monetary crisis: what are the consequences of the fall of the yen to a 20-year low?


This week, the Japanese yen fell to levels against the US dollar last seen in early 2002. The magnitude of this move has implications for the domestic economy, as import prices based on the yen are rising at a record annual rate, which is increasing the pressure on household balance sheets.

The Bank of Japan and the Japanese government issued a rare joint statement on Friday that they could intervene if the weakness persists.

So far, the fallout from the weaker yen has been minimal for broader financial markets, but that could change if the selloff gathers momentum.

Below are key questions about what a falling yen means for the Japanese economy and international markets:

WHY IS THE YEN WEAK?

The yen, the world’s third most traded currency, is now close to 134 to the dollar after starting 2022 at 115. With the dollar up 16% so far this year, the yen is on track to its largest annual decline since 2013.

The weakness stems primarily from widening interest rate differentials between Japan and elsewhere.

As the rest of the world, led by the US Federal Reserve, hikes rates aggressively to rein in soaring inflation, the BOJ has doubled down on its dovish policy stance.

The spread between Japanese 10-year government bond yields and those of the United States is 279 basis points – a high of almost 3 and a half years – while the spread with German yields is at an 8-year high.

WILL THE AUTHORITIES INTERVENE?

They certainly say they could.

On Friday, Japan’s government and central bank expressed concern over the recent sharp falls, the strongest warning yet that Tokyo could intervene.

The yen quickly rebounded from its two-decade lows, but not everyone is convinced real intervention is likely.

Considering the economy

On the export side, Japan has historically focused on halting strong yen rises and taking a hands-off approach to yen weakness, which is more difficult because buying yen forces the Japan to tap into limited foreign exchange reserves.

The last time Japan stepped in to support its currency was in 1998, when the Asian financial crisis triggered rapid capital outflows from the region. Before that, Tokyo intervened to counter the fall of the yen in 1991-1992.

Currency intervention is costly and could easily fail given the difficulty of influencing the value of the yen in global currency markets.

WHAT CAN STOP THE DECLINE?

A sharp improvement in growth prospects as the country reopens its borders post-COVID and higher inflation could alter the BOJ’s dovish stance.

Japan’s core consumer prices in April were 2.1% higher than a year earlier, beating the BOJ’s inflation target of 2% for the first time in seven years.

“The yen’s slide could halt if the BOJ changes course and becomes hawkish,” said Francesca Fornasari, head of currency solutions at Insight Investments.

Any sign that rates outside of Japan are peaking could also trigger a relief rally. There is no sign of that yet, however, with US rates expected to peak at 3.5% in mid-2023, according to futures markets.

IS A WEAKER YEN HELPING THE ECONOMY?

The yen weakened towards recent 7-year lows against the Chinese yuan and hit new multi-year lows against the Korean won and Taiwanese dollar, which should bring some relief to Japan’s growing trade deficit.

Some, like John Vail, chief global strategist at Nikko Asset Management, say the weak currency is crucial for the Japanese economy to maintain its competitiveness as a safe source of supply chain diversification.

The decline of the yen also reinforces the attractiveness of its stock market to foreign investors who consider it undervalued compared to European and American markets. Japanese equities have outperformed their rivals in 2022, although they are still down as investors broadly abandon riskier assets.

WHAT DOES THIS MEAN FOR FX MARKETS?

The yen has long been the currency of choice for investors undertaking carry trades, which involve borrowing in a low-yielding currency like the yen to invest in higher-yielding currencies like the US dollar or Canadian dollar.

A strategy borrowing in yen and investing in an equal basket of US, Australian and Canadian dollars would have returned 13% so far in 2022, according to data from Refinitiv.

But the speed of the yen’s fall and questions about policymakers’ intervention are fueling investor unease, especially with short bets against the yen near six-month highs.

Increased volatility and weakness could undermine its appeal as a funding currency.

WHAT ABOUT DOMESTIC INVESTORS?

The weakness of the yen puts Japanese investors in a bind.

Yields are high and rising, which makes foreign bonds much more attractive. But it also means that the cost of currency hedging increases.

Thus, Japanese investors can often only take advantage of higher yields if they buy foreign bonds without hedging.

But with the yen at such depressed levels, it is difficult for investors to bear such currency risk, such as the appreciation of the yen. Even a modest return to 115-120, where we were 4 months ago, would eat away years of yield advantage.

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