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Why the Yen Could Be Ready for a Fall

Japan's trade deficit could weigh on last year's strongest currency, making intervention by the central bank unnecessary.

Another month brings another euro zone crisis and another resurgence in the value of the yen, which has strengthened beyond ¥79 to the dollar for the first time since February.

The Japanese currency has been treated by investors as a safe haven whenever Europe’s sovereign debt crisis has taken a turn for the worse — appreciating to a record high of ¥75.35 against the dollar in October 2011, when fears about peripheral euro zone economies were acute. 

Recent research from HSBC shows that the yen has a strong tendency to rise at times of diminished appetite for risk-on investments, while currencies that are seen as proxies for global growth, such as the Australian dollar, fall with a roughly equal reliability.

In recent months, however, the dollar has been losing its strong post-2007 correlation with risk-off strategies, according to analysis by Nomura, Japan’s biggest securities house. This has increased the yen’s luster — triggering a strengthening from ¥80.3 at Wednesday’s close to just below ¥79.0 at one point on Friday, as fears about Greece and Spain grew. Nomura analysts have awarded the yen the coveted moniker of “still the safest currency,” in a recent note. At the end of Monday Asian trading, the yen was at ¥79.2 to the dollar.

The appeal of safe currencies may become even stronger this week, should fears escalate that Greece will become the first member state to leave the euro zone. Spurred by the currency union’s turbulent politics, how much stronger can the yen become?

Capital Economics, the independent macroeconomic consultancy, is bearish about Euroland, and its bullishness about the yen is a logical extension. “Our view for some time has been that the euro zone would experience some form of breakup this year, which will push the yen to ¥70 against the dollar by the end of 2012,” says David Rea, Japan economist at Capital Economics.

Short of a resolution of the euro zone crisis, is there anything that might stem this rise?

Direct intervention by the Bank of Japan may set a ceiling. The bank ended the yen’s appreciation by selling heavily in November, after the currency reached its record high.

Once again, ¥75 is likely to prove the most likely trigger for intervention, although the Japanese government will think carefully before acting. Intervention uses up political goodwill with the U.S. government, which is anxious about anything that keeps the dollar strong by making other currencies weaker. Many Japanese exporters have based business plans on the assumption that the yen might be about this level — a value that makes it harder for them to sell goods made more expensive by the strengthening currency. But few have made plans for an appreciation of the yen above this.

Another possibility is further heavy quantitative easing (QE) by the Bank of Japan, aimed at meeting its new inflation goal, set on Valentine’s Day, of 1 percent. But after an initial surge of QE in February the bank has shown a more muted appetite for pumping cash into the banking system, and this has allowed the yen to bounce back.

Yet speculating on the Japanese currency is not a one-way bet.

One of the historical cornerstones of yen strength has been Japan’s strong trade surplus, which has kept demand for the currency high. However, last year the country recorded its first trade deficit since 1980 — largely because of a surge of energy imports following the shutdown of nuclear power plants in the wake of the earthquake and tsunami, but also because of tepid demand for Japanese goods among countries mired in economic problems. Neither issue has disappeared.

Another potential weak point for the yen is Japan’s poor underlying economic outlook. Growth in gross domestic product (GDP) has averaged about 1 percent over the past two decades and remains depressed by the continuing decline in the country’s working-age population. The annualized 4.1 percent rise in GDP for the first quarter, published on Thursday, is caused partly by the temporary boost to public investment in infrastructure damaged by the earthquake and tsunami. It will not be sustained.

Japan’s low growth rate is one of the underlying factors behind another problem that could, in the long term, hit the yen: its extremely high debt. Investors have fled the euro since the beginning of May because of renewed fears that unsustainably high debt burdens would cause a collapse in the currency’s value. Instead, they have sought safety in the yen, where economists also fear the country’s debt burden is unsustainably high. Japan’s government debt is projected by the International Monetary Fund (IMF) to climb from 230 percent to 236 percent of GDP this year, and to rise above 250 percent in 2016. In the euro zone, even the debt of Greece, the sick man of Europe, is estimated in the IMF’s April Fiscal Monitor report at 153 percent this year. 

High debt creates many risks for currencies, including the fear that the central bank will respond to a government’s inability to service it by printing huge amounts of money to buy up the debt for itself — perhaps under the guise of QE. Another risk is that the central bank will create inflation in order to depreciate the size of the debt in real terms. Either policy would severely damage the yen’s value — as would the mere suspicion that it might happen in the future.

Japan’s high debt burden has not yet caused a collapse of confidence in Japan’s economy and currency because domestic investors, who hold about 95 percent of the bonds, are willing to accept paltry rates of interest for holding it — preventing the fiscal deficit from running away beyond 10 percent of GDP. At the end of Monday Asian trading, the year on the Japanese 10-year was 0.86 percent. However, as debt increases yet further, they may prove unwilling to tolerate such low rates. At that point the yen might tumble very quickly. Economists have been warning for at least ten years that Japan’s debt mountain was not sustainable, but their predictions have not yet come true. As the altitude of the mountain continues to increase, at what point will they be right?

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