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Yen: which way next?

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Foreign exchange markets pushed the yen up in the immediate aftermath of Japan's triple disaster of earthquake, tsunami and nuclear problems.

We believe that the yen should go down, not up, in the face of these problems.


The yen was very rapidly pushed to 76 yen to the dollar, from the low 80s.  Foreign exchange market logic was that Japanese insurance companies would be liquidating US dollar investments to settle insurance claims from the triple disaster.  In short, this would increase demand for the yen, and reduce demand for US dollar assets.

Very quickly, the Bank of Japan responded by pumping vast sums of yen into the market.  The yen has now basically bounced back to where it was.

As everyone knows, financial markets are always keen to take advantage of any situation.  But this can also mean that they can get it wrong.

We believe that there are many reasons to believe that the yen will now weaken in the period ahead:

.  Even before we look at the issue of reconstruction, Japan's current account balance will receive a negative shock.  Manufacturing exports could be adversely affected, especially if purchasers of Japan's high tech electronic components seek to diversify their supplies to Korea and Taiwan.  Moreover, Japan's imports will surely increase, particularly for food -- Japan already imports some 60 per cent of its food supplies, and the crisis affected area is principally an agricultural and fishing region.  This will be exacerbated by concerns about nuclear contamination of the food chain.

.  One of the very positive aspects of Japan's external sector has been booming tourism revenues, especially from Chinese tourists.  This will clearly take a big negative hit.  While there might also be a decline in Japanese outbound tourism, this effect will surely be less.

.  Reconstruction of the crisis-affected will require massive imports of construction materials and energy resources.  Natural resource exporting countries like Australia will clearly benefit.

.  The crisis is provoking an anti-nuclear backlash globally, resulting in an increase in oil prices.  Remember that Japan imports basically all of its energy resources, except for geothermal energy.  It is very exposed to oil price movements.

.  All of these effects will likely push Japan's longstanding current account surplus into deficit.  With its rapidly aging population now dissaving, Japan's current account was already heading into deficit territory.  A move into deficit would of itself put down ward pressure on the yen.

.  The massive reconstruction activities would push an already very high government budget deficit even further into deficit.  It would also contribute to a further ballooning of Japan's already world record public debt of 200 per cent of GDP.

.  All of these factors could provide the tipping point for the long-awaited loss of confidence in the Japanese government and economy.  As we have seen in many other crisis countries, the resulting fall in the exchange rate could be dramatic.

.  A big depreciation of the yen could result in high inflation in Japan.  The government may not necessarily be worried by that.  It is one way to fritter away the real value of yen-denominated debt.  But inflation above the rate of Japan's trading partners would also put further downward pressure on the yen.

So all things considered, we believe that the yen will be heading downwards.  This will not however be all bad.  It is part of a market economy's self-equilibrating properties.  In particular, Japan's exporters will benefit from this.  They may decide to keep more manufacturing activities in Japan, and stop outsourcing so much to their low cost Asian neighbors.