"Carried us away in captivity
Requiring of us a song
Now how shall we sing the lord's song in a strange land?"
One question which many people in Japan are asking themselves right now is "Why is the level of JPY/USD so high?" Not so long ago many of those very same people were busy asking themselves why it was that the yen was so cheap, and why all those imported products (like French mayonnaise) were so expensive. Only a year or so ago the currency was trading somewhere in the 105 to 110 yen to 1 dollar range, yet last month it hit a 13-year high against the dollar and is currently hovering around the 90 yen to 1 dollar mark - up 15 percent in just 12 months. In the meantime, as I pointed out in my last post, Japanese exports plummeted (down 16.2% y-o-y in November), and with them, the rest of the economy.
Indeed so seriously is the problem being taken that Bank of Japan governor Masaaki Shirakawa has made it plain that currency-market intervention is a distinct possibility at some point, and indeed Japan seems to have received a "fire at will" green-light mandate at the last G8 meeting to do just this when it feels such action to be appropriate. "The strong yen at a time of rapid decline in the global economy has a big negative impact on our economy in the short term," Shirakawa said recently. Of particular concern here is the financial health of major Japanese exporters such as Toyota, Honda and Sony. Many of Japan's most important companies are really feeling the pain caused by collapsing external demand and the soaring yen.
Just why the yen is so strong at the present time (as opposed to the Japanese economy which is so weak) can be seen in the above chart. The recent rapid rise in the dollar value of the yen has been the by-product of two distinct but inter-related processes: a decline in the appetite for global risk on the part of investors and the unwinding of what is known as the yen carry trade. For those not in the know, the term "carry trade" is a euphemism for the widespread practice among investors of taking advantage of the yield differential offered by Japan's ultra-low interest rates and then borrowing in yen in order to invest in currencies paying substantially higher ones. Some of the higher profile recipients of such funds have been the Icelandic krona, the New Zealand "kiwi" dollar and the Turkish lira, but in fact the practice was fairly extensive, with large inflows of funds being seen in emerging economies from India to Brazil.
The abrupt drop in carry trade activity, and hence the rapid drop in demand for yen denominated loans, can be seen in the chart (the JPMorgan EMBI+ index) which shows the price of emerging market bonds. As we can see, starting in early September, and coinciding with the bankruptcy of Lehman Brothers, the demand for emerging market bonds fell off a cliff (as the yield demanded by investors shot up, the relationship between bond prices and yields is an inverse one), all of which lead to a very rapid "liquidation" in yen positions, as a result a lot of yen had to be bought to pay down the loans. Hence the rise in the yen. The situation has now recovered somewhat since the end of November, and hence the yen has eased back slightly, especially in relation to the euro.
Of course people didn't only borrow to invest in emerging markets, US treasuries were also an attractive proposition for some time for those borrowing in or having Japanese yen. The difference between one-year US and Japanese government bond yields was around 4.6 percent in mid-2006 (5.2 percent vs. 0.6 percent), and it thus paid to invest in US government bonds, driving up the demand for dollars and pushing down demand for yen. This particular carry ride has since disappeared though - as the current differential has fallen very close to zero (0.43 percent for the US and 0.28 percent for Japan earlier this week). So there is no great advantage at the present time to borrowing in yen in order to invest in US securities, and indeed one of the really interesting questions as Ben Bernanke moves steadily towards his own version of quantitative easing is whether the US dollar will take over the poll carry position from the yen.
The carry trade is effectively an enormous by-product of financial globalization and the impact of the kind of massive unwinding we have recently seen is very hard to counteract. This is why Japanese officials haven't intervened in currency markets so far. Of course, with Japanese interest rates coming down to even lower levels, coupled with the distinct possibility that there will be a return to quantitative easing in the coming months, it's likely that as the recovery takes hold in a number of key emerging markets, we will once more see a revival in risk appetite and an increase in demand for emerging market bonds. With all this, a rise in yen carry and a fall in the value of the yen, may well be seen. It is this expectation, perhaps more than any other factor which has lead the Japanese authorities to hold back so far on intervention, since they are obviously anticipating that the problem will solve itself as the global economy rebounds. Let's just hope they are right.
Edward is a macro economist, specializing in growth and productivity theory, demographic processes and their impact on macro performance, and the underlying dynamics of migration flows. He is a regular contributor to a number of economics weblogs, including Global Economy Matters and Demography Matters.
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