The main factor that determines the value of a currency are trade flows. Investment flows however are also an important factor. In the case of Japan, the country has had a trade deficit for about two years now, but the yen has remained very strong.
As I noted in a previous article (please consider: Why Printing Euros Will Make The EURUSD Rise), as long as a country has a current account surplus, it doesn't matter how much money the central bank prints, the currency will go up. And even though the Bank of Japan has printed a great deal of money in the past, the yen has remained strong. The reason being Japan's current account surplus:
However recently things have changed a bit. As reported by the WSJ :
Japan reported Thursday that the seasonally adjusted current-account was in deficit in September-for the first time in more than 30 years. The sudden surprise drop has some economists warning that Japan's ability to generate wealth is eroding faster than expected, and its fiscal situation could be more fragile than many had thought.
Please note that the data is seasonally adjusted. So while Japan had a seasonally adjusted current account deficit in September, it was nevertheless a nominal current account surplus. Data for December 2012 suggests that the current account surplus is still positive, even if it was down 30% y-o-y.
So in Japan's case, the only other way to weaken the currency is with the aid of the central bank. The way to do this is simple. You simply ask the central bank to print money and buy foreign currency and bonds. At the margin, the central bank will create selling pressure for the yen in the FX markets and that should weaken the yen.
And that is what Japan plans to do if it is not already doing so. Ambrose Evans-Pritchard from the Telegraph notes:
Mr Abe's Liberal Democrats have already lambasted the central bank, threatening a new bank law unless it adopts radical measures to pull Japan out of deflation - including a growth target of 3pc for nominal GDP, implying massive monetary stimulus. He has set an implicit exchange range target of 90 yen to the dollar, instructing the Bank of Japan to drive down the yen with mass purchases of foreign bonds along lines pioneered by the Swiss.
In addition, the central bank intends to dilute the currency even more by buying local assets (from the same article):
Premier Shenzo Abe is to spend up to one trillion yen (£7.1bn) buying plant in the electronics, equipment, and carbon fibre industries to force the pace of investment, according to Nikkei news. The disclosure came just a day after Mr Abe vowed to revive Japan's nuclear industry with a fresh generation of reactors, insisting that they would be "completely different" from the Fukishima Daiichi technology.
Sounds like Ben Bernanke 101 to me. And for those who don't know what I'm talking about, please read Bernanke's 2002 speech, Deflation: Making Sure "It" Doesn't Happen Here.
It doesn't take much for the market to figure this out and take advantage of a sure trade:
If the policy of the Bank of Japan and the Japanese government remains in place for a long time, it means the revival of the yen carry trade and it will also be a liquidity shot for markets on a global scale.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.