Daisuke Karakama: Structural Changes in the Yen Exchange Rate at a Crossroads—The Beginning of the End for the "Mature Creditor Nation"?

2022/08/30

The dollar/yen exchange rate rose to the 139 yen level in July (as of July 15), its highest level in approximately 24 years, and remains high at the time of writing. While the pace of the yen selling faced since March of this year felt hasty, there was no great sense of incongruity in the direction itself. As long as Japan's political and economic situation is taken into account, it must be said that there is a lack of material for investing in yen-denominated assets. Multiple specific factors can be cited, but it is self-evident when viewed in light of basic points such as (1) growth rates, (2) interest rates, and (3) supply and demand.

First is point (1). Looking back at 2021, the growth rate gap between the West and Japan became quite significant. Regarding Western economies, they did not fixate on behavioral restrictions with an eye toward the post-COVID era, and ran through 2021 at a pace two to three times their potential growth rate to make up for the delay in 2020. In contrast, the Japanese economy remained obsessed with the level of new infections and preferred a path of stagnation while fearing some form of behavioral regulation. Even in early July at the time of writing, while the West is suffering from rising prices due to tight employment and wage conditions, Japan is daily making social issues out of "whether or not to wear masks" and "whether or not to continue entry restrictions." There is no way to compete under these circumstances. The foreign exchange market is likely not so simple that "high or low growth rates" directly translate to "currency strength or weakness," but there is a strong suspicion that at least in 2021, the "weakness of the Japanese economy" was directly linked to the "weakness of the yen" (Chart 1).

This point (1) is also related to point (2). Naturally, in Western economies that were able to restore robust demand, prices and market interest rates rose. That is why, regarding the normalization of monetary policy, progress such as "2021 is the year of discussion, 2022 is the year of execution" has been realized. On the other hand, even after entering 2022, Japan restricted economic activity for more than half of the January-March period under the name of priority measures to prevent the spread of disease, suppressing growth rates, and monetary policy was kept on an easing path consistent with that. In March and April, far from normalization, there were many comments that Japan pushed the yen to be sold by encouraging the widening of interest rate differentials through unlimited government bond purchase operations (so-called fixed-rate operations) to suppress long-term interest rates. However, as a problem prior to superficial interest rate differentials, how is the act of trying to artificially suppress long-term interest rates viewed globally in a situation where inflation concerns are rising worldwide? Could that fact itself become a reason for yen selling? It felt as though such a perspective existed.

However, growth rates and monetary policy are things that change from moment to moment based on market evaluations, and in that sense, (1) and (2) can be called fluid factors for yen depreciation. In contrast, the more deep-rooted medium- to long-term factor for yen depreciation is (3). The biggest reason the yen exchange rate has been called a safe-haven asset was that it constantly earned large current account surpluses and, as a result, maintained the status of the "world's largest net external asset holder." It goes without saying that an "impregnable supply-demand environment" was the background for the stable movement of the yen and Japanese government bonds despite having the world's worst government debt balance, a fast-paced declining birthrate and aging population, and the resulting low growth. In recent years, although the trade surplus has been lost, the current account surplus has been able to maintain a high level due to a primary income balance surplus that more than compensates for it. Earning through the income balance rather than the trade balance. This is the story of the change from an "immature creditor nation" to a "mature creditor nation" (Chart 2). However, from last year to this year, changes in the current account surplus have begun to be pointed out. In January of this year, the second-largest current account deficit in history was recorded, and as long as resource prices do not stop rising, the depletion of the current account surplus is likely to continue. The deficit in the trade balance becomes larger than the earnings in the income balance. This is a question of whether we are transitioning from a "mature creditor nation" to a "creditor-depleting nation." Whether that will happen remains highly uncertain, but the emergence of such doubts itself becomes a reason for yen selling.

In fact, the movement of foreign currency related to the country of Japan is facing a major structural change. This becomes clear when viewed together with the fact that outward direct investment has increased at a furious pace over the past 10 years in the financial account, which pairs with the current account. Japan's basic balance (current account + direct investment) began to intermittently suggest foreign currency outflows around 2012 (Chart 3), creating a climate where yen depreciation was easily justified. This change in the supply-demand environment began over the last 10 years and is not a recent development. There are those who still want to deny structural change, but if this is not structural change, what is? Looking at Chart 3, there is the fact that for the country of Japan, "outgoing foreign currency" is becoming greater than "incoming foreign currency."

Regarding the current account, if the decrease in the surplus or the fall into a deficit continues, the cumulative increase in net external assets, which has been taken for granted until now, could also stop. Of course, if the yen depreciates, the balance increases due to the price effect. In fact, the net external asset balance at the end of 2021 increased for the first time in two years to 411.1841 trillion yen, up +56.1 trillion yen from the previous year, and the gap with second-place Germany (315.7 trillion yen) widened to nearly 100 trillion yen. This means it has maintained its position as the "world's largest net external asset holder" for 31 consecutive years. However, when breaking down the factors for the +56.1 trillion yen increase, the amount that increased purely due to volume (transaction flow) factors was +10.8 trillion yen, and the rest was due to price factors. Price factors are divided into exchange rate factors (fluctuations in exchange rates) and other adjustments (fluctuations in asset prices), with the former at +62.2 trillion yen and the latter at -16.8 trillion yen. In short, the increase in net external assets in 2021 was almost entirely the result of yen depreciation. The ability to earn and accumulate foreign currency through current account surpluses (the room for increase due to flow factors) is declining.

If yen depreciation does not continue in the future, there is a possibility that Germany, which is fiercely chasing Japan, will take the status of the world's largest net external asset holder (Chart 4). There is no essential difference between being the world's largest and the world's second largest. However, will the impulsive foreign exchange market respond calmly to the loss of a status maintained for over 30 years? There is a risk that the evaluation of the setting sun of the yen will become harsh.

Finally, I would like to touch upon the short-term outlook for the foreign exchange market. The normalization process centered on interest rate hikes and balance sheet reduction that the FRB (Federal Reserve Board) is currently undertaking may stop in the near future as the US economy slows down. If that happens, US interest rates will turn downward, making it easier for a weak dollar market to emerge. Furthermore, the US current account deficit has already expanded to a level comparable to 2006, the peak of the financial bubble. This supply-demand environment is also a factor for a weak dollar.

However, as a problem prior to the weak dollar, I feel that the yen depreciation since the beginning of 2022 is fundamentally based on a trend of trying to avoid Japan, where a sense of inferiority exudes in all of (1) growth rates, (2) interest rates, and (3) supply and demand. To put it more grandiosely, my understanding is that the current yen depreciation is a theme of "selling Japan." Looking back at the past, when a risk-off phase arrived, it was difficult to see a difference in (1) or (2) for any country, so the currency superior in (3) was easily chosen. That was the "yen buying as a safe-haven asset" that was repeated in the past. However, as mentioned above, the current yen is in an unsettling situation regarding (3) as well. At the very least, the yen was not sought as a safe-haven asset at all following the Ukraine crisis. It is a harsh opinion, but could it be that the yen, whose (3) supply and demand is not valued, has no appealing points and has degenerated into a mere low-growth, low-interest-rate currency? Limiting it to the current phase, unlike the Japanese economy, which is fluctuating between joy and sorrow over the daily number of new infections, the world economy is focused on inflation concerns and the pace and number of interest rate hikes in response. As a result, the yen falls significantly behind other currencies in point (2) as well. Looking globally, central banks that had adopted negative interest rates like the Bank of Japan, such as the European Central Bank and the Swiss National Bank, are also turning toward a path of interest rate hikes, and the sense of isolation for the yen appears set to strengthen further.

Of course, because it is a floating exchange rate, there are phases of buybacks after being sold unilaterally. However, I think the swing back toward a strong yen expected at that time will be shallower than before. I believe we are standing at a crossroads where we should have a market perspective that is not bound by the past.