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The ever rising yen

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Economists have lots of theories on exchange rate movements.  But none of them manage to explain exchange movements very well.  Economic research shows that exchange movements follow a “random walk” pattern more than any theory. 

So let’s see if there is any logic in the strength of the yen which is now at a 15 year high against the dollar.  It is surprising at first blush in light of Japan’s towering public debt, revolving door of prime ministers, sluggish economic growth, low interest rates and ageing population. 

The first thing that we should remind ourselves of is that an exchange rate is simply the price of one currency in terms of another currency.  It is not something which is absolute!

What I mean is that the yen could seem strong against the dollar and the euro because these latter currencies are weak – not because the yen is somehow strong in itself.  There could indeed be something in this.  The US economy is still in bad shape after the global financial crisis.  The initial signs of a rapid recovery are now petering out.  There is some risk of a “double-dip” meaning a second recession.  And President Obama is in a very shaky position with his mid-term Congress elections coming up.  So there are lots of good reasons why the US dollar might be weak against the whole world, not only the yen – all the more so given that the US is easing monetary policy again.

Same sort of story goes for Europe.  The old continent has been struck by a sovereign debt crisis, most notably in Greece.  But all the so-called PIIGS are in bad shape (Portugal, Ireland, Italy, Greece and Spain).  In fact, Europe looks in much worse shape than the US.  So, once again, there is every reason to believe that the euro should be weak against the whole world, including the yen.

What happens in these situations is what is called a flight to quality or the search for a safe haven.  Seems strange, I know, but for the moment, the yen is perceived by markets to be a better bet than the dollar or the euro.

One of the actors in all this is clearly China which is overinvested in US Treasury Bills and euros.  It wants to diversify its holdings of foreign exchange reserves.  It has to find somewhere else, so why not the yen?  So China has been making big purchases of Japanese Government Bonds this year.  What else could they do?  Emerging economy currencies, perhaps, but it is not the same.

Many people might want to invest in the Chinese renminbi because the Chinese economy is so strong.  It’s a good idea, but at the moment the renminbi is not yet an international currency.  It’s not easy to invest in because it is not yet very liquid (difficult to buy and sell easily) and there are not yet many investment possibilities, although this is changing quickly.

In fact, one of the reasons why the yen is so strong may be because it so difficult to invest in the renminbi and many people want out of the dollar and euro.  The only big currency left is the yen.

There is one piece of theory that might help us understand the strength of the yen.  This is the so-called “purchasing power parity” theory.  One version of this theory argues that if your rate of inflation is running ahead of other countries, especially your trading partners, your currency will depreciate so that your “real exchange rate” can hold its value.  Makes sense.  And of course it works in reverse too.  If your inflation is lower than others, your exchange rate should appreciate.  With Japan suffering the curse of deflation (that is, falling prices), an appreciating yen is therefore not surprising.  In fact, Japan’s deflation means that real interest rates are quite high.

So, it all comes back to the Bank of Japan.  If only it could create a bit of inflation, the yen might stop appreciating.  The Bank of Japan should learn a few lessons from Zimbabwe’s central bank!

Japanese business and the government are worried about the strong yen.  It makes it difficult for Japan’s exporters who usually have their export contracts denominated in US dollars which means that their export receipts are declining.  This is why the government has been intervening in the foreign exchange market (the first time since 2004), selling yen in order to weaken it. 

Will this work?  For the moment, it seems to be having some effect.  But history shows that it is very difficult for foreign exchange market intervention to fight against market forces.

But there is a much bigger problem at the moment.  Everyone wants to have a weaker exchange rate to boost exports.  But it is logically impossible for everyone to have a weak exchange rate.  And Japan’s intervention to weaken the yen, make take the heat off China which is the country that really needs to let its exchange rate rise.

We will see what happens!  But already markets can see that something is wrong.  The price of gold has just risen above $1,300 an ounce for the first time ever.  The price of gold has increased five-fold in the past 10 years, up from a low of $258 in the year 2000.  A major factor is gold's traditional safe-haven role at times of economic uncertanty.