April 15 ECB Governing Council decided to keep the policy interest rate (interest rate on main refinancing operations (MROs)) at 0.05%, the upper limit (the interest rate on the marginal lending facility) at 0.30%, and the lower limit (interest rate on the deposit facility) rate on the deposit facility at -0.20%. As a result, the interest rate corridor (the difference between the upper limit and the lower limit) was maintained at 0.50 percentage point. Reflecting the fact that the it was the first meeting following the March 5 meeting, which presented revised ECB staff macroeconomic projections along with details of the expanded Asset Purchase Programme (APP), this meeting did not offer much new (excepting the disruption at the start of the press conference, when a female protester jumped up on the stage and criticized President Draghi5). At the press conference, President Draghi mainly limited himself to pointing out recent improvement in the Euro zone’s economic/financial situations while praising the effects of the ECB’s existing policies. Particularly regarding improvement in credit trends, Draghi referred to ongoing changes such as those reflected in the results of the April 2015 bank lending survey (see graph), and he appeared to be pleased with what he was reporting. In his introductory statement, he said – “the April 2015 bank lending survey confirms that improvements in lending conditions support a further recovery in loan growth, in particular for firms.” As the graph shows, however, growth in demand for loans decelerated from the level reported by the previous survey (in January), so the lending situation cannot necessarily be characterized as firm. Draghi also emphasized the “full implementation” concept several times, saying – “Looking ahead, our focus will be on the full implementation of our monetary policy measures.” – and – “The full implementation of all our monetary policy measures will provide the necessary support to the Euro zone recovery and bring inflation rates towards levels below, but close to, 2% in the medium term.” Categorical denial of tapering and deposit facility rate reduction The emphasizing of “full implementation” may reflect President Draghi’s desire to respond to the tapering-related concerns that some people have conceived. As expected before the meeting, there was a question about the tapering of QE. In response, Draghi said – “I’m quite surprised, frankly, by the attention that a possible early exit of the programme receives, when we’ve been in this programme only a month ” – and he thereby discounted the possibility of tapering. However, the reason this issue has attracted attention is that several high-level ECB officials have hinted at this possibility. Although there was no in-depth, concrete discussion of tapering this time, it is undeniable that there are concerns within the Governing Council regarding the sustainability of QE as well as regarding the various problems associated with QE. The tapering issue is stemming from a consciousness of the potential problem stemming from “concerns about an exhaustion of assets within the ECB QE purchasing scope,” and Draghi briskly disposed of those concerns by saying – “The worries about potential scarcity of government bonds, sovereign bonds, to be bought under our purchase programme, are just a little exaggerated. We don’t see problems.” However, most interest rates in the Euro zone are at historically low levels, and the interest rates on German government bonds, which account for the largest share of bonds in the area, are becoming chronically set at -0.20% or lower for issues with maturities up to four years. Regarding the potential drying up of assets eligible for purchase under the current QE scheme, which allows for purchases of assets with interest rates no lower than -0.20%, a reporter asked the question – “would you ever consider [further] lowering the deposit rate” – and Draghi explicitly replied – “The answer is no.”

5 The ECB’s March 18 inauguration ceremony for its new headquarters building was accompanied by an anti-austerity demonstration, and it appears that the incident at the last Governing Council Meeting stemmed from the previous demonstration. The ECB’s press release, “Statement on incident at ECB press conference,” explained that the woman presented a falsified credential when she went through an identity check and emphasized that President Draghi was not harmed.

Medium-term Forex Outlook Mizuho Bank Ltd. 16

-1,000

-500

0

500

1,000

1,500

2,000

2008 2009 2010 2011 2012 2013 2014 2015

（Bill euro）

（Source）ECB

Euro zone M3 variation factor （monthly, seasonally adjusted, YoY）

Credit to private sector Credit to governmentsNet external assets OthersLong term financial debts M3

（Note） Long term financial debts: M3's deduction such as deposit （more deposit→ reduction M3）

Despite that, however, since Draghi also stated during the press conference that – “our programme is flexible enough in any event to be adjusted if circumstances were to change.” – there are fully sufficient grounds for anticipating that there may be some fine-tuning adjustments to the scheme going forward. Simple base money volume correlation? Without waiting for the quarterly bank lending survey results, one can discern improvement in the credit environment from monthly reports on the money supply (M3). The Euro zone’s latest (at the time this article was written) M3 report, for February, showed that M3 was up 4.0% YoY, the most rapid growth rate seen since April 2009. The results of analyzing the factors contributing to the rapid M3 growth are shown in the graph on the right. The biggest factor is (1) growth in net external assets, followed by (2) growth in credit to governments and (3) a smaller margin of decrease in credit to the private sector. The growth in net external assets reflects the earning of foreign-currency by means of the non-financial sector’s exports etc. Via transactions with financial sector and other means, the net external asset factor adds to the money supply. This is logically consistent with the Euro zone’s continued accumulation of huge trade surpluses. Regarding the growth in credit to governments, this probably should simply be considered to reflect the Euro zone’s getting over the hump of the anti-austerity mood 6 . (Given the nature of the savings-investment (IS) balance, government-sector investment expansion can lead to private-sector savings expansion. Savings expansion leads to money supply growth.) While there is still no growth in the key area of credit to the private sector, the margin of decline has been sharply shrinking recently, and it will be worth watching closely going forward to see if credit to the private sector becomes transformed into a supporting factor. If the Euro zone real economy recovers in line with the ECB forecast, then one can expect continued robust M3 growth led by credit to the private sector, and there should be a rise in the Euro zone’s Harmonized Index of Consumer Prices (HICP) in line with the ECB’s ultimate objective. Compared with the current situation of M3 expansion led by credit to governments and net external assets, it is not difficult to imagine that M3 expansion led by credit to the private sector should make a relatively greater contribution to an increase in HICP. Going forward, it will be worth monitoring and analyzing the question of whether this kind of simple money volume relationship can be established amid the Euro zone’s current economic/financial situation. Continued EUR outlook for short-term weakness and medium/long-term strength The ECB’s monetary policies seem likely to continue taking the easing route and, given the unchanged Greece situation described below, it appears inevitable that EUR will be soft from mid-year through the autumn. As this article has stubbornly argued, however, to the extent that one considers the fundamentals related to the supply-demand and price situations, the current EUR weakness is something that should be described as “epic speculation” and its sustainability is questionable. Since April, for example, there has been an accumulation of speculative EUR selling in IMM currency futures transactions and other arenas, but the prevailing market exchange rates have not declined much. (In fact, they increased toward the end of the month.) One reason for this that simply cannot be disregarded is the existence of the Euro zone’s current account surpluses. The Euro zone’s current account surpluses have already greatly exceeded the size of Japan’s previous surpluses, and they are associated with real demand flows leading to EUR buying that are quite large. During the forecast period, one should probably continue watching out for the possibility that a perception of a lack of market moving factors at such times as immediately following the FRB’s first rate hike will cause a rolling back of speculative positions along with a sharp surge in EUR/USD. Memories of Japan’s experience during the period from 2005 through the summer of 2007 – when JPY depreciated amid current account growth and a lack of price increases, followed by a sharp appreciation in the summer of 2007 – should be kept in mind when considering the EUR outlook.

6 Please refer to the February 17, 2015 edition of Mizuho Market Topic entitled “Euro Area GDP and the EC Winter Economic Forecast.”

Medium-term Forex Outlook Mizuho Bank Ltd. 17

Supplementary Discussion: The Greek Problem, Now and Going Forward – Will for Solvency Improvement?” Chronological overview of the Greek situation The Greek situation has been attracting detailed analyses since April and I have received a growing number of related inquiries. There has been particularly strong interest regarding two points – “What is the gist of the February 20 agreement?” and “What are the key dates?” Since the twists and turns of the Greek situation are extremely confusing, I would like to present a simple overview of the situation’s development since late February. Regarding the first of the above questions, the concise answer is “the February 20 agreement is simply an extension and does not call for additional funding.” The confusion that has occurred from the time of the agreement to this point (April) was to a certain extent anticipated. Regarding the latter question, many people tend to focus on the May 12 IMF loan repayment (EUR750 million) date and, since there will be a Euro zone finance ministers meeting (Eurogroup) the previous day, it is possible that May 11 will be the key date. The February 20 agreement is simply an extension Regarding the first question, the February 20 agreement is simply an “extension” of existing programs, and the question of whether to permit any “funding” implementation within the programs was to be assessed and decided by the Troika subsequently. The result of the assessment was a decision not to provide additional funding, and the turmoil surrounding the situation has become still more profound as of April. Moreover, it was soon agreed that bridging funding would be “limited to the four month period through the end of June,” and this would appear to reflect an assessment that the Greek government could not operate without the provision of funding. Actually, however, the funding has remained frozen for two months. More specifically, bridging funding amounting to EUR7.2 billion has been suspended since last year and, given the fact that the Troika has set the funding amount to match the amount required, one frankly wonders why there has not been a drastic problem during the period of suspension. In this regard, there have been many reports that Greece has somehow been able to make it through the emergency situation by such measures as those to delay salary payments to government employees and draw down pension funds. However, as described below, since there are reports beginning to emerge of IOUs being issued in lieu of government employee salaries, there is a high likelihood that the country is getting very close to the brink of disaster. While watching the European debt problem develop since 2009, the issue that seems most difficult is the fundamental issue of determining how much funds Greece actually has in its treasury and how much that amount exceeds or falls short of the country’s requirements. Since even the Troika, which has endeavored to officially assess the situation, has not been able to establish a firm grasp of the situation, one must naturally recognize that there are limits to the ability of outsiders to analyze the situation. It has also been reported that, on the occasion of the February 20 agreement, the German authorities had referred to the Greek request for an extension of support as a “Trojan horse,” and it must be said that the request is actually functioning as such. Ultimately, the disbursement of bridging loans in installments was approved, but rather than making a fresh “rehabilitated” start upon being retained in the area, Greece has further increased the frequency of its troublesome statements and actions. The support extension is in fact becoming a “Trojan horse.” IOUs are a milestone on the path to a Greek exit I will now return to the task of overviewing the current situation. Following the February 20 Eurogroup agreement, it was in March that there appeared to be a slight temporary improvement in the Greek situation, but the problem began capturing renewed attention soon after the start of April. The trigger was an IMF Loan Repayment scheduled for April 9. Specifically, on April 1, Greek Interior Minister Nikos Voutsis stated regarding the repayment of the EUR450 million loan that the country was being forced to choose between repaying the loan or paying salaries and pensions, and he hinted that he would choose the latter. This immediately heightened anxiety about Greece’s situation. On April 9, Greece repaid the EUR450 million loan to the IMF on schedule, but, the liquidity problem stemming from the non-disbursal of bridging funding discussed in the February 20 Eurogroup agreement remained unsolved. One key factor that has further heightened fears of a Greek exit from the Euro zone through to the present appears to be an article entitled “Greece prepares for debt default if talks with creditors fail” that appeared in the United Kingdom-based Financial Times on April 13. That article presented the idea that Greece is preparing to default on its debt and quoted a government official as saying – “We have come to the end of the road . . . If the Europeans won’t release bailout cash, there is no alternative [to a default].” That triggered the often seen progression of “default fears → Greek exit fears → EUR selling.” Soon afterward, reform proposals were discussed at an April 15 meeting of vice-minister-class officials prior to the Eurogroup meeting (April 24) but, as has already been reported, the April 24 Eurogroup meeting ended in discord. After the meeting, Eurogroup President Jeroen Dijsselbloem stated that – “comprehensive and detailed

Medium-term Forex Outlook Mizuho Bank Ltd. 18

list of agreed reforms is needed a comprehensive deal is necessary before any disbursements can take place. We are all aware that time is running out.” – and yet the same kind of statements were being heard just two

months previously. Since the start of April, the number of disturbing Greece-related reports has clearly been increasing. On April 18, it was reported that there was a proposal to shift to the payment of Greek government employee salaries in the form of IOUs, because the ECB’s extension of Emergency Liquidity Assistance (ELA; considered the key to Greece’s remaining in the Euro zone) would be discontinued in the case of a Greek default (Reuters, April 18). While the source and authenticity of this report is questionable, if virtual currencies (including IOUs) were to begin circulating in Greece as a method of replacing the country’s official currency, then it could certainly be said to be an important milestone on the path toward a Greek exit. If Greece really wants to remain in the Euro zone, then they are showing extremely poor skills in rumor management. Moreover, in an interview that appeared in the April 24 edition of the French weekly magazine, Philosophie, Greece's Finance Minister Yanis Varoufakis was quoted as saying – “We cannot bluff anymore. When I say that we'll end up leaving the euro, if we have to accept more unsustainable austerity, this is no bluff” (Reuters, April 23; the interview itself was conducted at the end of March). To the extent discernible based on this series of situations, it appears that Greece has diverted its attention from considering the feasibility of fiscal reconstruction measures and has begun seriously considering the possibility of leaving the Euro zone. When rumors began circulating about Greece’s government having insufficient funds to operate after April 9, it was reported that Greek representative in a teleconference of Euro zone deputy finance ministers said delaying new loans until a deal with creditors could be reached was unrealistic, and that reforms should not be a “post mortem” for the country (Reuters, April 3). Essentially, it seems that the representative was suggesting that if Greece were to accept reforms sufficient to satisfy the Troika, the country would be a “corpse (default ≈ exit from Euro zone?), and this appears to indicate that Greece is strongly averse to undertaking aggressive fiscal reform measures. It has been said from the beginning that the Greece problem is not one of “liquidity” but one of “solvency,” and it can be said that it is now becoming impossible to continue keeping the focus away from the solvency problem. May 11 a key date – Japanese should keep aware despite holidays Many voices are saying that May 11 will be a key date. In May, Greece is scheduled to redeem EUR1.4 billion of short-term bills on both the 8th and 15th, but it is expected that these bills can be rolled over by domestic banks. The problem is the May 12 IMF loan repayment (EUR750 million). Since the amount is small, there is a possibility that Greece can surmount this challenge, as it has previous challenges, by reneging on a portion of its domestic payment commitments, but if the repayment is delayed, Greece would be in default. Given this, Greece is extremely eager to get its hands on the suspended EUR 7.2 of bridging funding, and that is why Greece told the Eurogroup on April 24 that it wanted the funding to be disbursed even if it had to be in installments (although the request was denied). If Greece does not seem likely to be capable of even making the IMF loan repayment of EUR750 million on May 12, then it must make sure to present a convincing reform plan to the Eurogroup meeting on the previous day so as to obtain the disbursement of the bridging funding. Given this situation, it seems that May 11 will be the key date, and although Japanese market participants may be distracted by the protracted Golden Week holiday period, they should do their utmost to keep abreast of related developments. Greek exit scenario beginning with default In the case that Greece manages to handle the May 11 repayment, it is likely to be positively reported in the media reports and foster a sense of relief on the parts of market participants reading those reports. However, to the extent that the country does not obtain the EUR 7.2 billion, it will suffer from a chronically empty treasury and an associated smoldering concern regarding the possibility of default. Greece’s current situation of making delinquent payments domestically is merely fostering abstract concerns and anxieties, but a delinquency in the payment of external obligations would immediately make default a concrete reality. As this article has stubbornly argued, it is the ECB’s ELA program that is supporting Greece’s financial system, but it would be difficult to logically justify sustaining ELA support for Greek domestic banks holding large volumes of government bonds issued by a country that is in default. A series of questions about the sustenance of ELA support for Greek banks were posed at the March 5 and April 15 ECB Governing Council Meeting press conferences, and ECB President Draghi has answered the questions along the lines of his March 5 response – “ELA can be given to solvent banks with adequate collateral. The Greek banks at the present time are solvent.” In the case of a Greek default, an “ELA discontinuation → Drying up of EUR within Greece → Greek exit” scenario would seem inevitable. In addition, the Greek domestic banks deprived of ELA support would go bankrupt. That situation would test the capabilities of the ECB, which has been responsible for bank oversight since 2014, but it is possible that the process of injecting funds into bankrupt banks might proceed smoothly. The need to make policy judgments and decisions associated with the burden of funding the injections would definitely foment internal strife within the ECB, as has been seen in the past. There probably would be a high likelihood that, even after the capital

Medium-term Forex Outlook Mizuho Bank Ltd. 19

injections, there would be renewed problems regarding Greece’s posture with respect to fiscal reconstruction. Indubitable need for a new framework from July The above sections of this article present a story of how events associated with the EUR 7.2 billion bridge funding may play out during the period through the end of June. From July, there will be a need to create a new financial support framework (as saving Greece is not so easy that it can be done with a mere EUR 7.2 billion). Greece will soon face this year’s largest government bond redemption challenge (EUR 7.64 billion, Bloomberg) in July, and it is clear that it will not be able to surmount that challenge without additional support. However, assuming that there is no change to Greece’s current attitude, it appears highly unlikely that agreement will be reached on a new support framework. Given this outlook, the quagmire of factors that have created the problem, and the dire scenarios likely to occur going forward, it should be apparent that everything will depend on whether or not Greece will earnestly strive to improve its solvency (or to progress with fiscal reconstruction). In this regard, since it would be difficult to expect that the current government (which was voted into power based on the perception that it would not earnestly strive to improve Greece’s solvency) to compromise on this issue, and since the government could not be expected to sustain its coalition if it were to compromise, one can anticipate a flow of events leading to the dissolution of the government and the holding of general elections. From late spring through summer, it will be continue to be important to closely monitor the Greek situation and its effect on the forex market.

Daisuke Karakama Chief Market Economist Forex Division Mizuho Bank, Ltd. Tel: +81-3-3242-7065 daisuke.karakama@mizuho-bk.co.jp

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