Is the falling Japanese yen cause for concern?

As the US dollar surges, Japan’s yen is at its weakest in decades, driving speculation in foreign exchange markets
So far, the Bank of Japan has shown no signs of changing course on interest rates, but if it does, markets could be in for a roller-coaster ride

Andrew Sheng

Published: 12:30am, 30 Jul, 2022

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It never rains but it pours. Every day this summer, we have been bombarded with bad news: raging forest fires, the relentless war in Ukraine, shootings in multiple cities, monkeypox and rising debt distress all over.

The good news for some is that the US dollar is stronger than ever. But that may be bad news for others. At the G20 finance ministers and central bank governors’ meeting in Bali last week, there was concern that currency volatility could drive instability in emerging markets.

The dollar is strong because the euro, yen and even the yuan are weakening. In times of global geopolitical uncertainty, and with the US Federal Reserve raising interest rates, the dollar is an attractive “safe haven” currency.

The euro is understandably weak: in addition to the war, there are gas shortages, rising inflation and widening fiscal deficits. China, meanwhile, is struggling to recover from months of Omicron-driven lockdowns. The country’s growth is at its slowest in more than four decades, excepting 2020.

Then there is the yen. Japan’s currency fell to 137 to the dollar in June, its lowest value in more than 20 years, and 16 per cent lower than at the beginning of the year. Three possible reasons for this drop have been given: the oil shock from the Ukraine war; the difference between the Bank of Japan’s monetary policy and those of other major central banks; and the possible return of “Mrs Watanabe”. Let’s deal with the two simpler reasons first.

A customer holds a 1,000 yen banknote at a supermarket in Tokyo on June 27. Photo: Bloomberg

Japan is a major energy importer, so higher oil prices increase its trade deficit, meaning a greater outflow of yen. But Japan maintains an overall surplus thanks to foreign investment assets worth more than US$3 trillion, meaning it is one of the world’s largest net lenders. As the country’s population ages (with a median age of 48 years), earnings on accumulated savings keep the balance of payments in surplus, so increased energy spending should not have too much of an impact on the yen rate.

Next, Japan has the loosest monetary policy of all reserve currency countries. It was the first major economy to experiment with quantitative easing, introducing a zero-interest policy in February 1999 during the country’s post-bubble recession.

Aggressive monetary policy came in 2013 with the first arrow of “Abenomics”, the economic policies of the late former prime minister Shinzo Abe. The Bank of Japan promised to double the money supply and achieve a 2 per cent inflation rate, which brought down the yen from a high of 77 to the US dollar to 101.8 within six months of the start of Abe’s second term in 2012.

Now that the Fed has raised benchmark rates by another 75 basis points, the gap between US interest rates (2.25-2.5 per cent) and those of the European Central Bank (raised this month from zero to 0.5 per cent) and the Bank of Japan (still at -0.1 per cent) is widening. This gap has enabled the return of interest rate arbitrage trading – the borrowing of cheap yen or euro to invest in dollar assets. Traders are now more willing to short-sell yen or euro and go long on the dollar, betting that the dollar will get stronger.

With US inflation at a high of 9.1 per cent per annum, the real interest differential is still negative by over 6 percentage points, suggesting room for more rate hikes before the end of the year.

02:08

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This raises the spectre of the return of “Mrs Watanabe”, the proverbial Japanese housewife who uses margin trading to earn higher interest rates to supplement the household income. She would lose heavily if the yen appreciates sharply instead of continuing to depreciate.

Markets worry about Mrs Watanabe because there is more than 1,000 trillion yen (US$6 trillion) in Japanese household deposits earning no interest, and if a portion were used to speculate on foreign exchanges, the markets would be in for another roller coaster ride.

So far, Japanese inflation remains low compared to levels in the US and Europe, so the Bank of Japan has not taken any steps to change its current monetary stance.

In my book, From Asian to Global Financial Crisis, I point out that the depreciation of the yen in the 1990s caused Japanese banks to pull back on their dollar loans to East Asia, triggering the dollar shortage. This time round, Japanese banks are well capitalised, but a weakening yen and euro (by implication of a stronger dollar) has historically always led to global liquidity tightening, causing foreign exchange losses for dollar borrowers, especially in emerging markets. Note, for example, the debt distress in Sri Lanka.

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With the risk that further Fed interest rate hikes could trigger a recession in the US, and as higher rates around the world reverse asset bubbles, we are caught between stagflation (high inflation and stagnant growth) and financial distress.

Every global financial crisis has been accompanied by major corporate or sovereign debt defaults – except for during the pandemic, when loose monetary and fiscal policies staved off mass borrower failures. But the period of postponing bankruptcies and low interest rates may well be over.

Thus, all eyes are now on what major surplus countries like Japan will do. Will Japan continue to supply the rest of the world with savings? Will interest rate increases cause Japanese investors to seek safety back home?

Those who have no yen for risk, hold on to your hats.

Andrew Sheng writes on global issues from an Asian perspective