The Japanese Yen Weakens, the Chinese Yuan Rises

The year has started very poorly for the Japanese currency. In January, the yen recorded a significant loss that at one point brought it down to its lowest level in four years against the US dollar. In addition to the Japanese currency, the Chinese yuan is also causing increasing headaches for Western leaders.

All of this has had consequences on a broader political level. In early February, financial leaders of the G7 countries pressured Asia to increase currency flexibility, but experts doubt that China will want to increase it further. Market analysts have therefore focused on the Chinese yuan, which is in a growth period, while, conversely, the Japanese yen continues to weaken.
The yuan rose 3.4 percent against the dollar last year, and this year has recorded an additional increase of 0.7 percent. Analysts believe that this figure could reach seven percent this year and cannot agree on whether the increase in the yuan is directly related to the Chinese trade surplus, which jumped 74 percent last year to a record $177.5 billion.

It has also contributed to the increase in Chinese foreign exchange reserves to an incredible $1.07 trillion ever since the People’s Bank of China bought dollars to curb the rise of the yuan. Therefore, US data will most likely show that the trade deficit with China has reached $230 billion and will continue to increase if the yuan continues to rise. For comparison, about ten years ago, the deficit was $39.5 billion. The so-called butterfly option, which explains the creation of profit if the exchange rate remains balanced over the next month, is the best current stance that investors should take as the G7 could not take specific measures to stop the decline in the value of the yen.

The G7 finance ministers held a meeting last weekend from which, instead of warning the Japanese government, they sent an appeal to market participants to reconsider the mass sale of the Japanese currency. Even such an approach was diluted by a later statement from European Central Bank Governor Trichet that it is not only about the Japanese currency but any risky trade. The yen touched only the bottom and record low ratios against the euro and dollar last month.

European Countries Complain About the Yen

It was concluded at the G7 meeting last April that a correction of the value of Asian currencies is needed to rectify the current imbalance in global trade and capital movement. Borrowing and spending capital countries, like the US, have a huge deficit, while ‘savers’ like Japan and China record a high surplus. Sudden changes in currency exchange rates have become a major problem for investors this year. The US dollar has lost about 10 percent against the euro since the beginning of the year, and since the Chinese yuan was undervalued, which put China in a privileged position in trading with the US, it was very likely that the People’s Bank of China would allow a gradual strengthening of the yuan. Asian countries can collectively resist the strengthening of their currencies either through interventions in the foreign exchange market or with the help of low-interest rates.

European countries are widely complaining about the yen, expressing concern that its weakening to record low levels against the euro is harming their economies as it excessively raises the prices of European products and services compared to Japanese ones. Japanese and American officials persistently downplay the significance of the low exchange rate. This stance from Tokyo and Washington has prompted many analysts to correctly conclude that the yen will not be singled out in the official statement from the G7 meeting as a particularly important topic. – There is a consensus in the market that the yen will not be discussed even if the Europeans insist on it – noted Derek Halpenny from BTM-UFJ.

His assessment was linked to a statement by US Treasury Secretary Henry Paulson that the value of the yen is defined by the relationship of supply and demand in the market, indicating that Washington does not mind the low exchange rate of the Japanese currency. The latest data on the surprisingly strong decline in consumption in Japanese households in December by as much as 1.9 percent was added to a series of unfavorable economic indicators that prompted the Bank of Japan to keep key interest rates at the current level of 0.25 percent during January. However, the Bank of Japan raised the rate to 0.5 percent at the end of February. This is only the second increase in interest rates in Japan in the past six and a half years, following last year’s decision by the central bank to end the policy of nearly free loans.

Chaos in the Japanese Economy?

When it comes to other data from Japan, investments continue to support growth, and industrial production in December rose by 0.7 percent month-on-month, significantly exceeding expectations. – It seems that there is chaos in the Japanese economy, and investors are questioning why increased activity, especially in industry, is not reflected in consumption growth. This is surprising, and the environment does not encourage the Bank of Japan to raise interest rates – concluded Chris Turner from ING. The exchange rates of Asian currencies were also discussed at the recent World Economic Forum in Davos. Nouriel Roubini, a former economist in the Clinton administration who now heads his private consulting firm, stated that the danger of ‘three hungry bears’, referring to the recession affecting the real estate market, the influence of the Central Bank on monetary contraction, and the reduction of mortgage loans due to their increased riskiness, could significantly undermine the US economy.

This assessment was countered, also in a vivid way, by Jacob Frenkel, Vice Chairman of the American International Group and former head of the Israeli Central Bank, who said that ‘many ugly bears have grown horns and become bulls’. Frenkel thus responded to Roubini that his pessimistic forecasts are unfounded, adding that he expects strong economic growth in the United States in the future. Experts concluded that Europe, which has recorded mediocre economic growth over the past five years, is expected to have a solid year in 2007, while the rising markets of China and some other Asian countries will lead global growth of around five percent. Laura Tyson, a professor from Berkeley, stated that a rebalancing of economic growth is already taking place in the world, so the world is no longer dependent on just one locomotive.

Professor Tyson shared optimistic forecasts for 2007 with Frenkel, reflecting on past poor predictions for 2006 that did not materialize, referring to the collapse of the dollar, the sudden rise of the Japanese yen, the price of oil at $100 per barrel, and protectionism, which did not happen. In recent years, the trend in financial markets has been based on a very simple principle – financing expensive (profitable) investments with cheap sources of funding. Thus, many investors are actually betting on low volatility, counting on a positive interest ‘spread’ to do the rest (bring a decent profit). A version of this tactic adapted for the foreign exchange market seems quite simple at first glance – a potential investor just needs to choose a ‘low-yield’ currency to ‘borrow’ and a ‘high-yield’ currency they intend to buy.

Due to extremely low costs, the Japanese yen emerges as a logical solution when choosing a ‘low-yield’ currency as the key interest rate currently stands at 0.25 percent, which is the highest in the last few years. Choosing the other side of the ‘cross’ is somewhat more complicated, but only because there is (at least this year) a whole range of currencies available that have the support of relatively high interest rates, from currencies of so-called commodity countries (such as the Canadian or Australian dollar), which have indeed benefited from strong global demand for raw materials, to the pound and euro, or ultimately the US dollar, in which case key interest rates reach their highest level since 2001.
Prepared by: Andrija Kralj