How the Japanese yen stays strong despite a faltering domestic economy

The yen’s strength derives from its safe-haven status and the fact that much of Japan’s wealth is held overseas, in foreign assets and currencies; in a crisis, investors repatriate the yen, boosting its demand and giving it strength

Neal Kimberley

Published: 2:00pm, 26 Nov 2019

Why you can trust SCMP

Japan’s economy is not in great shape. Policies that have arguably not proven that successful in the past are being dusted off yet again. But Japan’s currency will not necessarily weaken.

A cocktail of domestic economic woes might ordinarily lend itself to currency weakness but the Japanese yen has a habit of holding its own or even strengthening when Japan has problems.

The year 2011 illustrates the point. In March that year, a massive earthquake and the resulting tsunami off Japan’s Pacific coastline killed more than 10,000 people and caused a nuclear meltdown at the Fukushima power plant. Such was the reaction in the currency markets to the disaster that the central banks of the Group of Seven major economies intervened.

However, the G7 banks did so not to stop the yen falling, but to try to arrest a surge in its value that, by undermining the competitiveness of Japanese exporters, threatened to exacerbate the nation’s economic plight.

But why did investors want the yen when Japan’s economy had been hit by such a calamity?

There are a number of reasons, all of which, to varying degrees, remain pertinent.

First off, for all of Japan’s problems, the currency market tends to see the yen as a “safe haven” currency, an investment destination in times of trouble. Japan’s currency is often a beneficiary when events prompt risk aversion among investors.

Secondly, there is the very simple fact that, for all its well-documented problems, Japan is a rich country with very large overseas investments. In times of trouble at home, the Japanese can respond by liquidating overseas holdings, converting the proceeds back into yen, and repatriating the money. This occurred in 2011.

Thirdly, as Japan’s long-standing economic problems have seen the Bank of Japan’s monetary policy push interest rates into negative territory, the yen has historically been a funding currency in so-called “carry trades”. Market participants, including a substantial Japanese retail investor segment, seek to benefit from holding a higher-yielding currency versus a lower-yielding one.

Those positions come under pressure when the Japanese currency rises in value and have to be unwound, as in 2011, which necessarily involves buying back yen.

Earlier this year, the collective unwinding of yen-funded “carry trades” by Japanese retail investors contributed to a “flash crash” in the value of the Australian dollar versus the yen. On January 3, a public holiday in Japan, the yen leapt by almost 8 per cent vs the Australian dollar in minutes as an avalanche of orders hit a liquidity-impaired market.

Yet the Japanese economy is undoubtedly faltering, only managing an annualised growth of 0.2 per cent in the third quarter of this year.

Rugby World Cup, US trade deal successes can’t hide Japan’s economic woes

Official data last week showed Japan’s exports had fallen 9.2 per cent in October. The decline was characterised by weakening demand from China and the US for Japanese goods.

That is bad news for Japanese exporters and Japan’s economy, while also illustrating how the China-US trade war is affecting third parties.

When trade negotiations between Beijing and Washington appear to be going badly, it tends to trigger risk aversion in markets, resulting in renewed safe-haven demand for the Japanese yen even though Japan’s economy is itself struggling.

In the meantime, Japanese policymakers are already contemplating further measures to try to boost economic activity.

Despite having an eye-watering 232 per cent debt-to-gross domestic product ratio, Japan’s government is proposing yet another supplementary budget that will include some 10 trillion yen (US$92 billion) of extra spending.

The Bank of Japan may ease monetary policy even further. “There is plenty of scope to deepen negative rates from the current minus 0.1 per cent,” Bank of Japan governor Haruhiko Kuroda said last week.

Why Japan may have little choice but to accept a stronger yen

These developments are unlikely to trigger wholesale yen repatriation by Japanese investors as it is hardly breaking news that the economy faces problems, but there are other potential currency market implications.

The further that Japan’s monetary policy goes into ultra-accommodative territory, the more likely it is that the sizeable Japanese retail investor segment will again gradually increase their yen-funded carry trades in search of better yields overseas. Such trades can prove profitable but can also play out badly, triggering sudden and unexpected yen appreciation.

The bottom line is that the Japanese currency does not always move as it might be expected to. Just because Japan’s economy is in a downturn does not mean the yen will necessarily fall.

Neal Kimberley is a commentator on macroeconomics and financial markets

This article appeared in the South China Morning Post print edition as: Japan’s yen remains strong even when its economy falters

Post