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Yen/Dollar --The Strong Wind of Appreciation

By Scott B. MacDonald

A major adjustment is underway in the global economy -- the yen is on track for a gradual appreciation vis-à-vis the US dollar. This is a trend that is likely to continue into next year and has clear implications for helping the United States deal with one of its major problems -- a large current account balance of payments deficit that is expected to come in a little over 5% of GDP in 2003.

Although there are arguments to be made as to why the yen will not be allowed to appreciate, the arguments for such a development loom far larger. Some of the factors for yen appreciation are economic and some are political.

The September 2003 Dubai G-7 summit focused on foreign exchange, with the United States and the European Union looking at China (not part of the G-7) and Japan as well as other Asian countries to appreciate their currencies. The concern is that if global economic recovery is going to take place (and that means having sustainable growth in the U.S. and Europe), a number of Asian countries need to let their currencies adjust to market conditions – i.e. undergo an appreciation due to their relatively strong economic performance, much of it based on export expansion. This in theory should make trade competition fairer for various industrial sectors in the United States and Europe.

Over the last few years, the U.S. economy has been the mainstay of the global economy, willing and able -- though helped by a heavy dose of borrowing -- to buy a tsunami wave of foreign goods from China, Japan, Korea and Taiwan. While helping to keep the global economy afloat during tough times, this support of foreign exporters has come at a cost of employment in the United States (at least this is one of the popular arguments). Job loss in the United States is now a major political issue, in particular, the 2.7 million lost in the manufacturing sector over the last three years. Consequently, the Bush administration prefers a weaker dollar and a stronger yen and yuan due to (1) the pressing need to correct the massive current account deficit; (2) the need to reduce unemployment which could be helped by a potential boost to the export sector; and (3) the need to show that President Bush is tough in dealing with issues central to the common working man as in protecting job losses through currency devaluation (as well as protectionism). Bush increasingly faces potential voter discontent, which could complicate his bid for re-election in November 2004.

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All of the above puts considerable pressure on the yen to appreciate. We see the natural progression from yen 115/dollar to yen 110 and eventually in 2004, to 100. But economics is not without politics. If the yen goes too quickly to 100 to the dollar, it would be a major negative for Japan’s export sector, in particular, autos and heavy machinery. Thus far in 2003, the Bank of Japan has spent over $80 billion to slow any major appreciation of the yen. Y115 was for many months the benchmark around which the Bank of Japan intervened and today it has broken the 110 mark. G-7 pressure at Dubai as well as an improving Japanese economy changed this.

What is significant in Japan is that the domestic economy is now looking stronger and the dependence on the export sector has lessened. Real GDP growth for 2003 is well above last year’s torpid pace and possibly could come in around 2%. Consequently, it is easier for Japan to let the yen appreciate – to a point. The last thing Prime Minister Junichiro Koizumi wants to see is a disorderly and volatile appreciation of the yen. This could choke off the economy’s recovery and spook investors, especially as he plans on calling an election for the lower house sometime in November of this year. In addition, a rapidly strengthening yen could only give deflationary pressures a further push.

However, for all the efforts of the Bank of Japan to slow appreciation, there is considerable pressure for appreciation. As the perception of a Japanese economic recovery becomes more widespread, we expect that foreign investment will continue to be attracted to the Nikkei. Despite the recent slump the index remains far higher than the lows seen earlier this year. Indeed, according to the Tokyo Stock Exchange, net purchases of Japanese equities by foreign investors in the fiscal first half of the year came to Y6.02 trillion, the largest amount on record for any fiscal half. This was driven by growing expectations of an end to structural problems and hopes for stronger growth.

Another pressure for appreciation is Japan’s trade and current account surpluses. As long as Japan’s export companies continue to be so competitive, they will continue to suck dollars into the economy. More dollars means more pressure on the yen.

Taking all the various factors into consideration, in the short term we see the Bank of Japan struggling to keep the yen in a 110-112 range to the dollar, with a dose of tough talking, followed by intervention as the trend strengthens below the 110 mark. However, as the Japanese economy is likely to further signal a recovery, we expect that the yen could go to 105-7 by year-end. The bottom line in all of this is that Japan has a little more flexibility in terms of growth to give back a little to help deal with the U.S. current account deficit.

The excesses of the 1990s will require further adjustment in the 2000s. Foreign currencies will play a central role in that process and Japan’s appreciation of the yen is part of the picture. An eventual appreciation of China’s yuan would be another. By Japan moving first, it can now sit more comfortably in the chorus calling for an appreciation of the yuan. However, we do not see China’s jumping on to the appreciation band wagon any time soon nor do we think that it would be smart policy move on the part of Beijing, considering the massive challenges that continue to dog that country’s banking sector. These include huge bad loans and troubled state-owned enterprises. Instead, the yen will be further squeezed as the global economy moves into 2004. Ironically, Washington and Europe’s push for Asian currency appreciation has fallen much more on Japan, not China, the country where many of the lost 2.7 million manufacturing jobs have migrated.