Highlights
USD-JPY hits a 15-year low
Chinese security purchases in Japan are relatively modest…
…compared to significant increase in Japanese foreign security purchases
Sharp appreciation of yen in real terms threatens Japanese growth
A Yen For All Eventualities
Since the outbreak of the financial crisis in summer 2007, the Japanese currency has been by far the strongest currency. Not only does the yen put industrialised countries’ currencies in the shade, but it has also risen markedly against emerging market currencies. The Swiss franc has put in the best performance, losing a mere 18% against the yen; next on the list are currencies such as the real, the Singapore dollar and the yuan, which have dropped by over 20%. The US dollar and the euro have fallen by 30 and 35% respectively; the Korean won and the pound Sterling have weakened by more than 45%.
The yen’s rally should be seen to a large extent as a correction, as it was substantially undervalued.
The financial crisis triggered a widespread retreat from carry trades, causing the yen, which was the preferred funding currency for carry trades because of Japan’s extremely low interest rates, to appreciate significantly. Against this backdrop, the yen has indirectly attained a sort of “safe haven” status: whenever market participants feared an increase in global economic risks, the yen rallied parallel to the retreat from riskier assets.
Meanwhile, the yen seems to have become the retreat for all eventualities. The dollar fell against the yen when the euro plunged to below 1.20 against the dollar due to the sovereign debt crisis in Europe. And USD-JPY continued to fall when growth fears began to take hold in the US. Japan’s disappointing growth figures for the second quarter had no effect on the impervious yen either. Instead, USD-JPY slipped below 85 a few days ago – its lowest level since 1995. Currently, USD-JPY is just over 85, and EUR-JPY just under 109 (which is close to a 9-year low).
The interest rate situation in Japan offers little incentive to invest in yen: short-term interest rates virtually zero, yields on 10-year government bonds less than 1%. But interest rate spreads to Japan have narrowed considerably on fears of a new recession. Both Treasury and Bund yields are now closer to Japanese yields.
Given the fundamental structure of Japan, it is hard to explain the yen’s sustained strength. Admittedly, the economy posted sharp growth in both winter quarters of 2009/10, but in relation to the collapse in economic activity, the upward movement is comparatively modest. Real GDP is still 4.5% below its peak in Q1/2008. Furthermore, growth slowed down significantly in Q2 – even though, due to special effects, the pace of growth had not really slackened quite as much.
The Bank of Japan has no intention of tightening its extremely expansionary policy, quite the contrary in fact: the government is more likely to push for further quantitative easing measures.
Japan’s dwindling interest rate disadvantage suggests that net capital outflows should diminish. This idea was supported by reports that China had increased its purchases of Japanese securities, presumably in order to diversify its currency reserves. However, the balance of payment statistics do not fully uphold this concept. Particularly in the last few months, there has been a sharp increase in Japanese investment in foreign securities, primarily bonds. Japanese net portfolio investments abroad rose significantly in the first six months of 2010. In June alone, capital outflows reached almost 8000bn yen. In contrast, Chinese purchases totalled only 460bn yen in June. Moreover, China has invested primarily in money market papers, which does not support the diversification theory.
Although the markets tend not to be very interested in long-term equilibrium exchange rates, analysts have recently taken pains to point out that the deflationary price trend in Japan implies that the yen has depreciated in real terms. Thus a USD-JPY exchange rate of 90, for example, would be much more justified than 15 years ago based on price competitiveness. This argument is basically correct. Although the yen has appreciated in the past three years, Japan now has a significant trade surplus again. It should be taken into account, however, that the appreciation was abrupt: the real trade-weighted exchange rate has risen by almost 38% over this period. This might be too much of a challenge for the Japanese economy, especially in the current difficult situation. This could dampen growth. On the other hand, however, the strong yen facilitates direct investment abroad, which helps to compensate for the exchange rate disadvantage.
Overall, in our view the yen’s strength over the last few weeks is overdone. The Japanese growth outlook and the capital flows offer no reason for a stronger yen. The purchasing power argument is to some extent justified. The undervaluation of the yen has probably now been largely corrected.
The OECD (and also the Big Mac-Index) now see the yen as slightly overvalued. Above all, however, policymakers will have to take action if the yen continues to appreciate in real terms. Recently, there has been increasing demand for currency market intervention. Against this backdrop, we are expecting USD-JPY to firm somewhat in the medium term.
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