In a highly unusual step, the G7 agreed on Friday morning to coordinate their efforts to control the sharp rise in the Japanese yen. The decision today was prompted by a sudden surge of strength by the yen that by Thursday morning (in Tokyo) had pushed the Japanese currency to a record high against the U.S. dollar. Though the yen had subsequently pulled back a bit, it was still at a level worrying to Japanese policymakers. Japan freaks out when the yen strengthens, because it makes Japanese exports more expensive in international markets and thus can dampen economic growth.
With Japan traumatized by three disasters – the giant earthquake, the catastrophic tsunami and ongoing crisis at its Fukushima nuclear facility – we all should do whatever we can to help the country get through this awful period in its long history. At the same time, I have my doubts about the G7 decision. Here’s why:
First of all, will the G7 action work? In the short term, probably. Joint action by major economies in currency markets has historically proven much more effective in achieving results than unilateral action by one central bank. In September, the Bank of Japan tried to stop the yen’s rise all by itself, but failed. The G7 measures could also work because of the causes of the recent strengthening of the yen. Investors may have been betting that the yen would rise in response to the quake and tossing money in that direction. If that was the case, now that the G7 are creating a firewall, that speculation could very well stop, or even reverse.
But there are far greater forces at play here that suggest there could be continued pressure on the yen to appreciate, at least in coming weeks. This time of year is usually a period of yen strength. The Japanese fiscal year ends March 31, and traditionally Japanese firms repatriate some overseas assets in the process of finalizing their books. With the quake, that repatriation process could be even bigger than usual. Japanese companies and individuals may sell assets held overseas to pay for damages back home. Like all economies that run giant current account surplus, Japan has tremendous holdings outside of the country. Japan is the second-largest holder of U.S. Treasury securities, for example, with $885.9 billion. Some estimates suggest this natural disaster could be the costliest ever –Barclays Capital, in a new report, estimates that losses might reach as high as 17 trillion yen, or more than $200 billion – so Japan could potentially need to sell a ton of assets held abroad to help with reconstruction at home. That would not only put heavy upward pressure on the yen, but also wreak havoc with financial markets around the world. In that scenario, any short-term intervention by the G7 would have limited impact over the medium term in controlling the value of the yen.
My own view on this issue, however, is somewhat different. I think the yen’s recent strength might have been temporary, even without G7 intervention. First, despite 20 years of economic malaise, Japan is still a fantastically rich nation with huge pools of domestic savings, so I think a big international sell-off of foreign assets by Japanese investors is highly unlikely, whatever the final costs of reconstruction might be. Secondly, the economy is probably going to take a pretty serious hit in coming months. Many economists are predicting GDP will contract, mostly likely in the next quarter. Declining economies often don’t go hand in hand with strong currencies. The yen was strengthening even before the quake since the currency was seen as a “safe haven” in a time of great economic uncertainty. With Japan’s economy likely to sink, that impression may fade.
The next question we need to ask is: Is a weaker yen really a good idea for Japan? With the economy very likely to contract due to the quake, it needs all the stimulus it can get, and weaker yen is one way of getting that boost. However, we can also argue that in the short term a strong yen would actually be a big help to Japan. It would make the imports Japan needs to restock basic necessities and start rebuilding cheaper. Any potential damage to export competitiveness from a strong yen is a bit irrelevant right now, since companies are facing the much more fundamental problems of getting factories repaired and running and dealing with power outages.
Over the long-term, however, Japan needs to overcome its obsession with the value of the yen. Japanese policymakers use a cheap yen as something of a crutch, to avoid making the hard decisions on reform the economy really needs. The whole idea that Japan is an “export-dependent” economy is something of a myth. Exports are equivalent to only 12.5% of Japan’s GDP, not much higher than the United States, at 11%. The problem is that Japan’s growth relies too heavily on external demand, since domestic investment and consumption remain so pathetic. That’s because Japan’s leaders have never addressed the real flaws of the economy. Domestically oriented sectors are still wrapped up in too much bureaucratic red tape and consumers are encouraged to save, not spend. A stronger yen would actually help Japan’s economy. By making imports cheaper, Japanese consumers could afford to spend more, while the enhanced competition in the home market would improve domestic services and efficiency.
Perhaps, with Japan stricken by crisis, it is not the proper moment to discuss these long-term issues. But hopefully, the current trauma will wake Japan’s leaders to the need to address these long-standing economic problems. In the future, it would be best for Japan if the yen wasn’t such a big worry.