The US dollar fell sharply against the yen yesterday after Japan's ruling Liberal Democratic Party (LDP) said it had struck an alliance with the opposition Liberal Party, raising hopes of more concerted moves to kick-start the country's ailing economy.
The parties said they had agreed to review the sales-tax rate, a step long sought after by the Liberal Party.
Tokyo increased the tax to 5 per cent from 3 per cent in April last year, a move some economists argue is partly to blame for halting Japan's recovery.
'Now that we have agreed to review it fundamentally, we hope we can hold various discussions over [the tax],' LDP Secretary-General Yoshiro Mori said.
The dollar slid as low as 118.7 yen in late London trading - its lowest level in two weeks - but had recovered slightly in mid-morning New York trading to 119.42 yen. Those rates compared to 121.75 yen late in New York on Wednesday.
'The market has some optimism that political developments in Japan will make it easier for the Japanese Government to push through bank reform and implement a sales tax reduction,' Avinash Persaud at JP Morgan said.
Traders said the announcement came as a major hedge fund began unwinding a short-yen, long-dollar position in a bid to capitalise on the recent rally by the dollar in which it had risen above 122 yen.
Chief Cabinet Secretary Hiroku Nonaka said the two sides would aim for about 10 trillion yen (about HK$638 billion) in cuts in income, residential and corporate taxes in the next fiscal year in addition to the near 24 trillion yen economic package announced this week.
'It seems there is a greater sense of urgency in respect of coming up with meaningful policies and going down the fiscal reflation route,' Michael Derks, senior market strategist at Nomura said. 'The government appears to be more serious about reform than the market thought.' But some analysts said the yen's strengthening was likely to be short-lived.
'Reducing the sales tax is not going to trigger an economic recovery,' Mr Persaud said.
Any reduction in taxation would lead to greater savings, not increased demand, he said.
Similarly, any banking reform would also have a negative impact, as the government's proposals to sell bad debts would weaken asset prices that, in turn, would cause currencies to lose value.
'Currencies always weaken in the early stages of a credit crunch and currency weakness often accelerates at times of public bail outs of banks,' Mr Persaud explained.
'The key influence on currencies during a credit crunch is not monetary policy but asset prices.'