Thursday, February 1, 2007

The Incredible Shrinking Yen

Much has been documented of late with respect to the demise of the currency of the world’s second largest economy. The Japanese yen currently stands (30 Jan) at a 4.5 year low against the US dollar, has been hitting all-time lows against the euro almost on a weekly basis for the past 6 months and last week touched a 14 year low against sterling. In the past 18 months, the euro has gained 18.7% against the yen, while the pound has gained almost 20% in the last year alone. While Japanese authorities have been the first to cry foul about the failure of the Chinese yuan to appreciate, they have been deafening in their silence in response to the virtual collapse of their own currency. Why? Much of the blame for the yen’s depreciation can be put at the door of Japanese political figures that constantly undermine both the currency and the independence of their own Central Bank. Japanese politicians have long had a strategy that a weaker currency is in the best interests of their country with Japan being a predominantly export-oriented economy. In exchange-rated trading terms, the yen registers as the most under-valued currency of all developed countries right now. Yet Japan has a current account surplus the envy of the world and year-on-year trade surpluses registering 40%+ increases are not uncommon for the country. So why is the currency in freefall? I offer 3 major reasons, in order of significance.
1) Carry Trades --> Because Japan has such low interest rates (0.25%), traders have been funding investments in other higher yielding securities and currencies using the yen. The sheer volume and extent of the carry trade appears to have grown increasingly in the past 6 months. One has only to look at the performance of the Swiss franc in the same period to realise that this is not purely a yen phenomenon. It is interesting to see how easily good economic news out of Japan is dismissed so quickly by the market, against how easily the yen is sold off when economic data is not so good. The underlying fact is that the yen is being used to fund investments elsewhere and those borrowing the yen to fund these other investment s are going to continue to do so as long as they can get away with it. The global carry trade is now so heavy that it is going to take some significant event to dislodge the weight of short positions currently held against the Japanese currency. If the authorities that be (Central Banks and Governments) leave the fate of carry trades to such a major event, then a single major issue could lead to a sharp unwinding and collapse of the carry trade that could wreak havoc for financial markets.
2) Domestic consumption --> The principal reason why the Bank of Japan has been unable to raise Japan’s low interest rates is because the Japanese domestic economy remains rather brittle. The Japanese consumer is simply not spending money and domestic demand is stagnant. While wage growth in Japan may have been modest in comparison to some other countries, spending has actually been in decline. Prices have hardly increased, because Japanese retailers are competing for a smaller pot of cash. We could in fact see consumer prices shift back into deflationary mode over the next few months, something that could stall indefinitely any prospect of the Bank of Japan raising rates. This in itself does not explain the current low value of the yen as the Japanese economy has been in this sort of domestic economic predicament for much of the past number of years. But it serves to demonstrate how dependent Japan is on its export industry and why the Japanese Government are not complaining too much about a weak yen.
3) Bank of Japan --> The Bank of Japan has the least credibility of all the major Central Banks right now. The recent debacle regarding the ‘no rate hike’ in January diminished their reputation even further and their independence has largely been called into question. The ongoing interference from Japanese politicians, airing their public opposition to rate increases, highlights the fact that in Japan, monetary policy tends to be as much politically as economically driven. Add to this the poor communication that exists between the Bank of Japan and financial markets and you have a recipe for trouble. Much of the muscle behind the carry trade in recent months has come directly from the perceived weakness and willingness of the Bank of Japan to react in any way. The euro’s uninterrupted ascent against the yen since last summer reveals an unusually one-sided and worrying trend amongst two major currencies. The Bank of Japan has thus far failed to address the weak yen issue at all, let alone do anything about it. The truth is that it may be powerless to do so, as it appears gagged from a fear of offending the government. Recent comments from Japan’s Minister of Finance who dismissed the issue and said that the yen’s current value reflects economic fundamentals give an indication of where the Government sit on the issue. The Japanese Government seem happy to tolerate a weak currency to grow exports, but they are playing a dangerous game. With the failure of the either the Japanese Government or the Bank of Japan to act, it may be left to other global players to address the worrying imbalance.