Japan has emerged as a key victim of the fallout from the U.K.’s vote to leave the European Union, with its government led by Shinzo Abe and central bank now facing the most serious crisis yet in their 3 1/2 -year campaign to revitalize the country’s economy.
The Bank of Japan had already been struggling to bolster the country’s economy through measures that relied heavily on cheapening the currency to support corporate profits — much of which are earned abroad.
But the U.K. vote sent the yen soaring as investors poured money into currencies, like the U.S. dollar and yen, that are seen as stable stores of value in times of turmoil. It also pummeled Japanese stocks — whose near-8% decline on Friday was around twice as much as that of any other major market outside of Europe.
The yen’s continued rise this year — which has come despite the BOJ’s setting negative interest rates for the first time in January — now poses a major challenge to “Abenomics,” the program aimed at stirring higher growth and inflation led by Mr. Abe and Bank of Japan Gov. Haruhiko Kuroda.
Until mid-2015 a weaker yen had been central to the most tangible achievements of Abenomics to date.
The U.K.’s Brexit decision, ironically precipitated by voters looking to put up economic barriers, is the latest example of how events elsewhere have conspired to blow the BOJ off course. The U.S. Federal Reserve’s dialing back of its plans to enact a series of interest-rate rises this year has also helped the yen to continue rising against the U.S. dollar.
Many economists say the BOJ’s existing policies have reached their limits, and can do little more to reverse the yen’s rise in the face of a global flight to safety, meaning the Japanese government may be forced to directly intervene in currency markets.
Abenomics now faces a “watershed moment,” said Toshihiro Nagahama, chief economist at Dai-Ichi Life Research Institute. Intervening in currency markets might not bring the yen down for long but “would still be better than nothing,” Mr. Nagahama said.
“Prices will surely weaken as import costs fall. Earnings are set to drop, which may cause the demand-supply balance of the labor market to worsen. Deflation could take root once again if the yen is allowed to keep appreciating,” he said, adding that without action, markets would react by driving the yen even higher while pushing Japanese shares even lower, he said.
The yen’s steep decline from late 2012 through mid-2015 pumped up Japanese corporate profits earned overseas, driving total earnings to record levels, and created inflationary pressures by raising import prices.
But the “virtuous cycle” of higher wages and consumption that was predicted to follow never fully materialized.
Japan’s economy has swung between modest expansions and contractions in recent quarters. Inflation is falling, and price expectations along with it. One inflation gauge that includes energy prices, once the preferred measure of the BOJ, turned negative months ago. Businesses and consumers, having already turned cautious, could scale back investment as confidence in the global economy falters after the Brexit vote.
Two other nominal pillars of Abenomics — fiscal stimulus and structural changes — have been sporadic and limited, analysts say. Without those reforms, analysts say, Abenomics has become over-reliant on its monetary policy arm.
Mr. Kuroda has said the central bank is prepared to take more action, but has so far offered no details. The central bank is widely expected to ease policy further at its next scheduled policy meeting in July.
The BOJ’s most likely options are to expand its asset-purchase program, currently at Yen80 trillion ($782.83 billion) annually, and to push a key interest rate on some bank reserves further into negative territory.
Another possibility is that the government and central bank could announce coordinated monetary and fiscal-policy actions, with so-called “helicopter money” as an extreme option, said Takuji Okubo, chief economist at Japan Macro Advisors. Such a move would see the central bank financing government spending with direct purchases of government bonds.
“If the BOJ really wants to change the game they have to step up,” he said.
Any further yen rise would be painful for corporate Japan, which is already suffering from a stronger currency and slowing global growth. The Japanese government’s estimated average “break-even” level for exporters this year is Yen103.2 versus the dollar — meaning exporters will lose money unless the yen is weaker than that level or companies offset the damage by, for instance, cutting costs.
Leading auto maker Toyota Motor Corp., which enjoyed several years of yen-driven record profits, set its earnings projection on its forecast that the yen will average Yen105 to the dollar this financial year through March.