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« More on the Yen and Japan ... | Main | Two New Additions to My Blogroll »
Thursday
Oct192006

The Conundrum of Japan and the Yen

Japan.jpg(update; I have added a few links and corrected typos and misspellings) 

I have reported a few times recently about the struggling yen and how policy makers were trying to talk up the Japanese currency. The implicit narrative here I think is that some believe that the yen should take its part of the global rebalancing act along side the Euro. Even at a brief glance I think this is extremely unlikely since the future path of the Euro and Yen does not permit much optimism. I consequenltly think it is highly unlikely that the ECB can continue raising rates well into 2007 and when it comes to the BOJ ... well ditto and square. However, the Russian Central Bank seems to be keen on supporting the Yen through a gradual diversification of its reserves.

(From Bloomberg - linked above; bold parts are my emphasis)

'The dollar fell the most against the yen in two weeks after Russia's central bank said it was adding the Japanese currency to its foreign-exchange reserves.

The dollar fell after Alexei Ulyukayev, the Russian central bank's first deputy chairman, told Interfax he may increase holdings from almost zero percent. Russia's reserves, the world's third largest, have swelled about 50 percent this year to $267.9 billion as oil prices surged.

``The move could lead toward broader U.S. dollar weakness,'' said Mark Meadows, a strategist at currency-trading company Tempus Consulting in Washington. With the dollar near key trading points of 120 yen and $1.2470 per euro ``it brings up the question of whether the dollar is going to be able to sustain moves past these levels.'''

Monetary union among the Persian Gulf monarchies, which pump about a fifth of the world's crude oil, may lead to the end of their currencies' peg to the U.S. dollar, and ``a more flexible currency regime,'' said Monica Malik, an economist with Standard Chartered Bank in Dubai.'

So what is it with the Yen and its reluctance to push on? To answer that question the Economist had a piece recently which tries to shed light on the Yen's situtation. The magazine begins the article by invoking the Yen as the world's most mis-priced currency; yes you heard right and as the magazine points out forget all talk about the Yuan because it is the Yen you should be looking at. So what is the rationale here? First of all we need to look at the 'end of deflation' argument and also at the end to the quantitative easing.  The argument goes that since the BOJ chose to abandon its zero-interest-rate-policy the Japanese economy has been looking perkier and as the price levels have moved up again; furthmore Japan is running a big trade surplus. In short the Yen should actually be climbing ... right?

The story is however not so easy as The Economist rightly points to ...

But to predict where the yen is heading, you have to understand why it is so weak today. One reason is that at 0.25%, Japanese interest rates are still unattractive. And inflation has gone up by more than the quarter-point rise in Japanese interest rates, leaving real rates close to zero and even lower than last year.

More concretely the Economist forwards two possible explanations ...

1. Carry Trade

The most popular explanation of the yen's languor is a revival of the “carry trade” (ie, borrowing in cheap yen to buy higher-yielding investments elsewhere). This means selling the currency and thus pushes it down. In the past month or so, carry trades have become more attractive; the expectation that the BoJ would raise interest rates again this year has faded as a result of slower economic data. If this is the case, at some stage the yen could rebound sharply if America's economy stumbles and falling American interest rates narrow the gap with Japan's

2. Currency Funelling (based on the work of Stephen Jen from Morgan Stanley)

Most international trade is settled in dollars or euros, so importers have to sell their local currencies in order to buy from abroad. Mr Jen calls these “upstream currency flows”. “Downstream flows”, in contrast, are what Asia and oil exporters do with their accumulated reserves. The currency compositions of the two flows do not necessarily match.

Because Asian countries trade a lot with each other, the bulk of upstream flows involves the selling of yen and other Asian currencies. In contrast, most downstream flows go into dollars and euros. Central banks prefer to put money into well-developed financial markets, so the liquid and secure markets of America, the euro area and Britain attract more capital.

This causes a funnelling from Asian currencies into dollars and euros. Emerging economies' rising foreign reserves therefore push the yen down against the euro, regardless of fair-value calculation.

In the end the Economist seems hot on the idea of this funelling process of Asian currencies in which the Yen becomes a vessel to be sold as capital flows downstream from the point of view of Japan and other Asian exporters. I cannot reject this hypothesis but it seems that it should be seen as a secondary explanation to the real conundrum here which goes back to the re-vitalization of carry trade. In short; why has the BOJ not raised rates yet and why is it unlikely that the central is going on a hike anytime soon? I have argued this case several times and I believe that the expectations of a rising yen (in the longterm) are flawed in the sense that all this ultimately is based on the belief in the sustainable (relative!) recovery. Let us take a quick look here ... business cycles are topping globally at the moment and perhaps even reversing in the US. In Europe growth has been revised down for 2007 as result of budgetary tightening and well a slowing US. Obviously China is much more important for Japan's exports but in the midst of quite impressive economic growth going out of 2006 Japan is still running inflation under the 1% mark. So why is Japan so reluctant to get off the mark?

This is an important question since anwsering it will demostrate that the real problem/issues for Japan (and the Yen for that matter) are not so much about the funnelling of Asian currencies than it is about the fundamentals of the Japanese economy with the world's oldest population and a consumer demand to match this. This would also explain why Japan is running a big trade surplus while silmultaneously having a currency not very keen on correcting to the facts. Japan's deflation story is also important here as it is now quite clear that Japan has not been able to entire shed this ball-and-chain from her leg. Could it be that Japan's difficulties with escaping deflation and the consequent very low trend growht demonstrates a rather direct feedback mechanism with the country's population structure? We already have the evidence from India; why should Japan be much different?

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