The Japanese Government Is Right to Defend the Yen (Part 1)
Japan's unique balance of payments and inflation dynamics allow the Ministry of Finance to focus on supporting the currency even as the Bank of Japan continues to keep domestic interest rates low.
The yen is one of the worst-performing currencies in the world. Only the Argentine peso and the Turkish lira have lost more value relative to the currencies of their trading partners since the start of this year (or since the end of 2019, for that matter).
This is unhelpful for most Japanese, as well as their trade partners.
Fortunately, Japanese policymakers have the power to reverse—or at least halt—the yen’s slide without needing to alter the Bank of Japan’s (BOJ) policy stance, which remains broadly appropriate for the country’s domestic conditions. The Ministry of Finance is right to sell foreign reserves to prop up the yen, and it should continue to do so at least until after global inflation normalizes and Japan’s tourism revenues recover. The governent should also consider modifying the guidelines for hedging the Government Pension Investment Fund’s (GPIF) foreign assets, which would support the currency and also reduce portfolio risk.
Why the Yen Is Down
As I explained in a previous note, Japan has been hit hard by two distinct terms of trade shocks. First, imported food and energy have become scarcer, and therefore more expensive. At the same time, Japan lost an important source of hard currency income when the government shut the borders during the pandemic. Together, these shocks mean there is less money available to pay for everything else without some offsetting increase in Japan’s other exports. This requires an adjustment.
One option is to cut domestic input costs and international purchasing power relative to the rest of the world. This real exchange rate depreciation would discourage spending on imports and shift domestic production to export industries. Cutting prices and wages in yen terms could work, but that would be painful both psychologically and financially. Better, for Japan, if everyone else’s prices and wages went up.1 Failing that, the nominal exchange rate could fall enough to make foreign goods relatively more expensive and to make Japanese exports relatively more affordable for buyers in the rest of the world.
The alternative to depreciation is dissaving: Japanese would buy fewer assets from—or sell more assets to—foreigners in exchange for hard currency that could be used to cover the import bill.
Until recently, Japanese officials have let the yen bear the brunt of the adjustment, with excessive inflation outside Japan covering the difference. They are right to change their mind now. Depreciation makes sense when the hit to purchasing power is long-lasting and when foreign currency assets are limited. Neither of those conditions seem to apply to Japan today.
Besides which, the yen has depreciated far more than most other currencies despite Japan’s unremarkable exposure to higher commodity prices. While Japan’s terms of trade have deteriorated by about 12% since the end of 2019, the real effective exchange rate (REER)—the price of Japanese goods and services relative to the prices of goods and services in Japan’s trading partners—is down by 25%. That makes imports more expensive than they should be while making Japanese exports unreasonably cheap. So far this year Japan’s REER is down by 15%, which is worse than any other country in the world by far. (The next-worse performers are Korea at -7% and the U.K. at -6%.)
That’s likely because the BOJ—unlike every other major central bank—is continuing to buy financial assets and peg interest rates near zero.2 That is widening shorter-term interest rate differentials, lowering the cost of betting against the yen3 and encouraging investors to sell Japanese assets for higher-yielding ones abroad.4
That explanation makes sense, but it would make more sense if Japan were dealing with the same problems as the rest of the world. Japan’s circumstances are radically different from almost everyone else’s.