Relatively recent upstarts like the euro and the yuan may hog the currency headlines these days, but for sheer drama and gut-wrenching volatility, no currency can match the venerable Japanese yen. The yen has frequently found itself in the spotlight since it transitioned to a floating currency in the early 1970s. It has had an incredible trading range over the past 40-plus years, ranging from 360 to the dollar in 1971 to 75.35 in late 2011. Along the way, the yen has spawned a whole series of fascinating sub-plots with colorful terminology - a massive asset bubble, the “lost decade,” carry trades, “Mrs. Watanabes,” “Abenomics” and “three arrows.”
The Early Years
Under the Bretton Woods system, the yen was pegged at a level of 360 to the dollar from 1949 until 1971, when the United States abandoned the gold standard in response to a huge outflow of bullion holdings spurred by the nation's mounting trade deficits. To redress its trade deficits, the U.S. also devalued the dollar against the yen in 1971, fixing it at a level of 308 per dollar.
By 1973, most major world currencies, including the yen, were floating. The Japanese economy managed to withstand the challenging environment of the 1970s, characterized by soaring oil prices and rampant inflation. By the mid-1980s, the Japanese export juggernaut was again accumulating substantial current account surpluses. In 1985, with the U.S. current account deficit approaching 3% of GDP, the G5 countries (the U.S., France, West Germany, Japan, and the United Kingdom) agreed to depreciate the dollar’s value against the yen and deutsche mark, in order to rectify burgeoning trade imbalances.
This agreement, which has gone down in posterity as the Plaza Accord, caused the yen to appreciate from about 250 to the dollar at the beginning of 1985, to below 160 in less than two years. Some experts believe that this surge in the value of the yen was the root cause of the subsequent asset bubble and bust, which in turn led to Japan’s lost decade.
Japan’s Asset Bubble and Lost Decade(s)
The 50% appreciation in the yen took its toll on the Japanese economy, which fell into recession in 1986. In order to counter the yen’s strength and reinvigorate the economy, Japanese authorities introduced sizeable stimulus measures, which included reducing the benchmark interest rate by about 3 percentage points. This accommodative monetary policy stance was left in place until 1989. In 1987, a sizeable fiscal package was also introduced, even though the economy had already begun taking off.
These stimulus measures caused an asset bubble of truly breathtaking proportions, with stocks and urban land prices tripling from 1985 to 1989. An oft-cited anecdote about the extent of the real estate bubble is that at its 1990 peak, the value of just the Imperial Palace grounds in Tokyo exceeded that of all the real estate in California.
These valuations were simply unsustainable, and predictably, the bubble burst in early 1990. Japan’s Nikkei index lost a third of its value within a year, setting the stage for the lost decade of the 1990s, when the economy barely grew as deflation took an iron grip. While Japan was one of the fastest-growing economies in the three decades from the 1960s to the 1980s, real GDP growth has averaged only 1.1% since 1990.
The first decade of this millennium was another lost decade, as the economy continued to struggle and the global credit crisis made matters worse. At its October 2008 low of just below 7,000, the Nikkei index had plunged more than 80% from its December 1989 peak. In 2010, Japan was overtaken by China as the world’s second-largest economy.
The Trillion-Dollar Yen Carry Trade
In order to get the economy going and combat deflation, the Bank of Japan (BOJ) adopted a zero interest rate policy (ZIRP) for much of the period since 1990. This made the yen an ideal funding currency for the carry trade, which essentially involves borrowing a low-interest currency and converting the borrowed amount into a higher-yielding currency. As long as the exchange rate remains quite stable, the trader can pocket the interest differential between the two currencies. Since foreign exchange fluctuation is the main risk of carry trades, their popularity is inversely proportional to exchange rate volatility.
By 2007, with volatility on one-month yen options at a 15-year low, and with the Japanese currency depreciating steadily against the dollar, carry trades with the yen as a funding currency had reached an estimated $1 trillion. But that hitherto profitable trading strategy began to unravel as the credit crisis began hitting global financial markets in the second half of 2007. As risk appetite vanished literally overnight, panicked speculators and traders were forced to sell their highly leveraged assets at fire-sale prices, and then endure the mortification of repaying their yen borrowings with a sharply appreciating currency.
The yen surged by 20% against the dollar in 2008, the year the credit crisis peaked. A popular carry trade before the crisis erupted involved borrowing yen to invest in Australian dollar deposits, which were yielding a significantly higher rate of interest; this was equivalent to a short JPY/long AUD position. As the crisis worsened and credit dried up, the stampede to close out this position resulted in the Australian dollar plummeting by 47% against the yen in the one-year period commencing October 2007. A speculator who had borrowed 100 million yen, converted it to AUD in October 2007 (at an exchange rate of about 107.50) and placed the resultant AUD in a higher-yielding deposit, would have suffered a loss of 47 million yen a year later, as the exchange rate plunged to a low of 57.
Domo Arigato, Mrs. Watanabe!
Currency speculators large and small were severely affected by the 2007-2008 credit crisis. Among the smaller players, Japanese retail investors lost an estimated $2.5 billion through currency trading in August 2007 alone, as the crisis was just unfolding. Their eventual losses by the time the crisis peaked may have been many multiples of that number.
An unexpected category of speculator to be lured by the prospect of quick profits through online currency trading was the Japanese housewife, dubbed “Mrs. Watanabe” by forex traders. Given the paltry returns from yen deposits in the first decade of this millennium, legions of Mrs. Watanabes ventured into online currency trading in order to increase the low returns on their portfolios. Their modus operandus was typically to sell the yen and buy higher-yielding currencies, unwittingly getting into the carry trade by doing so.
While estimates vary about the extent of currency trading by these Japanese retail investors, some experts placed it at about $16.3 billion per day in 2011, or almost 60% of daily customer forex transactions (excluding interbank trading) during Tokyo trading hours. Retail trading volumes contracted sharply from 2012, as regulations imposed by Japanese authorities in August 2010 on the maximum permissible forex leverage went into effect. These restrictions limited forex leverage to a maximum of 25 times the invested amount, compared with as much as 200 times before the regulations were imposed.
In any case, the influence of Mrs. Watanabes and other Japanese retail investors on the level of the yen was tacitly acknowledged by the Bank of Japan in 2007, although it stopped short of saying Domo Arigato (translation: thanks a lot!). In July of that year, Bank of Japan member Kiyohiko Nishimura said that the “housewives of Tokyo” were acting to stabilize forex markets, by taking yen positions (i.e. selling yen and buying foreign currencies) opposite to that of professional traders.
Yen Trading Surges
According to the Bank for International Settlement’s (BIS) triennial survey of forex turnover, conducted in 2013, trading in the Japanese yen increased the most among the major currencies over the preceding three years, surging by 63% since the 2010 survey. While overall currency trading in the global forex market increased by 34.6% since 2010 to $5.345 trillion per day, trading in USD/JPY soared by 72.5% to $978 billion daily.
While a tiny part of that USD/JPY forex turnover may be backed by actual trade flows, the bulk of it seems to be speculative. Japan was the United States’ fourth-largest trading partner in 2013, accounting for just over 5% of total trade for the U.S. The United States had a merchandise trade deficit of $73.4 billion with Japan in 2013, importing goods worth $138.5 billion (cars, machines, industrial equipment, and electronics) and exporting goods worth $65.1 billion to Japan (mainly agricultural products, meat, pharmaceuticals and healthcare equipment).
The 2013 BIS survey noted that regional semiannual surveys suggest most of the increased yen trading occurred between October 2012 and April 2013, during which period there were growing expectations of a regime shift in Japanese monetary policy. Which brings us to “Abenomics” and “three arrows.”
Will Abenomics’ Three Arrows Hit Their Mark?
Abemonics refers to the unprecedented and ambitious economic policy framework announced by Japanese Prime Minister Shinzo Abe in December 2012, to revitalize the Japanese economy after two decades of stagnation. Abenomics has three main elements or arrows - monetary easing, flexible fiscal policy and structural reforms - aimed at ending deflation, boosting economic growth and reversing the increasing amount of the nation’s debt.
The first arrow from the Abenomics quiver was launched in April 2013, when the Bank of Japan announced that it would buy Japanese government bonds and double the nation’s monetary base to 270 trillion yen by the end of 2014. The BOJ’s objective in introducing this record level of quantitative easing is to vanquish deflation and achieve inflation of 2% by 2015.
The second arrow of flexible fiscal policy involves debt-financed spending and fiscal consolidation starting in 2014, with the goal of slashing the fiscal deficit in half by fiscal year 2015 (from its 2010 level of 6.6% of GDP) and achieving a surplus by 2020. One of the tools to this end is an increase in Japan’s sales tax to 8% starting April 2014, from 5% previously. The third arrow - widespread structural reform - while potentially imparting the biggest benefit to the Japanese economy over the long term, is also seen as the hardest one to launch.
Abenomics’ measures paid off in spades in 2013, as the Nikkei index soared 57% for its biggest annual gain in 41 years, and the yen depreciated 17.6% versus the dollar. However, economic data in the first two months of 2014 has cast some doubts on the sustainability of the positive effects of Abenomics. The Japanese economy grew only 0.3% in the fourth quarter of 2013, which translates into an annualized growth rate of 1%, well below economists’ expectations of 2.8% growth. Japan also reported a record trade deficit of 2.79 trillion yen in January as a 25% increase in imports to an all-time high outweighed a 9.5% rise in exports.
The Bottom Line
Traders who are bearish on the yen point to Japan's huge debt load and dismal demographics as evidence of the nation's grim prospects over the long term. Japan’s net debt-to-GDP was 140% in 2013, making it the second-most indebted nation in the world after Greece. But as history has shown on more than one occasion, betting on a one-way decline in the yen can be a recipe for disaster. Retail investors and traders who are tempted by the idea of shorting the yen would do well to leave this trade to large institutions and banks that can afford to take the hit if the yen - currently trading at about 102 to the dollar - does not tumble as expected.