The Japanese Yen

One of the important features of the current Japanese export driven 'recovery' is the relatively low (indeed vis-a-vis the euro historically low) value of the yen. Surprisingly few commentators have seen fit to comment on this, or on the significance it might have for the debate about whether or not Japan is finally escaping the deflation problem. In the days when people still used to talk about this issue, there was one proposal on the table (principally advocated by Swedish economist Lars Svensson) known as the 'foolproof path' (Professor Svensson's homepage is here, and it contains a whole slew of papers related to this topic).

The foolproof way is to announce (1) an upward-sloping price-level target path to be achieved, (2) a depreciation and a temporary peg of the yen, and (3) the future abandonment of the peg in favor of inflation targeting when the price-level target path has been reached. Then, the BOJ and the MOF just have to behave accordingly.

Now it can easily be seen that a key component of this 'foolproof way' is a substantial depreciation in the value of the yen, and this is what we have seen across 2006. Surprisingly however, and despite the low yen values and extremely high energy costs, Japanese inflation has yet to poke its head above the 1% mark, and with falling energy prices and a slowing global economy is now more than likely (IMHO) headed back into negative - and hence deflationary - territory.

Now one of the important details about the current low values of the yen is that it is in part driven by an outflow of funds from the Japanese themselves:

The yen weakened against the dollar and euro on speculation Japanese investors are seeking the extra yield of U.S. and European assets.

Japan's currency was near a record low against the euro as a government report today showed demand for services in the world's second largest economy fell twice as much as expected in September. The Bank of Japan started a two-day policy meeting today, with economists saying interest rates will stay at 0.25 percent, the lowest among the world's major economies.

``People are looking to the BOJ meeting for more clues on the rate hike outlook,'' said Niels From, a currency strategist in Frankfurt at Dresdner Kleinwort, ``You're still getting big returns from investing in higher-yielding currencies, and the yen should continue to suffer against the euro.''

Now Morgan Stanley's Stephen Yen (who Brad Setser apparently doesn't like at all) had an interesting post about this situation on the MS GEF last week (what Jen calls retail flows are in fact movements of funds by individual investors):


"The accelerated decline in the 'home bias' for mutual funds and retail investors is worth a closer examination. While there is still no definitive explanation of this trend, there is a possibility that it may not be the case that the individual investors' 'home bias' is genuinely lower, but rather that there is just more capital controlled by individuals and therefore more to invest overseas."

"Something that happened 60 years ago may be one contributing factor behind the general weakness in the JPY. During 1946-1949, Japan experienced a mini baby boom. Though it was milder and shorter-lived than the US baby boom (from 1947 to 1964), it nevertheless created a big enough demographic bulge to have consequences now. Relative to a long-term average of around 1.2 million a year in the 'natural' rate of population (birth rate minus death rate), during these four years, the bulge in the demographic profile was close to 2 million, i.e., there was a net 2 million increase in population during this period — an average of 500,000 a year."

"Sixty years later, in 2006, the first wave of these baby boomers reached retirement age. When they received their cash retirement payments, they may have allocated a greater portion of their assets overseas than in previous generations. This may have helped propel an accelerated decline in the collective 'home bias' of mutual funds and retail investment."

Now this is fairly interesting since Jen attempts to link this behavioural change away from home bias to some features of Japan's changing demographics, and in particular to the need (in the uncertain climate of Japan's ongoing problem in funding its pensions liabilities) of finding added yield to cushion any future problems.

Now takes on a lot more interest when you start to think about the fact that a lot of the recent rise in the Japanese stock market was driven by capital inflows - from people with oil surpluses, things like that - on the expectation that the 'recovery' was finally coming. OTOH Jen seems to be indicating that the individual Japanese (institutionally the Japanese will of course always have home bias, which is why you shouldn't expect 'melt down' any time soon, this is one of the big differences between Japan and Italy, IMHO) are sending their money to where they can get higher returns, and in particular the US.

My guess is that people like Brad Setser and Nouriel (and even the likes of Martin Wolfe) with all their dollar-melt-down orientation are completely missing this. So what happens when it becomes obvious that the recovery in Japan isn't sustainable and the BoJ has to back down and re-introduce ZIRP. Well a lot of the foreign money goes out, that's what happens. And the 'retail' flows (as Jen calls individual investors) will keep heading for New York etc. So we are really talking about the Yen potentially holding to very low values (and of course never forget that the renminbi is to some extent weighted to this).