The Japanese yen (FXY) (JYN) has been on the move in recent months, depreciating from a high of 77.64 per US dollar on 9/14/12 to an intraday low of 94.20 on 2/25/13. This large move has created a lot of discussion as to the true value of the yen. Before proceeding, here is the chart showing the recent history of the yen against the dollar:
To understand this move better and determine if it should continue or perhaps reverse this article will look at some of the fundamental factors that determine exchange rates, especially the concept of purchasing power parity and the impact of inflation on exchange rates. In addition, the article considers Japan's motivations for setting an inflation target and whether the country's stated intentions are credible.
Purchasing Power Parity
The concept of purchasing power parity (PPP) is central to the determination of exchange rates over time. From Wikipedia:
[PPP] asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate.
PPP is sometimes criticized because large deviations can persist over many years or even decades; however, many of these deviations can be explained by taking a view on future price and interest rate environments in different countries. In addition, government policy often distorts exchange rates through interventions in order to achieve social goals such as low unemployment in which case the disparities can last until policy changes.
Turning to Japan, the following chart, compiled using OECD date, shows the PPP implied value of the yen against the dollar, the actual yen exchange rate versus the dollar and the level of over / undervaluation on a static basis by dividing PPP by the exchange rate (a positive percentage represents overvaluation):
As the chart shows, both the PPP implied value of the yen and the actual exchange rate have shown a strong trend of appreciation. The PPP implied value has appreciated from 224 yen to the dollar in 1982 to 104 yen to the dollar in 2012, a compound annual gain of 2.5% per year. The actual exchange rate has appreciated somewhat more, but was largely driven by the massive change in the early 1980s due to the political agreement known as the Plaza Accord when the yen moved from being undervalued relative to PPP to overvalued. Based on the most recent exchange rate of 91.71 yen per dollar, the yen is overvalued on a static basis by about 13% down from the 30% overvaluation based on 2012's average exchange rate of 80.
As noted above, PPPs give a good indication of relative valuation on a "static basis" or in other words at a moment in time. Conceptually, if one currency buys a basket of goods in year one but only one-half a basket in year 10 and another currency buys a (whole) basket of goods in both year one and 10 the second currency would be more desirable to hold, all else equal. Of course the first currency could also pay a higher interest rate, which could in theory completely offset the fact that it loses some nominal value each year, at least before the impact of taxes, so that impact must be modeled as well.
For the yen and dollar we can model these effects by looking at interest rates, inflation and real interest rates as shown in the following graphs, compiled using data from the OECD:
The real interest rate is defined as the interest rate minus the inflation rate. This is the pretax return on holding a short-term deposit of a given currency and is a way to judge the intrinsic value of one currency versus another. When the interest rate and inflation level of one currency reach the zero bound tax considerations make comparisons more difficult. For the dollar, although real interest rates were positive for much of the 1990s and some of the 2000s, after paying tax on the interest earned most holders would have had a much smaller or even negative real return. However, for holders of yen, where the interest rate was nearly zero and real return generated by deflation, the impact of taxes would have been very small. The upshot is that over the last twenty or so years, holders of yen deposits have gained purchasing power over holders of dollar deposits both before and after tax.
In recent years, the impact of real interest rate differentials have moved decisively in favor of the yen. Currently, Japan and the U.S. have short-term interest rates of virtually zero. But, the U.S. has an inflation rate over 2% and Japan has essentially no inflation. The holder of yen is gaining 2% purchasing power per year versus the holder of dollars. We can calculate what a buyer should be willing to pay for a currency given future real interest rate spreads using a 2% differential and the number of years the rate is sustained. So for example, if a currency maintains a 2% differential for five years, it should be worth 110% of the current PPP implied value. The following table shows values for various scenarios:
The insight of this table is that holding a currency where the implied PPP value is less than the exchange rate can still be good value. Over time, if the after-tax real interest rate differential is favorable for a given currency, it is worthwhile to own that currency above and beyond the current implied PPP value because it gains value every year.
Real Effective Exchange Rate
The real effective exchange rate (REER) removes the impact of foreign and domestic inflation differentials from stated exchange rates and is therefore conceptually similar to the PPP calculated above; however, the REER includes the relationship between all of a country's trading partners and not just one. The REER index therefore allows for a quick way to compare values of the yen over time against Japan's trading partners.
The following chart constructed using BIS data shows the real effective rate for the Japanese yen versus major trading partners through 1993 and all trading partners thereafter (note that a strong yen is denoted by a higher value):
Whereas the nominal yen index shows a dramatic appreciation over the last several decades from 250 in 1982 to 80 in 2012 and 92 currently, the REER shows that compared to trading partners, the yen is in fact weaker today than at most times since before 1985. The one disadvantage of the REER index is that it does not provide an anchor or that level where exchange rates normalize purchasing power, but the PPP index above can serve as a guide for that piece of the puzzle.
From the above analysis it is easy to see the cause of the recent turmoil in the yen. If the Bank of Japan's (BoJ) recent decision to target 2% inflation on the urging of the new Prime Minister Shinzo Abe's government results in increased inflation, then it is likely that real interest rates in Japan will normalize with the U.S. and other trading partners and the yen will cease gaining purchasing power against most global currencies.
While a new inflation regime in Japan would create pressure on the currency, do the Japanese really want 2% inflation or is it a bluff? The consensus is that Japan is primarily interested in a weaker yen as a result of inflation targeting, hence comments by policymakers, business leaders and the media about currency wars. One of the primary reasons for wanting a weaker yen is to boost net exports, which have suffered in recent years. The problem with tying the inflation target to a desire for stronger exports brought on by a weaker yen is that inflation reduces export competitiveness over time. At present, Japan's competitiveness in the export market improves by two percentage points per year against the U.S. and other countries with similar inflation because prices are not rising in Japan - therefore production costs are not increasing. Therefore as a long-term strategy, inflation targeting to devalue the yen will not help Japan's export business.
However, it could be a very useful bluff. If the markets believe the 2% inflation target is real and sell the currency, then Japan could get the benefit of the weaker currency without the disadvantage of inflation. And since Japan's price level is currently deflating slightly, which is probably mildly negative for Japan due to the impact on existing indebtedness, a slight increase in inflation would be acceptable. In addition, even a small move in inflation would likely weaken the currency more as the market believes in the credibility of the 2% target since progress is being made. The positive impact on exports of a 10 to 20 point move in the yen would take five to ten years to erase through increased inflation so this is a very useful bluff indeed for the Japanese. Still, if the BoJ goes too far and actually manages to achieve 1-2% inflation, it will be very hard to reset expectations lower - the country then has to suffer from decreasing export competitiveness over many years. That is why inflation targeting is useful as a bluff but little more.
It is likely in my view that the authorities have other motives in addition to weakening the yen. The impact of buying domestic assets by the BoJ will be to lower returns further on those assets which will disincentivize holding them, both at home and by foreign investors and incentivize the export of capital. Capital export could weaken the exchange rate, at least temporarily, until trade exports pick up in response. But the currency is not the most important part of the equation here. What Japan really wants is the export business and not all of that is exchange rate driven. Exporting capital can accelerate the export of goods even absent exchange rate changes since the provision of credit can be tied to goods procurement; for example when Japanese car companies provide more credit to Malaysians for the purchase of cars. Even indirect effects are important. The provision of tens of billions of credit to the U.S. economy by Japanese banks each year drives demand for a range of Japanese manufactured consumer goods, even though the link is not explicit.
Other motives make sense as well. The Liberal Democratic Party (LDP), which in fact is Japan's "conservative" party, has recently seen a resurgence after losing power to the opposition in the mid-2000s. By driving down the exchange rate, the LDP knew it could inflate the stock market and make people more optimistic. Never mind that Japan is a major importer of foreign goods and people would see price increases on a broad range of products over the medium term because of the drop in the currency. Those impacts would take years to feel, while a 30% rally in stocks would create an immediate wealth effect. In June, there is an upper house election where the LDP can take back full control of the government. Keeping the stock market strong until then could be seen as critical and an easy way to do that is through the exchange rate.
Furthermore, Japan is dealing with a very significant energy crisis that needs a political fix; namely, the shutdown of its nuclear industry. The new government has come out in favor of a restart of the nuclear facilities and according to a recent poll most people are comfortable with letting reactors run until their lives are over, which for Japan's fleet is in the 2030s. Still, the population is uneasy and the government can make its job easier by pointing to ballooning energy import costs made even more expensive by a weak yen.
Handicapping currency moves is difficult because there are many factors responsible for determining exchange rates, especially in the short-to-medium term. Over the longer-term currency values should follow changes in price levels in the domestic economy relative to those in other economies. The factors which can overwhelm this causative effect are speculative capital flows in the short term and government policy in the medium term. It is difficult to say where speculative capital will take the yen over the short term, 100 yen to the dollar is certainly a possibility if Japan can show some movement in the inflation rate, but in my view the Japanese government is not interested in generating an inflation rate of 2%, it is merely bluffing to fool the market into giving it a cheap yen over the short term.
Additional disclosure: I am long a basket of stocks on the Japanese domestic market with a small currency hedge held through futures contracts.