The Fall of Yen

While Japan's currency hasn't plunged uncontrollably, it seems to be steadily heading in that direction. The yen has been on a downward trend since 2021, but recent weeks have seen a notable acceleration in its decline.

In the past few trading sessions, the yen dropped even more, from $154 to $160. For almost the last two decades, people used to approximate one yen as roughly equivalent to one cent, perhaps slightly less. However, the current value sits at around 0.63 cents per yen. This represents a significant decrease.

The citizens of Japan are naturally not very happy about this, and they have a good reason for the same. Japan is one of the most import-dependent countries in the world, it imports over 90% of its energy supply and over 60% of its food. A weaker yen is making Japanese people feel suddenly poorer, as power bills go up.

Foreign Exchange 101, a "weaker" exchange rate isn't always bad. A cheaper currency makes a country's exports more affordable, meaning it can sell more overseas. The U.S. Dollar's perennial strength of being the world's top reserve currency is one big reason why U.S. manufacturing and exports have suffered over the years. This is the reason why Japan a long time ago, used to intervene at regular periods to keep the yen cheap.

Japan could potentially leverage the devalued yen to re-establish its presence in global supply chains, particularly in the electronics and automotive sectors. An example is TSMC's semiconductor fabs in Kumamoto, where the weak yen allows for increased investment in construction and wages, given TSMC earns revenue in New Taiwan dollars.

But you know what, there's a limit to how much a weak currency can be a boon to a country. If the yen weakens so much that the country can't pay for food and fuel, it will rapidly fall into deep poverty, despite cheap exports. This is what is currently happening in emerging markets that suffer currency crises, like Sri Lanka in 2022. The yen's fall since 2021 is almost the same as the Sri Lankan rupee's 40% fall in 2022.

And yeah, Japan is no emerging market - it's the 3rd largest economy in the world. So, surely a Japanese economic collapse wouldn't just make people of Japan's life miserable; it would create turbulence in the global economy, causing domino effects in the Western financial systems and trouble for companies.

The prospect of Japan experiencing a currency crisis as those seen in emerging markets should raise alarms globally.

So let's discuss about why this is happening, and what Japan could do to reverse it.

Why is the yen getting so weak?

So before helping you understand why the yen is weakening, let me glance you through how exchange rates work.

When a country floats its currency, japan in our case, the currency's value in the foreign exchange market is determined by supply and demand. In Japan's case, the supply of yen isn't changing very much, so we're looking at a drop in demand.

Firstly why the heck people would want yen? There are two things you can buy with yen: Japanese products, and Japanese assets (mostly bonds). So when demand for the yen rapidly goes down, it's either because people want to buy fewer Japanese products or fewer Japanese bonds. Apparently, there has been no collapse in demand for Japanese goods and services lately, so we're looking at a drop in demand for Japanese bonds. In other words, people are selling Japanese bonds and moving their money out of the country.

But why are they selling the bonds? Well, there's one big obvious reason: They can get a better rate of return elsewhere. This is true in both nominal and real terms.

Many economists talk about this in terms of nominal interest rates. Currently, Japanese interest rates (i.e., the rate on government bonds) are much, much lower than those of other countries.

These are the rates that matter the most for bond investors, but the economic theory says they should care about real interest rates (i.e. rates adjusted for inflation). And when we look back in history, this makes sense. Since the 1990s, Japan's nominal interest rate has been near zero (yeah, you read it right, it means that the price you paid for buying 1kg of rice two decades ago, will most likely be the same price today as well, as Japan had inflation rate for a loooong time).

But since Japan had deflation while other countries had positive inflation, real rates were more or less similar.

However, that changed recently. Japan experienced a burst of inflation starting in 2021, just like the other nations did. While other countries responded with aggressive rate hikes, Japan kept rates extremely low, doing only one small rate hike very recently. This was mainly because deflation was deteriorating Japan's economy over the last few decades, so that Bank of Japan (BoJ) didn't see a couple of % inflation as a worrisome thing.

Thus, other countries real interest rates stayed the same or went up, and Japan's went down so that now Japan's real rate is lower than that of other rich countries.

Also, one thing to note here is that it's not only short-term rates that matter here; demand for long-term bonds as well as other assets like stocks and real estate are important.

So, if you're a bond investor, getting your money out of Japan and putting it into some other country has become a kind of no-brainer thing to do. Hence, people have been selling off Japanese bonds, swapping their yen for other currencies, and buying higher interest-rate bonds elsewhere. And thus the yen is getting weaker.

BoJ raising Interest Rates?

So, now you may be wondering that why doesn't the BoJ simply just raise interest rates, and stop the currency from depreciating any further and attracting investors back to Japan? If the real rates are what matters to the investors, the BoJ wouldn't need to hike very much to bring Japan in line with other nations.

The obvious reason for the hesitation is that the BoJ is still more afraid of a recession than a currency crisis. Rate hikes would probably hurt the Japanese economy, which is still very weak and just nudged the Recession last year. The country had almost zero inflation for decades, despite zero interest rates, which indeed indicates a shortage of aggregate demand or a stagnant economy. However the reason for the same have to do with the population shrinkage (almost 40% of the population is more than 50 years old), low fertility rate and slow productivity growth - that's the root cause of the Japan's difficult economic times.

In such an environment, raising rates even a little bit can create a panic situation in the economy. And a slower economy would reduce demand for Japanese assets even more, making the currency problem much harder to solve. So it's understandable why BoJ is a bit scared to take that stance just because of the weak yen. The currency might have to get a lot cheaper before it forces the BoJ out of the low-rate mindset it's been in the last few decades.

Some people have another opinion on why the BoJ isn't hiking rates, and damn this is a lot scarier. Japan has a very large amount of Government Debt. Officially, this is more than 250% of the Japan's GDP, almost half of that debt is held by the BoJ. This debt doesn't matter as much, because when the government pays interest to the BoJ, the BoJ returns the money to the government.

What matters is the amount of debt relative to Japan's power to tax its economy. When interest rates go up, the government has to pay higher interest costs. When your debt is over two and half times of GDP, that is a big constrain. If Japan can't raise taxes to pay those costs, it will have to borrow yet more just to keep paying interest, and if it does that, things can get nasty.

Now you may think that why couldn't Japan just raise taxes to pay the higher interest costs? Higher taxes, like higher rates, hurt aggregate demand and impact the real economy. Taxes can also cause a slowdown in the economic activity. Japan raised taxes in 1997 and 2014, but this ended up weakening consumption and hurting growth. The double blow of higher taxes and higher interest rates could therefore be very painful for Japan.

So you see, Japan is stuck into this very vicious cycle -> low interest rates - investors selling the bonds - trying to hike the interest rates - borrowing cost of the overall debt increases - trying to increase the taxes to makeup the cost - People reducing their consumption - Hence slowdown of the economy.

The other option would be for Japan to cut government spending. Like there are lot of budget items, like support for failing corporations, that could be cut. However, cutting off the stimulus programs won't be enough, they will also probably have to cut benefits for old people (Now that's very extreme thing IMO).

If Japan is truly in a situation of having high debt, then it's in very big trouble. As long as interest rates stay high around the globe and low in Japan, it means that the yen will keep weakening until the cost of food and fuel imports reaches its peak.

Any Other Options?

In the short term, Japan can intervene to prop up the currency. The BoJ has over a trillion dollars of forex reserves that it can sell in order to buy the yen and support its value. However, if the root cause of this issue is not addressed, this will only delay the days of disaster.

This creates the question of what else Japan could do to stabilize its currency. If forex reserves start running low, and rate hikes can't be done, there's literally only one other option, and that's capital controls.

In my first article (Globalizing the INR), I wrote about how central banks can intervene using capital controls to stabilize their currency.

Just to give you an overview, capital controls mean that japan would basically ban people from moving their money out of the country, past a certain point. Countries often use capital controls to try to stop currency crises. China used them in 2015 when its stock market crashed and money fled the country, and Russia used them after 2014 when sanctions were imposed on them.

So, Japan hasn't had capital controls more almost about half a century now, and it would be a significant move to impose them. But if rate hikes are off the table, it might be the only viable option to prevent a cutoff of food and fuel imports.

The bigger challenge here is that capital controls are very very hard to implement. People tend to find ways to get money out of a country when they really want to. It takes governments a long time and a lot of effort to plug all the holes (think about demonization).

But sooner or later Japan may have to face this unavoidable choice. If money doesn't stop flowing out of the country soon, its leaders will have to decide whether to cause a recession with rate hikes or to take the historic step of temporarily banning people from selling their yen.

Arbitrage?

For the enthusiasts of economic theory (like me), it's worth noting that according to Economics 101, the countries with lower interest rates should see their currencies get stronger and not weaker (Interest Rate Parity) , the reason is simple that in equilibrium, you'd only hold the bonds of a low interest rate country like Japan if you thought the yen would get stronger over time, which would comp off for the lower interest rates.

So now instead of yen appreciating, we are seeing yen being depreciated. So is there an arbitrage opportunity that's being created??

Like take a loan from yen (or sell yen-denominated bonds) and invest it in USD (or buy $ denominated bonds) and earn the differential? Let me know your view on this.

Ara Ara Sayonara!!