During 2010, the yen became about 12% stronger compared to the US. Dollar. At the same time, the Nikkei 225 lost 3% during 2010 while the S&P 500 gained 13%, the German DAX 16% and the NASDAQ 17%. In Dollar terms, the Nikkei still gained 10%, but in general, the Japanese economy is not doing great.
In Q3 2010, its annual GDP growth rate was only 1.1% adjusted for an inflation that is close to zero. GDP was then still 0.23% lower than four years before in 2006. Its public debt is about 200% of GDP. This is much higher than in Greece or Ireland and about double than in the US.
This all does not look too rosy for Japan. Thus why then is the yen still getting stronger and where is this going to end for Japan?
Why Is the Yen Getting Stronger?
In astronomy there is something called a black hole. Gravity in such a black hole is so strong that nothing can escape from it, not even light. It looks black. In the end, ta black hole evaporates. It ceases to exist.
What is the future for Japan with an economy, a currency and public debt from which no money seems to escape anymore? Will it evaporate and cease to exist in the form that we know?` Let’s hope not. But what is at play here? Why is the yen then still getting stronger?
The cause for the strengthening of the yen is that the yen is a currency with net inflows; more yen are bought then that there are yen sold. The reason for this is the combination of the strengthening trend itself, the Japanese trade surplus, the uncertainty around European public debt, the expected monetary policy in the US and the diversification of foreign reserves in other countries away from the US dollar and euro.
From an historic perspective, the strengthening of the yen is nothing new and not unexpected. The overall trend during the last 20 years is clear; the yen has been getting stronger against the US dollar.
But What About the Economy?
When comparing Japan with the US, one could be surprised by the strengthening of the Japanese yen. The economic situation for Japan compared to the US does not look that good and one may expect countries with a healthier economy to get a stronger currency, or not?
- The domestic interest rates in Japan are about the lowest in the world making Japan not a very attractive place to park your money.
- Japan has an aging population and this will temper the economic growth compared to the more vibrant demographics in the US, for example.
- Japanese public debt as a percentage of GDP is about twice the size of US public debt. And the Japanese deficit does not look much better.
However we see a continuous strengthening of the yen versus the dollar. Why is that?
Demand and Supply for Yen
In short, it is all about demand and supply. When there is relatively more supply and less demand for yen, the yen will weaken. When there is more demand and less supply of yen, the yen will strengthen.
Thus a strengthening yen means an increasing demand for yen compared to relatively less supply (selling yen and getting other currencies in return).
The strength of a currency is driven by trade and current accounts. These are two sides of the same coin.
The trade cash flow
- Exports from Japan cause demand for yen to buy the Japanese goods.
- Imports into Japan create supply of yen to buy other currencies to pay for the imports.
2. The investment cash flow
- Investments from outside Japan in Japanese assets cause demand for the yen. If these assets are more in demand, the price goes up and the yen becomes even stronger.
- Investments from Japanese investors outside Japan create supply and thus a weakening factor for the yen. When there is less demand for these assets the price in yen goes down and the yen would strengthen.
Japan’s Trade and Investment Cash Flow Keep the Yen Strong
What is happening in Japan with the trade and investment cash flow?
The Japanese Trade Cash Flow keeps the yen strong:
- Japan has a trade surplus and is exporting more than importing. This keeps the currency strong.
- The strengthening currency could lower exports and increase imports in the long run. But in the short term it reinforces itself, for example, by reducing the supply of yen required for imports.
- Note that the US is importing more than that it is exporting. Remember the US trade deficit? This weakens the US currency.
And also the Japanese Investment Cash Flow keeps the yen strong:
- Japanese savers have preferred Japanese Government Bonds for decades, allowing the yen to stay strong. With Quantitative Easing II in the US and the public debt issues in Europe, you can see that this is probably not an optimum time for Japanese investors to start changing this pattern.
- There also seems to be a strong demand from non-Japanese investors for Japanese assets and thus a demand for yen.
Foreign Demand for Japanese Assets
Where is this demand from non-Japanese investors for Japanese assets (one of the reasons the yen is strengthening) coming from?
- Partly this could come from foreign reserves diversification. Think about China, for example which wants to be less dependent on the US dollar or euro.
- The Chinese central bank put a lot of money in the US before the credit crisis. The Chinese central bank then switched over to investing in euros, and the euro sovereign debt crisis occurred. It seems to make sense that the next diversification would be into yen, as the yen is holding its strength.
- Other investors are seeking a temporary parking place for their money when they sell their other assets. With the uncertainties in Europe (debt), the very low interest rate on US Treasuries and the strengthening trend in yen, yen money market instruments could look very attractive.
- There could also be a perception among market players that the US. Federal Reserve may be more willing to continue its aggressive monetary easing than the Bank of Japan. The expectation that more new US Dollars will be printed than that there will be new yen printed, will strengthen the yen.
- The expectation for the differences in interest rate in Japan and the US will also have its influence on the exchange rate. The Japanese interest rates have always been the lowest. But when the expectation is that this difference is will become less big (e.g. dropping US treasury rates) or when the US is not expected to increase interest rates for the foreseeable future, the carry trade will slow down or unwind, strengthening the yen further. The same thing will happen when investments outside Japan are expected to become more risky or providing lower returns.
Thus, in summary, repeating what we said above: the cause for the strengthening of the yen is that the yen is a currency with net inflows; more yen are bought then that there are yen sold. The reason for this is the combination of the strengthening trend itself, the Japanese trade surplus, the uncertainty in the rest of the world, the expected monetary policy in the US and the diversification of foreign reserves in other countries away from the US dollar and euro.
What About Japan’s Future?
Japan seems to be in the black hole of a stronger currency, lower corporate profits, lower stock prices, deflation or very low inflation, more locally financed public debt, a higher deficit, a continuous trade surplus and more inflow of money.
The Japanese nightmare scenario is that the economy in the rest of the world does not improve. The black hole economy then will suck in more money until the moment that debt and deficit are out of control, the population ages further while saving less, interest rates on the public debt rise and eventually Japan defaults on its debt. And, only then the yen will weaken.
Printing money does not seem to be a very good option for Japan. Its economy and exports are very dependent on the import of raw materials and food. A substantial devaluation of its currency compared to strong raw-material currencies and food exporting nations may harm its industry and impoverish its population. In that scenario Japan does not need to worry about deflation anymore. More printing could be one of their only options.
Due to demographics, the local demand will not increase to bring the trade cash flow in balance. Breaking the circle, weakening the currency and getting an outflow of money can only happen by declining exports and by assets outside Japan being more attractive investment opportunities than the ones in Japan.
Thus a much faster improvement of the economy in the rest of the world than in Japan is Japan’s only hope. But declining exports and an economy that lags the rest of the world could not be a great prospect for the Japanese companies and stock market.
Does anybody see a scenario that is positive for Japan?
Disclosure: I am long SPY.
