Currency Thoughts

Why the Yen is Strong

September 14, 2011

First, here’s some history.  Prior to the summer of 1971 when most dollar exchange rates were fixed, a dollar was worth 360 yen.  In the 1970s, Japan’s currency appreciated 50% to 240 per dollar, and it climbed another 67% to 144/USD by the end of the 1980s.  When the euro was launched at the end of 1998, one only needed 113.5 yen to obtain a dollar and 133 yen to get a euro.  Little net movement occurred between then and the start of the world financial crisis in early August 2007 when a dollar and euro fetched 119 yen and 134 yen.  However, the yen has been stronger than 90/USD since mid-2010 and pricier than 80/USD for almost two months.  Early this week, it touched 103.89 per euro, its strongest level against the common European currency since June 14, 2001.  Since the outbreak of the financial crisis just over four years ago, Japan’s currency has advanced about 56% against the dollar and some 27% relative to the euro.

This chronic strength in the yen violates many conventional wisdom about what factors make a currency strong or weak.  Japan has several presumed vulnerabilities such as

• Weak economic growth:  Real GDP grew just 0.7% per annum in the 20 years between the second quarters of 1991 and 2011.
• Low short-term interest rates:  The Bank of Japan’s target has not exceeded 0.5% for the past sixteen years.
• Poor fiscal metrics:  The budget deficit will again exceed 8% of GDP this year, and gross debt of about 225% of GDP easily tops all G7 economies.
• Unattractive long-term bond yields:  The 10-year JGB yield is currently 1.00% and has averaged 1.38% during the past ten years.
• A battered stock market:  The Nikkei-225 closed today at 8,519, 78.1% below its record high of 38,916 at the end of 1989.  That’s a six and three-quarters percent per annum rate of value destruction sustained over twenty-one and three-quarter years.
• Dismal demographic prospects:  The population likely crested in 2010.  A low birth rate and barriers to immigration point to accelerating drop in the future and an ageing population.
• A dysfunctional political landscape:  There have been 19 different prime ministers since early 1981, more than the 14 Italian prime ministers and much more than the total number of U.S. presidents and British prime ministers (5 each) or the number of French presidents (4) and German Chancellors (4).
• A lack of indigenous energy resources and a predisposition to weather and earthquake disasters round out this list.

The list of yen supports is shorter but sufficient qualitatively to outweigh the above factors.  First, the dollar and euro are not cherished.  Diversification is transitioning the dollar from being a reserve currency without close peer to a state where it will at best have to share power.  The euro has potentially fatal political foundations.  The Chinese yuan meanwhile remains managed and therefore not even a reserve currency. 

Second, exchange rates measure the external value of a country’s money, while inflation calibrates change in the internal value of money.  The two concepts tend to dovetail one another over the long run.  While other G7 economies have experienced lower inflation during the past 15 years, none can match Japan’s performance where chronic deflation has set in.  In inflation-adjusted terms, the yen is nowhere near as overvalued as the Swissie became before such was pegged recently. 

By maintaining the yen’s competitiveness in the face of a rising yen, price deflation promotes Japan’s chronic current account surplus, which is expected to hover near 2.5% of GDP this year and next.   The United States has a big deficit, and Euroland includes several members with large deficits and overall runs a current account that is insignificant in size.

Worldwide risk aversion also buoys the yen.  People are looking for a return of their investment, not a return on their investment.  The importance of high interest yields is diminished, and low long-term yields in Japan are a sign of confidence, whereas high yields in Europe’s peripherals are a sign of scant willingness to hold government paper at any cost.  Overall gross Japanese debt may be elevated, but foreign debt is much lower and manageable.  In times of prosperity, yen selling was generated by the formation of carry trade positions in which the yen served as the liability currency.  The unwinding of those positions gave the yen considerable lift in the present era of risk aversion.

Investors do not fear Japanese intervention selling of their currency because international sympathy is scant for Tokyo official complaints about the yen’s strength.  This is related to the point about deflation.  The Big-Mac index compiled by The Economist and updated at end-July found the yen to be overvalued against the dollar by just 0.2%, or in other words almost exactly at perfect equilibrium.  By comparison, the Swissie was then overvalued by 98%, the euro was overvalued by 21%, and the Chinese yuan was undervalued by 44%.  Intervention by Japan’s Ministry of Finance has been done on just three days spaced widely apart: JPY 2.13 trillion in September 2010, JPY 0.693 trillion in March of this year, and JPY 4.51 trillion last month.  Only the smallest of these operations, the one in March following the Sendai earthquake, was supplemented by yen sales among other central banks.  So Japan is basically on it’s own so far as intervention is concerned, and to intervene heavily and frequently would violate its written pledge as a member of the G20 and G7 to “refrain from competitive devaluation of currencies.” 

In summary, the yen is a highly suitable candidate for the risk averse investor, and there is little chance of yen holders being sandbagged by a dramatic policy change along the lines of what the Swiss did.  The safety of yen holdings will only be endangered when Japanese officials at the Finance Ministry and Bank of Japan agree that there is no more urgent priority than a much weaker yen.  The authorities have had it in their power since 1990 to debase the yen so by simply setting an inflation target of 3% or more and promising to flood domestic markets with high-power money until the yen settles back to whatever stated value they wish to call equilibrium.  However, there is almost no chance of that getting done.

Copyright 2011, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

Tags: Japanese yen

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