G7 compromises on yen exchange rate

But currency's weakness likely to continue unless BOJ decides to act

by Yasushi Azuma


Strong concern expressed by euro-zone financial leaders moved the Group of Seven nations to suggest the yen’s weakness against the euro should be corrected to reflect expectations Japan’s economic recovery will continue.

Even so, the yen may remain weak against the euro for now as Japanese interest rates are expected to remain below those in the euro zone.

The yen’s fall to record lows against the euro has emerged as a major focus of attention, with euro-zone politicians voicing concern that the Japanese currency’s further fall will dampen the competitiveness of European exports. The yen weakened against the euro by 13 percent in the past year.

Japan feared that if the weak yen was singled out in statements issued at the end the meeting of G7 financial leaders and the yen staged a sharp rebound, it would cast cold water on the recovery by weakening Japanese companies’ international competitiveness.

The chairman’s statement was ambiguous about the G7’s stance on the yen’s depreciation against the euro.

“The euro area is experiencing an increasingly broad-based upswing” and “Japan’s recovery is on track and is expected to continue,” the statement said. “We are confident that the implications of these developments will be recognized by market participants and will be incorporated in their assessment of risks.”

These phrases, added to a statement which says, “We reaffirm that exchange rates should reflect economic fundamentals,” are apparently a product of compromise between Japan and the euro-zone G7 members.

Analysts say Japan can argue the current yen-euro exchange rates do not deviate from economic fundamentals as the Japanese currency was not singled out in the statement, while euro-zone members can say the new phrases indicate the G7’s view that the yen should rebound against the euro to better reflect Japan’s economic recovery.

Finance Minister Koji Omi told a news conference after the meeting that the newly inserted language does not indicate the need to correct the yen’s weakness against the euro.

However, he added these phrases mean exchange markets should recognize the risks of moving unilaterally in a certain direction.

Omi’s remarks suggest the new wording is aimed at curbing yen-carry trade, in which investors borrow yen funds at low interest rates and invest them in higher yielding assets denominated in the dollar and other currencies.

Yen-carry trade has become popular amid Japan’s extremely low interest rates, increasing the risk of volatile movements in financial markets when investors unwind their positions.

Apparently referring to the inserted wording, German Finance Minister Peer Steinbrueck, who chaired the meeting, indicated the G7 nations agreed on the need to correct the yen’s weakness to reflect Japan’s economic growth.

Given the interest rate gap between Japan and the euro zone, however, it remains unclear whether the yen will gradually rise against the euro on the back of Japan’s ongoing recovery.

Likewise, yen-carry trade, driven by hedge funds, may not subside as long as Japanese interest rates remain low.

Last July, the Bank of Japan abandoned its “zero interest rate policy” and raised the key short-term rate to 0.25 percent, the first rate hike in six years. Since then, the rate has remained unchanged at that level, the lowest among the G7 nations.

The European Central Bank maintains its benchmark rate at 3.5 percent. The ECB is widely expected to raise the rate next month to keep inflation at bay.

Although the BOJ is eager to raise the unsecured overnight call money rate from the current level to “normalize” its monetary policy, it faces high hurdles — weak private consumption, soft consumer price index data and domestic political pressure.

BOJ Gov. Toshihiko Fukui, showing willingness for a near-term interest rate hike, told reporters during the G7 meeting Japan’s central bank will hold a “more solid” debate on whether to raise interest rates when its Policy Board meets Feb. 20 and 21.

Many BOJ watchers believe the chances are slim it will hike the overnight call money rate at the upcoming policy meeting.

Some predict that expected year-on-year falls in the core nationwide consumer price index from the spring and the House of Councilors election in July will force the BOJ to delay the next rate hike until fall or even later if it misses the February meeting.

“Should the BOJ not hike the overnight lending rate with the upbeat GDP result, the yen is likely to keep falling against the euro,” said Hiromichi Shirakawa, chief economist at Credit Suisse Securities (Japan) Ltd.

If the BOJ can’t raise interest rates and the yen remains weak against the euro and other currencies, it is certain Japan will face fresh pressure from euro-zone G7 nations to do something.