The question on why the Japanese Yen is now so strong against the U.S. Dollar is asked repeatedly the last few weeks, months and years.

The Yen reached recently a 15-year high against the Dollar. Was this in line with expectations? What is happening and what is causing this? Here are the analysis and conclusions on why the Yen is so strong.

Click here for the USD/JPY 20-Year Exchange Rate Trend Chart.

In summary, the cause for the strengthening of the Yen is that the Yen is a currency with net inflows; more Yen are bought then that there are Yen sold.

The reason for this is the combination of the strengthening trend itself, the Japanese trade surplus, the low return on investments in the rest of the world, the expected monetary policy in the U.S. and the diversification of foreign reserves in other countries away from the U.S. Dollar and Euro. In an historic perspective, the strengthening of the Yen is nothing new and not unexpected.

Yen / Dollar Historic Trends

Before going into the explanation on why the Yen is so strong, we start with a review of the historic trends in the Yen (JPY) / Dollar (USD) exchange rate.

When looking at the chart (download the PDF at the end of this page for a larger image), note the following:

• The overall trend during the last 20 years in clear; the Yen is getting stronger against the Dollar.
   
• The Yen / Dollar exchange rate has a fluctuating pattern with continuous lower tops; the current strengthening of the Yen since the last top in the chart is already taking place since mid 2007.

Thus a strengthening of the Yen is something that fits well with the historic perspective of both the last 20 years as well as the last 3 years. Thus, there are no big surprises here when the Yen is continuing at this moment this trend.

Just as a note, the unusual period in the last 20 years was in the 1993 – 1996 timeframe. The Yen was then relatively very strong. I am interested to hear explanations that cover that period.

Expected the opposite

When comparing Japan with the U.S., one could be surprised by the strengthening of the Japanese Yen. The economic situation for Japan compared to the U.S. does not look that good and one may expect countries with a healthier economy to get a stronger currency, isn’t it?

• The domestic interest rates in Japan are about the lowest in the world and not very attractive to park your money.
   
• Japan has an aging population and this will temper the economic growth in Japan compared to the more vibrant demographics in the U.S. for example.
   
• Japanese public debt as a percentage of GDP is about twice the size of the U.S. public debt. And the Japanese deficit does not look much better.

At the end of this article we list for completeness some other factors that are also sometimes mentioned as developments and that could have weakened the Yen recently.

Currency Theory

However we see a continuous strengthening of the Yen versus the Dollar. Why is that?

In short, it is all about demand and supply. When there is relatively more supply and less demand for Yen’s, the Yen will weaken. When there is more demand and less supply of Yen’s, the Yen will strengthen.

Thus a strengthening Yen means an increasing demand for Yen’s compared to relatively less supply (selling Yen’s and getting other currencies in return).

The strength of a currency is driven by trade and current accounts. These are two sides of the same coin.

1. The trade cash flow.

• Exports from Japan cause demand for Yen to buy the Japanese goods.
   
• Imports into Japan create supply of Yen to buy other currencies to pay for the imports.

2. The investment cash flow.

• Investments from outside Japan in Japanese assets cause demand for the Yen. If these assets are more in demand, the price goes up and the Yen becomes even stronger.
   
• Investments from Japanese investors outside Japan create supply and thus a weakening factor for the Yen. When there is less demand for these assets the price in Yen goes down and the Yen would strengthen.

Japan’s Trade and Investment Cash Flow

What is happing in Japan with the trade and investment cash flow?

Trade Cash Flow

• Japan has a trade surplus and is exporting more than importing. This keeps the currency strong.
   
• The strengthening currency could lower exports and increase imports in the long run. But in the short term it reinforces itself for example by reducing the supply of Yen required for imports.
   
• Note that the U.S. is importing more than that it is exporting; remember the U.S. trade deficit? This weakens the U.S. currency.

Investment Cash Flow

• There seems to be a strong demand from non-Japanese investors for Japanese assets, especially short-term money market instruments.
  • Overseas investors bought for example a net 5.5 trillion Yen in Japanese assets from January to July (data from Japanese Ministry of Finance).
     
• The demand for assets outside Japan has definitely not been very strong recently; just think about how the stock markets around the world have behaved the last six months.
  • There is also the fact that Japanese savers have preferred Japanese Government Bonds for decades, allowing the Yen to stay strong despite world record low levels. Compare this with the low savings rate in the U.S.

Demand for Japanese Assets

Where is this demand from non-Japanese investors for Japanese assets (one of the reasons the Yen is strengthening) coming from?

• Partly this could come from foreign reserves diversification. Think about China for example who wants to be less dependent on the U.S. Dollar or Euro.
  
  • The Chinese central bank put a lot of money in the U.S. before the credit crisis. The Chinese bank then switched over to investing in Euros, and the Euro sovereign debt crisis occurred. It seems to make sense that the next diversification would be into Yen, as the Yen is holding its strength. Chinese net purchases of Japanese debt have increased to 1.7 trillion Yen in the first six months of 2010, up from 255 billion Yen in the whole of 2005.
    
    
• Other investors are seeking a temporary parking place for their money when they sell their other assets. With the poor performance of stock markets around the world, the very low interest rate on U.S. treasury and the strengthening trend in Yen, Yen money market instruments could look very attractive.
   
• There could also be a perception among market players that the U.S. Federal Reserve may be more willing to conduct aggressive monetary easing than the Bank of Japan. The expectation that more new U.S. Dollars will be printed than that there will be new Yen printed, will strengthen the Yen.
  
  • This perception was further strengthened last week when the U.S. Federal Reserve in a statement indicated that it might embark on more quantitative easing, increasing the amount of money in circulation in an attempt to help the economy pick up.
    
    
• The expectation for the differences in interest rate in Japan and the U.S. will also have its influence on the exchange rate. The Japanese interest rates have always been the lowest.
  
  But when the expectation is that this difference is will become less big (e.g. dropping U.S. treasury rates) or when the U.S. is not expected to increase interest rates for the foreseeable future, the carry trade will slow down or unwind, strengthening the Yen further.
  
  The same thing will happen when investments outside Japan are expected to become more risky or providing lower returns.
  • Before investors borrowed Yen at very cheap interest rates, used it to invest in other countries where the returns were higher. Now there could be some unwinding or less carry trade (paying back the loans in Japan and needing more Yen for that or exchanging less Yen than before).
    

Summary

Thus in summary, repeating what we said above: the cause for the strengthening of the Yen is that the Yen is a currency with net inflows; more Yen are bought then that there are Yen sold.

The reason for this is the combination of the strengthening trend itself, the Japanese trade surplus, the low return on investments in the rest of the world, the expected monetary policy in the U.S. and the diversification of foreign reserves in other countries away from the U.S. Dollar and Euro. In an historic perspective, the strengthening of the Yen is nothing new and not unexpected.

Just some crazy after thoughts

1. Is the strengthening of the Japanese Yen a clear indication for the expected weakness in the growth of the economy in the rest of the world?
    
2. Is Japanese public debt a bubble?
    
3. The ROI in Japan is too low to keep the money there unless you are a Japanese saver and unless the situation in the rest of the world is very bad.
    
4. Japan is in the black hole corner of a stronger currency, lower corporate profits, lower stock prices, deflation, more locally financed public debt, a higher deficit, a continuous trade surplus and more inflow of money.
    
5. Due to demographics, the local demand will not increase to bring the trade cash flow in balance. Breaking the circle, weaken the currency and getting an outflow of money can only happen by declining exports (this is not good for the Japanese companies and stock market), and by assets outside Japan being more attractive investment opportunities than the ones in Japan. Thus a much faster improvement of the economy in the rest of the world then in Japan is Japan’s only hope.
    
6. The Japanese nightmare scenario is that the economy in the rest of the world does not improve. The black hole corner then will suck in more money till the moment that debt and deficit are out of control, the population ages further while saving less, interest rates on the public debt rise and eventually Japan defaults on its debt. And, only then the Yen will weaken. Does anybody see a scenario that is positive for Japan?
    
7. The strengthening of the Yen fits well with a world where the inflation in Japan is lower (or there is even deflation) compared to the rest of the world. Prices in Japan deflated in terms of Yen, but in terms of Dollars they keep up with the rest of the world. It is all in balance with each other.
    
8. A topic for another article could be if the U.S. Dollar is getting weaker against the average of all other currencies and what are the reasons for that. Input is welcome.

Recent developments that could have weakened the Yen
(but didn’t)

The following factors are occasionally mentioned as developments that could have weakened the Yen during the current year instead of the strengthening that we see:

• Japanese households have been steadily investing abroad in 2010. Net buying of overseas equities, bonds and money market instruments by Japanese investment trusts from January to July has risen 65 percent from the same period last year to 2.8 trillion Yen ($32.9 billion).
  • Note however that overseas investment by Japanese mutual funds seems to go increasingly toward higher-yielding currencies rather than the dollar; such capital outflows will not provide much support to the U.S. Dollar then.
    
    
• Life insurers have increased their foreign securities investment to 1.2 trillion Yen from 1.1 trillion Yen in January-July 2009.
  
  • Note however that since the cost of hedging against foreign exchange risk is now relatively cheap, life insurers are likely having more currency-hedged investments, resulting probably in a lower net impact on currencies than otherwise.
     

Read Also Our Other Popular Posts on the Economy

• History of US federal debt as percentage of GDP: Why is This Now Important

   

• Factors contributing to Economic Growth and Causes for Recession and Economic Crisis
  

   

• Debt or Deficit: are we into trouble compared to other countries?

   

• Why is China Facing Inflation?
  

Click here for the USD/JPY 20-Year
Exchange Rate Trend Chart.

Thanks to the following sources that are used in this article

http://www.reuters.com/article/idUSTRE67B1PJ20100812
http://www.svb.com/10125/Why_is_the_Yen_So_Strong_Against_the_U_S__Dollar_/

Click here to sign up for our FREE newsletter and get our latest blog post in your email inbox.