The rising sun - the falling yen?

To say that the Japanese yen has been on something of a rollercoaster ride in recent weeks would be an understatement, as Julian Ryall reports

No sooner had the yen risen to a high of Y122 to the dollar in late February that it then subsided to the Y116 level in tandem with a series of stockmarket slumps round the world triggered by the Shanghai exchange's rapid fall on 27 February. And while both the yen and the global economy need some stability at present, experts say, neither are likely to get any peace for at least the next few months.

Finance ministers and central bank governors of the Group of Seven (G7) countries met in the German city of Essen on the weekend of 11 and 12 February, a meeting which has been described as a turning-point in the state of Japan's economy. In recent years, low interest rates in the world's second largest economy have been tolerated by Japan's partners due to recognition that the recovery from well over a decade of recession in the 1990s was fragile and based on narrow economic reasons.

But in December, when the number of consecutive months of growth surpassed that of the Izanagi boom of the 1960s, it became clear that the Bank of Japan was looking to raise interest rates further. The central bank had ended the zero-interest rate it had doggedly adhered to in July last year and, on 21 February, raised interest rates to 0.5%.

Discussions at the G7 meeting about the yen had been extensive, with European members expressing concerns about the yen's depreciation. But the US took the position that the exchange rate reflects Japan's economic fundamentals and effectively won the argument, as the yen was not even mentioned in the joint statement issued at the close of the talks.

'The US government is happy to have Japan in this position because it is very afraid of the rising economic influence of China,' said Noriko Hama, a professor of economics at Kyoto's Doshisha University. 'The Europeans, on the other hand, are complaining that the euro is far too strong against the yen and that is hurting them, but they caved in when the US told them to shut up.'

The weakening yen has lead to a vicious cycle revolving around the phenomenon known as carry trade, she said, in which hedge funds and other large-scale investors borrow yen funds at very low rates of interest and invest them in higher-yielding assets that are denominated in other currencies. As a money-making vehicle, she pointed out, it is a win-win opportunity.

As the yen is targeted, that means more yen are bought and more sold, leading to further depreciation, she said. 'And the hedge funds are having a field day on the currency.'

Policy

The Japanese prime minister, Shinzo Abe, is sticking to policies designed to continue the steady economic growth by keeping interest rates low and avoiding a return to deflation. A weak yen, so the thinking goes, is a major boost to exporters and hence the national bottom line. But if Japan's trading partners reach the conclusion that Tokyo is deliberately keeping its currency weak to strengthen its trade surplus, the complaints will become louder.

'Exporters want the weak yen to remain, as do the foreign-currency speculators and securities traders because they're doing well out of it,' said Satoru Ogasawara, an economist with the Tokyo unit of Credit Suisse. 'The businesses that are going to be hit hardest if the yen weakens further are importers who cannot pass on cost hikes to their output prices.'

The problem for Japan, believes Hama, is the rest of the world. 'If the yen remains undervalued, that will undermine the competitiveness of companies in Europe and the US. But it is also a problem for Japan because the longer this situation goes on - and remember it has already been around for a long time - then we could see a stampede out of the yen and no one touching the currency.'

AndHama is not optimistic about the impact on the Japanese - or wider - economies. 'If it tumbles further, then interest rates will have to go up in spite of efforts by the Bank of Japan to keep them low, and that will hurt the domestic economy,' she pointed out.

And for all the positive economic news that the government has been reporting in recent months - industrial output was up 0.9% in December, the overall economy grew 4.8% in the October-December quarter, unemployment is low and stable and the upcoming Tankan report on economic attitudes is expected to be optimistic - many economists believe the recovery is based on narrow expansion at Japan's largest companies and that it has not trickled down to the average Japanese. Proof of that is the failure of the anticipated boom in spending to ignite and drive the recovery.

'Yes, the global economy is cruising along at the moment, but if the turmoil that I expect in the foreign currency markets happens then that will put a very sudden halt to the euphoria that is around at the moment,' said Hama. 'There is an imbalance in the US deficit and questions about broader growth to use a Japanese phrase, "The global economy is riding on a bicycle; if the bicycle slows down, the whole thing could collapse".'

In an editorial after the Essen meeting, the Asahi newspaper stated what many have been thinking for some time.

'In this era of relentless global competition, Japan cannot hope to continue enjoying the comfortable environment of low interest rates and a cheap currency forever,' the left-leaning daily stated. 'Instead of breathing a sigh of relief over the G7 statement, which did not refer to the yen's weakness, Japan should take this opportunity to launch efforts to put its economy more in step with the rest of the world.'

'The problems stem from the Japanese government being inconsistent in its economic policies,' said William Sarlibbi, a market strategist and fund manager for the Vienna-based company Cycles Research Investment. 'They indicated they were going to raise interest rates and they didn't and that weakened the yen; then they reversed that position, raised rates and the currencies reacted to that. We have seen a lurch to Y122 to the dollar and then the rally back - and it can all be traced back to the govenment's inaction.

'Where the currency goes next is heavily dependent on the government's actions, but in the short term I would expect it to strengthen to around the Y114 level,' he said. 'I also believe the government has to again raise rates, which would be the appropriate thing to do in the circumstances - although governments are not always rational creatures.'

Sarlibbi's predictions are quite different to those of Ogasawara. 'We expect the yen to go to around Y125 to the dollar over the next five or six months, assuming the currency markets stabilise and there are no changes to both the fundamental global and Japanese economic outlook,' he said. 'Right now, the Bank of Japan is keeping a very close watch on the global markets and they are concerned about further unwinding of the yen carry trade. The usual participants are also keeping out of the markets as well. It would be fair to say that they are all nervous about the possibilities.'

Julian Ryall is a freelance journalist who has lived in Japan for 13 years, covering business, politics and social issues.