Japan's Economy Is Cruising Downhill as Fast as Any Other Developed Economy, So Why Is the Yen Skyrocketing?

By Charles Kirchofer, Feb. 15th, 2009

Some surprising things have happened as a result of the credit and economic crises. A steadily weakening dollar, which seemed set to keep on weakening as the world began to diversify away from it, suddenly became stronger. The euro held its own in the storm, proving it was indeed a safe haven for its member states, but at the same time it proved that it was not ready to take over the dollar's role as the reserve currency (investors preferred dollars to euros when in doubt). No surprise, on the other hand, was the pound: as the City's over-leveraged banks went south, so too did their over-valued currency. In Japan, a country whose banks were not heavily involved in shady investments, a rise in the yen seems unsurprising. The fact that the yen continues to rise rapidly even as Japan looks set to contract more quickly than any other developed country outside the UK tells us there may be more to the story.

The answer, though, is relatively simple when we look a bit deeper. As illustrated in The Economist, the big thing in the 2000s has been a yen carry trade. Investors borrowed money in yen at incredibly low interest rates and used this money to buy other currencies that would give them higher returns. This means yen were being sold more than bought, pushing the exchange rate down. Japanese households did similar things, buying into investments abroad (selling yen).

We're looking at yet another economic snowball effect. Investors could only make money on the carry trade deal as long as the yen stayed low. If it began to rise, the amount of debt they would have to pay back denominated in other currencies would increase, making their investment not worth it. For example: say you borrowed ¥10,000 and bought $100 with it at an exchange rate of ¥100 per $1. The interest on your loan in yen was 1.5%. You only had to beat that rate on an investment somewhere else to make a profit with easy money, easy to do in the bubbly 2000s. But now let's say the yen starts rising. The exchange rate climbs to around what it is now: ¥90 per $1. Your debt, without counting the interest charges, has gone from $100 to $111, an increase of around 11%! Add in the interest you'd have to pay and it becomes nearly impossible to pay back the loan with investment.

So what's the answer? At the first sign the yen might be revaluing, investors sold their investments in other currencies and bought yen to pay off their debts before they became unpayable (the smart ones and the ones that hadn't already lost too much to pay back, that is). In addition, no one borrowed yen to make a carry trade anymore. The result: more yen being bought than sold, resulting in a rise in the price of yen compared with other currencies.

So what's the solution? Unfortunately for Japan, there doesn't appear to be an easy one. Tim Geithner of the U.S. Treasury would be quite displeased if Japan were to try to intervene to weaken its currency, as the dollar is quite strong at the moment as well. Strong currencies mean uncompetitive exports and often larger current account and trade deficits. It is also likely that most of the other large economies, like China and the EU, would be unhappy to see Japan devaluing its currency to help its exporters when their exporters are suffering, too. It would also be difficult for the Japanese government to intervene on its own. It would likely need other governments to help sell yen to reduce its value enough to please Japanese exporters, and this would not be in other countries' best interest as it would hurt their own exporters. Looks like Japan's in a pretty pickle. Again.


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