The yen is a unique problem for the fundamentalist: It’s perverse. In the late 90s, Japan’s banks were failing left and right and its economy was falling into a recession that became deflationary, but the yen went up. This makes no sense, and neither do the current setups that, based on the fundamentals, would dictate a different direction. Is logic of no use at all with this currency?
In September, a number of extraordinary events took place that should have had had an enormous effect on the yen, but failed to impact noticeably the currency. Four stand out. First, the merchandise trade surplus (for August) rose an eye-popping 95.5 percent to ¥200.5 billion ($1.71 billion) from ¥102.5 billion a year earlier. As we all know from the preaching of the conventional wisdom crowd, a country with a high and rising trade surplus has an undervalued currency, and the market should respond by driving the currency up in anticipation of rebalancing.
Second, the Group of Seven (G7) met in Singapore, chaired by Japanese Finance Minister Heizo Takenaka. It made no direct comment on the Japanese yen in its communiqué, but before the meeting a German finance ministry official complained the yen was too weak vis-à-vis the euro. Right after the G7 communiqué was released on Saturday, Sept. 16, European Central Bank chief Jean-Claude Trichet claimed the G7 had indeed spoken about the too-strong yen and had agreed it was too high.
We imagine such lack of courtesy — insulting the host at his own table, so to speak — and diplomacy on Trichet’s part has created a storm of harsh words behind the scenes. A day later, minister Takenaka said the G7 had not officially discussed the yen, but whether they did or not, for one top official to speak out of turn is unheard of, especially considering underlings had spent months carefully crafting the nuances of the official G7 statement.
The forex market assumed (for a day or two, anyway) the Japanese would bow, however reluctantly, to European wishes and talk the yen down. This jawboning process is often quite effective, especially if the market believes talk will be followed by outright intervention.
The Japanese know more about intervention than anyone on the planet, having spent some $300 billion from 2003 to March 2004 trying to prevent the yen from getting too strong vs. the U.S. dollar.
But wait a minute. Where’s Japan’s self-interest in strengthening their currency? It might be nice for foreign buyers of Japanese stocks and bonds, but surely it’s bad for exports, and Japan is an export driven economy.
Also, Chief Cabinet Secretary Shinzo Abe won the vote of the ruling Liberal Democratic Party and took over as Prime Minister from the retiring Junichiro Koizumi on Sept. 24.
Koizumi is a remarkable person, hailed by the Economist magazine as “the man who remade Japan.” He wrestled control from political factions in April 2001 and forced monumental change on a moribund economy and aging society. Some observers fear Abe may turn out to be an old school, back-room opportunist who rules in a way that leads mostly to gridlock and a glacial pace of change. Abe has already threatened the independence of the Bank of Japan by opining it should delay rate hikes, something that does not sit well with BOJ Governor Toshihiko Fukui. (Abe has also committed to fixing relations with China, Japan’s no. 1 trading partner, while at the same time visiting the contentious Yasukuni war shrine.)
If Abe is going to be a weak prime minister (at least compared to Koizumi), quarreling with the BOJ and the like, the reform movement will falter. Reform is what brought about the revival of the Japanese economy and a stronger yen, so Abe could be a factor for a weaker yen.
Finally, new U.S. Treasury Secretary Henry Paulson visited China and reached a “consensus” regarding the policies that need to be in place for the yuan to rise, if not the timing of those policies. The week of his visit, the yuan rose 0.5 percent, the biggest one-week move since its July 2005 revaluation. Annualized, the weekly move was 26 percent, a pace that should satisfy even the most diehard critics in the U.S. Senate and elsewhere.
The same week, the Chinese central bank announced a freer interest-rate market, which is a prerequisite for a fully floating exchange rate. All of this is a bit vague and not really satisfactory — the new money market will still be under the control of the central bank, for example — but it points toward a stronger yuan in the upcoming year. Since the yen is traded as a proxy for the yuan (because it’s more accessible and has greater liquidity), you’d think the yen would be stronger. Instead, the yen has weakened from 114.60 on Aug. 1 to 118.27 on Sept 18.
Three of these four big-picture factors would dictate a stronger yen; only the new prime minister and a potential drop-off in reform suggest otherwise. There are a few other potential stronger-yen factors, too, including the demographic time bomb that is already going off, requiring Japan to remove some of its tremendous national savings (about $800 billion) from the U.S. Treasury to fund the pensions of its old people. This would necessitate selling dollars and buying yen. Also, global investors continue to buy Japanese securities (mostly equities), having earlier been “underweight” in Japan.
With the majority of factors supporting a giant rise in the yen, we must assume tension is quite high. Most forecasters see the yen at 105 to 110, or even 100, sometime soon, in line with their forecasts earlier in the year. It might be a mystery why it’s not happening, but analysts are unwilling to abandon their forecasts.
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