Commentary / Japan

The forces fueling the yen's rises and falls

by Masaharu Takenaka

President Donald Trump’s announcement May 5 that the United States will impose additional tariffs on Chinese goods has killed the optimism that had begun to emerge over the U.S.-China trade talks, causing them to take a turn for the worse. With the subsequent imposition of the additional tariffs, pessimism prevailed over the course of the world economy and stock markets worldwide, including in the U.S. and China, plummeted.

As of May 14, the Nikkei 225 average had declined 7.2 percent from its April high. The yen also went up from the 112-113 range to the dollar in April to 109-110. It was not the first time that stock market declines have caused the yen to rise. As indicated in the accompanying chart, since 2004 there has been a strong tendency that a stock market fall in Japan leads to a stronger yen, while a surge in share prices leads to the yen’s fall. Why is this?

Selling and buying by foreign investors plays a key role when Japanese share prices trend sharply in one direction or the other. When Abenomics began pushing up share prices in 2013, the net purchase of Japanese stocks by foreign investors amounted to ¥14.7 trillion, while the yen declined sharply against the dollar.

When foreign investors, who hold their funds mainly in dollars, buy Japanese stocks, one might expect that the yen would appreciate since they sell the dollar to buy the yen. Likewise, when they sell Japanese stocks, one might expect the yen to depreciate since they sell the yen for the dollar. But the exchange rates move in opposite directions. Let me explain why.

First, in the modern-day financial market, it is possible for foreign investors to procure yen funds from financial institutions to buy Japanese stocks. When they sell the Japanese stocks that they had bought, they just pay back the yen funds. In short, such transactions have no effect on supply and demand of the yen in the foreign exchange market.

Second, a weak yen has the effect of boosting corporate profits, mainly among export firms, which pushes up stock prices. A strong yen, on the other hand, pushes the stock market down.

Third, the total value of net external assets (overseas assets minus overseas debts) owned by the Japanese government and private sector combined is still the world’s largest at ¥328 trillion as of 2017. When stock prices are steady, Japanese investors tend to raise their risk tolerance for investment and increase overseas investment, which entails selling the yen for foreign currencies. On the other hand, when the economy is bad or stock prices have dropped significantly, they act to avoid the risk and reduce or sell off their overseas investments, which entails buying the yen and selling foreign currencies.

The latter tendency was conspicuously visible in the early 1990s when the bubble boom collapsed. As shown in the chart, a rapid appreciation of the yen and a steep fall of stock prices occurred simultaneously. Up till then, Japanese institutional investors were big buyers of overseas bonds, stocks and real estate.

But the collapse of Japanese stock and real estate prices lowered their risk tolerance for investment. They quickly reduced and streamlined their overseas investments. As a result, they either scaled back their yen-selling for foreign currencies or turned to net buying of the yen, causing the yen’s exchange rate to spike from 160 to the dollar in 1990 to around 80 in 1995.

The fourth factor is the ultra-low interest rate prevailing for an extended period in Japan. From around 2004, “yen short carry trade” — the practice of selling the zero-interest yen and buying a higher interest currency like the dollar — became popular in the foreign exchange market because the traders profit from the interest rate differentials between the two currencies. Among investment trust products, a type that invests in foreign government bonds that carry higher interest rates became popular.

Since all these transactions involve selling the yen and buying foreign currencies, the yen depreciated from the 100-105 range to the dollar in 2005 to 124 in the first half of 2007. But the global stock market crash, triggered by the financial crisis in the U.S. from late 2007 to 2008, led market participants to rush to avert the risks. They unwound their yen-short positions, which had piled up in large volumes, and bought the yen. As a result, the yen quickly appreciated to around 75 to the dollar.

After the Lehman Brothers shock, short-term interest rates in the U.S. have come down to zero — just like in Japan — because of monetary easing, wiping out the yen short carry trade. But in and after 2016, when the U.S. started raising interest rates again, the yen short carry trade revived. Since then, the expansion and shrinking of yen short positions corresponding to ups and downs in stock price have strongly influenced the fluctuations in the yen’s exchange rate the way that I explained earlier.

There was a time, however, when the relationship between stock prices and the yen’s exchange rate was in reverse. From 1997 to 2004, a stock market slump led the yen to fall and a surge in share prices caused the yen to appreciate — the opposite of what was happening in other periods.

In fact, a fall in share prices causing currency depreciation and booming stock market leading the currency to rise are trends that are generally observed in emerging economies where investment risk is high. During that period, banks in Japan were saddled with mountains of non-performing loans and foreign investors were worried about the possibility of a banking crisis in this country. Therefore it’s believed that the yen’s exchange rate and the stock market during that period moved just like the currencies and share prices do in emerging markets.

When the next recession comes around — and one certainly will at some point in the future — there is no doubt that the stock market fall will be accompanied by a surge in the yen’s exchange rate. I expect the yen will rise to the tune of 90 to the dollar by the end of 2020.

Masaharu Takenaka is a professor of economics at Ryukoku University in Kyoto.