Downside risks to Japan’s economic outlook increase following Brexit; BoJ likely to expand QE

The Brexit decision today has increased risks on the downside to Japan’s economic outlook. The financial channel is expected to have the most impact. The Japanese yen appreciated sharply amidst risk off sentiment. The Nikkei ended the day down 7.9 percent, bringing down the year to date performance to -21.4 percent. If the tightening in financial conditions is not addressed, it will adversely impact the economic growth.

The risk-off environment set off by the Brexit decision also increases the urgency for the central bank policymakers to react. The Brexit decision has increased the possibility of the Bank of Japan to respond with further quantitative easing, either during its next meeting in July, said HSBC in a research report. In the June’s policy board meeting, the central bank had noted its concern that volatility in t he market from a Brexit decision might “weigh on the economy”.

If the Bank of Japan does not respond, it would deepen the pressure on the yen to bolster further, increasing the threat that the Japanese economy might fall back into deflation. The BoJ is likely to expand the monetary base target by JPY 10 trillion and also increase the ETF target, according to HSBC. Moreover, there are increasing risks of the central bank lowering interest rate.

If the Japanese yen continues to be under pressure to strengthen, there is a high possibility that the BoJ governor Kuroda might call in an earlier emergency policy board meeting next week to express a higher sense of urgency.

Moreover, the Bank of Japan is expected to make direct FX intervention in the near-term due to sharp currency moves set off by Brexit, noted HSBC. Even if JPY continues to be slightly undervalued, Japan might intervene on the basis of stemming volatility.