Commentary / Japan

The yen finds its sweet spot after 50 years of trying

by Peter Tasker

Bloomberg

For most of the past half century, the yen has either been severely undervalued or severely overvalued against the dollar, resulting in a highly destructive boom-bust supercycle in Japan’s economy. But now, the currency is finally showing signs of stabilizing at somewhere close to fair value as defined by the OECD’s measure of purchasing power parity, offering perhaps the healthiest configuration for businesses and investors in decades.

The thing about the foreign exchange market is that currencies move around much more than they should. Country fundamentals — meaning purchasing power parities (PPPs) — change slowly over time, but financial markets respond to a variety of transient factors. Also, currencies are inherently political. The yen-dollar rate influences and is influenced by the twists and turns of the relationship between Japan and the United States. That is why Japanese finance ministers and other high-level officials feel obliged to make public comments on the market’s gyrations.

To understand where the yen is now, it’s helpful to know where it has come from. After World War II, Japan effectively became a U.S. protectorate; sponsoring its economic development made perfect sense for the U.S. in its face-off with the Soviet bloc. Under the Bretton Woods system of fixed exchange rates, the yen was set at 360 to the dollar. By the late 1960s, that represented a 40 percent undervaluation and a huge boost to Japanese competitiveness.

The “Nixon shock” of 1971 saw the U.S. abandon the gold standard and spelled the end of Bretton Woods. The yen surged but remained undervalued in PPP terms for most of the next 14 years. Trade friction with Japan grew into an ugly political issue, especially in the manufacturing heartlands of the U.S. Lawmakers took a sledgehammer to a Toshiba boom box on the steps of the Capitol. Books claiming Japan would overtake the U.S. in economic scale topped American best-seller lists. Such was the background to the enormous currency revaluation that Japan — and West Germany — had to swallow as a result of the Plaza Accord of September 1985 to arrest the dollar’s decline.

The yen appreciated rapidly, and at its highest point, in 1995, the market rate of the yen was more than double its PPP — an astonishing level of stress for any economy to take. Only with the emergence of the internet economy and clear evidence that Japan’s economic model was in serious trouble did what journalist and author Bill Emmott called “Japanophobia” abate. By then, the Cold War was long over and Japan’s value as an ally had evaporated. Rivalry was replaced by indifference.

Along the way, the yen acquired the unwanted status of a haven in times of turmoil, along with gold and the Swiss franc. If anything nasty happens in the world, such as a financial crisis or a catastrophe, the yen rises. Even if the nasty thing happens to Japan itself, as with the 2011 triple disaster of earthquake, tsunami and nuclear meltdown in Fukushima, the yen gets stronger.

The rationale is that Japan is the world’s largest creditor nation, with net external assets equivalent to more than 60 percent of gross domestic product. Therefore, fear or necessity is likely to provoke repatriation of capital. The Bank of Japan’s gargantuan quantitative easing program has weakened the haven phenomenon but not destroyed it. However, with BOJ Gov. Haruhiko Kuroda set to remain at the helm until 2023, any serious financial market turbulence would likely be met by another blast of unconventional monetary policy.

The current state of geopolitics also suggests that the age of the grossly overvalued yen is over. Japan is back as a valuable U.S. ally as China shows a willingness to challenge the American presence in the region. Without a confident, successful Japan, containing China’s influence would be much harder, as U.S. President Donald Trump appears to have realized, despite his fiery anti-Japanese rhetoric on the campaign trail.

It’s a shocking thought, but the yen may just settle at somewhere close to fair value. That would be disaster for currency traders, but great news for almost everybody else.

Peter Tasker is an author of novels and nonfiction books and founding partner of Arcus Investment, a fund management firm specializing in Japan.