Untangling Crash of Japanese Yen: Key Factors

Since 2022, the Japanese yen has devalued by 45%, sparking considerable discussion and analysis. Typically, countries devalue their currency due to a negative trade balance, but this is not the case here. Japan maintains a highly positive trading balance with the USA. This situation piqued my curiosity, leading me to explore the key factors contributing to the yen's devaluation.

Divergent Monetary Policies

One primary reason for this devaluation is the divergent monetary policies between Japan and the USA. The Bank of Japan has maintained very low interest rates, even dipping into negative territory, to stimulate domestic economic growth and combat deflation. In contrast, the United States Federal Reserve has significantly increased interest rates to tackle rising inflation.

This difference in interest rates has led to increased demand for US dollars. Investors typically seek higher returns, and with the US offering higher interest rates, there has been a substantial shift in capital from yen to dollars. This movement exacerbates the yen's devaluation as more investors sell yen to buy dollars.

As a result of these dynamics, the yen has been losing value over the last couple of years, reaching its lowest exchange rate against the dollar since the 1990s. This historic low underscores the significant impact of the current monetary policy environment on Japan's currency.

Impact on Trade Balance

A weaker yen might make Japanese exports cheaper and more competitive globally, but it also increases the cost of imports. Despite Japan's positive trading balance with the USA, where exports significantly exceed imports, Japan's total trade balance is negative, importing more than exporting. Since 2022, the weakened yen has made these imports much more expensive, widening the trade deficit. This situation is fueling inflation, as the Japanese economy heavily relies on imports for raw materials and energy.

First Interest Rate Increase in Almost Two Decades

The Bank of Japan (BOJ) is under mounting pressure to address the yen's decline and combat rising inflation. In March, the BOJ symbolically increased its interest rate for the first time in 17 years by 10 basis points, from negative to 0. This move marks a significant shift in Japan's monetary policy, reflecting the urgent need to stabilize the yen and manage inflationary pressures.

Potential Impact on US Treasuries

Despite repeated interventions by the Ministry of Finance, including record interventions between April 26 and May 29 when it sold $62 billion in USD in the foreign exchange market, the yen has continued to plunge. These big and costly interventions highlight the challenges faced by BOJ in stabilizing the yen amidst global financial pressures.

Another critical aspect to consider is the impact on Japan’s treasury holdings. As the BOJ uses its USD deposits to protect the exchange rate, it might need to start selling US treasuries. Japan is one of the largest holders of US treasuries, and significant sales could have broader implications for global financial markets, potentially affecting yields and investor sentiment. However, Japan also has a swap line agreement with the Federal Reserve, which can be used to access dollars without selling treasuries directly. While this helps prevent dumping US treasuries into the market, it places the USA in a disadvantageous position, as it must ensure sufficient liquidity.

Future Implications

The market is putting the BOJ under immense pressure, likely necessitating further interest rate increases and the implementation of QT policies. However, it's unclear how the Japanese economy will react after nearly two decades of QE. There is no easy way out. Additionally, the potential need for the BOJ to sell US treasuries or rely on its swap line with the Federal Reserve to support the yen could have significant ramifications for global financial markets and place the USA in a challenging position. It will be very interesting to observe how this situation unfolds over the next 12 months.