26 Mar 2012 | Eimear Daly, Schneider Foreign Exchange
THE EURO has been an easy fall guy for the markets of late. Recent comments from the Bank of Japan pin the yen's strength on safe haven flows from the euro sovereign debt crisis. What is more, the central bank is justifying its easy monetary policy on trying to rebalance the effects of euro contagion.
However, the Japanese yen has persistently strengthened against the US dollar since 2007, and against sterling since 2008. If we take the beginning of the euro debt crisis to be February 2010, when fear of Greek insolvency first emerged, blaming the currency's strength on the euro situation seems a little far-fetched.
Japan is a net exporter to the rest of the world. This means structurally Japan runs a trade and current account surplus. Running a persistently high current account surplus is not sustainable. Market forces will act to restore balance. They do this through a real appreciation of the exchange rate and this force is currently acting on the Japanese yen.
This is not the first time it has come under pressure to appreciate. Barring periodic reversals, this is what we saw from 1971 to 1995. Japan is also privy to bouts of deflation. No matter how Japan may try to resist it, this deflation will be dissipated through the exchange rate and will force the yen to rise over the long term, adding more pressure to appreciate.
Japanese yen against most Western currencies has historically been driven by interest rate differentials. When interest rates were high in most western countries, Japan's near zero interest rate didn't matter and the currency traded lower against the Western majors.
However, when the financial crisis hit in 2008 interest rates in the West were decreased. Persistent economic threats in the Western world meant they remained lower and yield spreads narrowed. JPY strengthened against the Western majors. This a long-term trend in the currency markets and not something that monetary policy can simply correct.
The recent Japanese earthquake - and to an extent the strong yen - has caused a decline in the current account balance. The other side of the balance of payments has more than compensated with a sharp increase in the financial account in the final two months of 2011. As a result, there has been a huge cash inflow into the Japanese economy, as Japanese investors pull funds from abroad and foreign investors seek Japanese assets. All this cash inflow adds to the case for further yen strength.
The yen is swimming against a strong tide of structural reasons for it to appreciate. All signs point to a stronger yen. The least of these is risk aversion from the euro zone crisis. Throwing money at the situation, as in the 10 trillion yen quantitative easing programme the BoJ announced this month, will not solve the problem. At least it will not solve it in the long term, and will cost the BoJ a lot of money and lost credibility in the process. The last time Japan tried to offset the yen's strength with monetary easing the result was the Japanese bubble from 1986-1991. Therefore, monetary easing should definitely be used with caution.
The problem stems from how the Japanese economy developed. Like many developing nations, Japan exported its way to growth. In fact it did so exceptionally. No country grew at the same rate between 1950 and 1973. However, despite the rapid pace of its growth, Japan never developed into a fully formed balanced economy. The Japanese government championed national poster companies such as Sony and Mitsubishi, but it neglected the domestic economy. In the need to create strong companies, the state favoured the producer and financier at the expense of the consumer, meaning consumption was low.
A productivity imbalance also developed between the export and domestic sectors. Domestic industry lagged behind in terms of productivity, mainly because Japan protected the domestic economy from imports through high tariffs and import restrictions. While this was meant to provide the space for domestic companies to flourish, it led to bad habits and inefficiencies.
However, despites huge discrepancies in productivity, the domestic and export sectors paid the same wages. High wages relative to productivity meant domestic prices were high. As a result, domestic demand never really developed in Japan - as evident by a high savings rate.
Japan developed into a lopsided economy with a massive export sector and an underdeveloped domestic economy. The problem with a dependence on exports is that Japan is victim to the highs and lows of the global economy. This latest global economic downturn has come at a time when other negative forces are acting on the economy. The structural forces that have been threatening to appreciate the Japanese yen for so long are coming into play. A strong yen is pushing the Japanese trade balance down, affecting growth. Japan has an ageing population, thus a shrinking workforce and output potential.
Whilst Japan may put the blame on Europe for a strong yen, it is just as guilty of Europe's mistakes. Japan has run a persistent budget account deficit. These deficits have led to a build up of 5.22 trillion yen in public debt. This is 208.2% of GDP and is the heaviest for any industrialised nation. Japan takes a 43.4% lead in front of Greece.
If the S&P's threats of a credit downgrade for Japan materialises, all the cards in Japan's economy may come tumbling down. Japan will be subject to higher borrowing costs and will be forced to implement austerity measures in order to cut the budget deficit and debt burden. Japan already has a contracting economy and perhaps even more critically, contracting output potential. A strengthening yen may be just as bad as a monetary union with no central bank.
A stronger yen is just one symptom of Japan's ailing economy. Monetary easing will not solve Japan's problems. It is likely that much more painful measures will be required if Japan is to survive.
Eimear Daly is a market analyst at Schneider Foreign Exchange
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