Yen Devaluation Too Much of a Good Thing

The weakness of the Japanese yen in currency markets has been good news for Japanese companies.  Exports have always made up a large part of the country’s economy, and a weak currency has given the companies a competitive advantage.  But recent reports out of Japan suggest that the yen depreciation might not be all good.  The rise in exports may be offset by higher input prices and lower purchasing power for domestic consumers.  And we have not even considered how politically dangerous the yen depreciation could prove to be internationally.

Trading in the forex market was pretty yen-positive at the beginning of last week.  The first few days were about strength in the Japanese currency, with gains across the board.  But with overall household spending, manufacturing PMI, housing starts and inflationary data all coming in lower than expected, the currency took a nosedive.  Even with this morning’s positive TANKAN release, Japan continues to wage a battle against deflation, preventing the Bank of Japan from raising interest rates.  This allows forex traders to continue to cash in on their carry trades.

Using the real effective exchange rate compiled by the Bank of Japan, the yen has fallen to a 22-year low against the currencies of its major trading partners.  And while that may create a competitive advantage with regard to exports, its costs may be even higher.  Japan imports almost all of its energy needs, and with oil rising above $70/bbl, energy costs for companies skyrocketed 10-20% for Japanese companies.

The undervalued currency also creates problems in competition practices.  Rhetoric regarding an “unfair advantage” (because of the currency) has been ratcheted up both by United States lawmakers and multinational competitors.  The weak currency also makes many companies too dependent on export demand.  Companies are able to do well so easily that it eliminates some of the incentive to improve.  Conditions are starting to approach those of 1998, when the yen gained 10% against the dollar in two days following the Russian debt default.  Mainly because companies had relied too much on easy exports, GDP ended up falling by 2% that year.  A currency that is this undervalued is not conducive to steady future growth, and many companies are starting to realize the problem.  And so the Bank of Japan may actually have some political cover regarding future rate increases this year.