Why is the Japanese Yen so Weak?

The Japanese Yen has been making headlines for all the wrong reasons, hitting multi-decade lows against the US dollar and other major currencies. This persistent weakness has sparked concerns about its impact on the Japanese economy, prompting questions about the underlying causes and potential consequences.

This article delves into the factors driving the Yen's depreciation, examining its implications for various economic sectors in Japan and exploring the potential risks associated with government intervention in currency markets.

Why is the Japanese Yen falling?

The weakness of the Yen can be attributed to a confluence of factors, but one stands out as the primary driver:

Divergent Monetary Policies and Interest Rate Differentials: The Bank of Japan (BOJ) has maintained ultra-low interest rates for decades, aiming to combat deflation and stimulate economic growth. In contrast, other major central banks, particularly the US Federal Reserve, have been aggressively raising interest rates to combat surging inflation.

This divergence in monetary policy creates a significant interest rate differential, making the Yen less attractive to investors seeking higher returns. Investors are drawn to assets denominated in currencies with higher interest rates, leading to capital outflows from Japan and increased demand for currencies like the US dollar, further weakening the Yen.

Differing Economic Conditions: The interest rate gap reflects the contrasting economic realities of Japan and other major economies. Japan has faced prolonged economic stagnation and stubbornly low inflation, known as "the lost decades," while countries like the US have experienced robust growth and higher inflation. The BOJ's loose monetary policy aims to break free from this deflationary spiral, but it comes at the cost of a weaker currency.

Market Momentum and Speculative Positioning: The Yen's multi-year downtrend has become self-reinforcing, creating a vicious cycle. As the Yen weakens, investors anticipate further declines, leading to increased selling pressure. This is exacerbated by a surge in speculative short positions against the Yen, where traders bet on its continued depreciation, further driving down its value.

Divergent Economic Outlooks: Markets anticipate that the US Federal Reserve and other major central banks will maintain higher interest rates for a longer duration to tame inflation. Meanwhile, the BOJ is expected to lag in policy normalization, reinforcing the expectation of a widening interest rate differential that favors the US dollar over the Yen.

Potential US Protectionism: While less influential than other factors, some analysts suggest that a persistently strong US dollar, potentially fueled by protectionist policies, might contribute to the Yen's weakness.

In essence, the Yen's weakness is primarily a consequence of the BOJ's commitment to ultra-low interest rates to revive its economy. This policy divergence creates a significant disadvantage for the Yen in the global currency market.

Outlook for Japanese Yen for 2024 and 2025

In an analysis published by Goldman Sachs in May 2024, the bank expects the Japanese yen to remain weak throughout 2024 and into 2025. Here's a breakdown of the key factors influencing this outlook:

• Global Economic Landscape: The yen tends to strengthen when there's a high risk of recession, as investors flock to safe-haven currencies. However, the current environment features surprisingly strong global growth, particularly in the US, despite the Federal Reserve maintaining high interest rates. This weakens the yen's appeal.
• BOJ Monetary Policy: The Bank of Japan (BOJ) recently ended its negative interest rate policy and lifted the cap on 10-year government bond yields. However, these changes were modest and haven't significantly impacted the FX market. The BOJ is prioritizing achieving sustainable inflation, and further rate hikes are expected throughout 2024, potentially reaching 0.75% by year-end.
• US Monetary Policy: The US Federal Reserve is expected to implement fewer rate cuts than initially anticipated in 2024. This, combined with the BOJ's minimal rate hikes, means the interest rate differential between the US and Japan won't significantly support the yen.
• Japanese Investor Activity: Low domestic yields compared to other markets are prompting Japanese investors to seek foreign investment opportunities. This outflow of capital weakens the yen.
• Potential for Intervention: The Japanese government has the capacity to intervene in the foreign exchange market if the yen weakens excessively. However, such interventions have limited effectiveness and could have unintended consequences.

While the BOJ is raising rates, the pace is unlikely to significantly strengthen the yen in the near future. The global economic environment and continued investor activity abroad are likely to keep the yen weak throughout 2024 and into 2025, according to Goldman Sachs.

Which Sectors in Japan Benefit the Most From a Weak Yen, and Which Are Hurt the Most?

The weak Yen has a mixed impact on the Japanese economy, creating both winners and losers:

Beneficiaries:

1. Export-Oriented Industries: A weaker Yen makes Japanese products cheaper for foreign buyers, boosting demand and increasing profits for exporters. This is especially beneficial for sectors like:
2. Automotive: Japan's large automotive industry benefits from increased price competitiveness in global markets.
3. Electronics: Japanese electronics companies gain a competitive edge, selling more affordable products internationally.
4. Manufacturing: Various manufacturing industries producing goods for export, like machinery and precision instruments, benefit from the favorable exchange rate.
5. Tourism: A weaker Yen makes Japan a more affordable travel destination, attracting more foreign tourists. This leads to increased tourism revenue, supporting hotels, restaurants, airlines, and other tourism-related businesses.
6. Japanese Companies with Overseas Operations: These companies see their overseas earnings amplified when they convert profits back into Yen. A weaker Yen increases the Yen value of their foreign earnings.

Those Negatively Impacted:

1. Import-Dependent Businesses: A weaker Yen makes imported goods more expensive, raising costs for businesses reliant on imported raw materials, components, or finished products. This affects sectors like:
2. Energy: Japan imports a significant portion of its energy needs, and a weaker Yen drives up energy costs, impacting businesses and consumers.
3. Food and Beverage: Japan imports a substantial amount of food, and a weaker Yen pushes up food prices, adding to inflationary pressures.
4. Retailers: Retailers importing goods from overseas face higher costs, which can squeeze profit margins or necessitate passing on these costs to consumers through higher prices.
5. Consumers: A weaker Yen translates to higher prices for imported goods, squeezing household budgets and reducing purchasing power. This is particularly challenging for consumers with fixed incomes or those spending a large portion of their income on necessities like food and energy.

The weak Yen presents a trade-off for Japan, boosting certain sectors but posing significant challenges for others.

What Are the Risks Associated With Currency Intervention to Prop Up the Yen?

While intervening in the currency market to support the Yen might seem like a straightforward solution, it carries several risks:

1. Limited Effectiveness and Depletion of Reserves: Currency interventions are expensive and often have limited long-term impact, especially when fundamental economic factors drive the currency's movement. Japan would need to spend considerable foreign exchange reserves to buy Yen and sell other currencies. This could deplete its reserves without fundamentally changing the Yen's trajectory, with the Yen potentially resuming its decline once interventions cease.
2. Negative Market Perception and Loss of Credibility: Frequent or ineffective interventions can damage the central bank's credibility, signaling a lack of confidence in its monetary policy. This could make future interventions less effective and make investors wary of holding Yen-denominated assets.
3. Trade Tensions and Retaliation: Currency manipulation to gain a trade advantage can trigger accusations from trading partners and lead to retaliatory measures. While Japan's recent interventions have been relatively small-scale, larger and more sustained interventions could raise concerns among its trading partners.
4. Distortion of Market Mechanisms: Interventions can disrupt the natural functioning of the foreign exchange market, hindering price discovery and potentially creating inefficiencies.
5. Increased Volatility: Interventions can introduce volatility into the market, leading to unpredictable swings in the Yen's value, making planning difficult for businesses and creating uncertainty for investors.
6. Conflict with Monetary Policy Objectives: Currency interventions might contradict the BOJ's goals of stimulating inflation and economic growth. Propping up the Yen could counteract these objectives.

Given the risks, Japan might consider alternative approaches to address the Yen's weakness:

1. Adjusting Monetary Policy: Although the BOJ has been hesitant to deviate from its ultra-loose policy, a gradual tightening could narrow the interest rate differential with other major economies, potentially slowing the Yen's decline.
2. Structural Reforms: Addressing structural economic issues, such as boosting domestic demand, promoting innovation, and increasing labor market flexibility, could improve long-term prospects and make the Yen more attractive to investors.
3. Fiscal Policy Measures: Targeted fiscal policies, such as subsidies for import-dependent industries or measures to support consumers facing higher import costs, could mitigate the negative impacts of a weak Yen.

Ultimately, Japan must carefully weigh the risks and benefits of intervention and explore alternative strategies to address the Yen's weakness sustainably and effectively.