Why The Yen Is So Strong

By Eric Fox | April 12, 2011 AAA
Why The Yen Is So Strong

The earthquake and tsunami that struck Japan on March 11 was a terrible tragedy that killed thousands and resulted in hundreds of billions in property damage. The natural disaster also had an impact on the position of Japan in the global economy, affecting the value of the Japanese yen versus other major currencies, as well as affecting GDP growth in Japan and other countries in the region. (For related reading, also take a look at The US Dollar And The Yen: An Interesting Partnership.)

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Cost Estimate
The final cost of the natural disaster will not be known for years, but the Japanese government recently estimated the damage in a range between US$200 billion to US$300 billion. This makes the earthquake and Tsunami the costliest natural disaster in history.

Currency Impact
The initial reaction in the currency markets was a strengthening in the value of the yen versus the U.S. dollar, something that might seem counterintuitive to many investors due to the large amount of expenditures required to repair the physical damage to Japan. The yen continued to rise in value and eventually reached a post World War II high of approximately 76 yen to the dollar.

One reason the yen might have strengthened in value compared to other currencies is that the market felt that the Japanese government and corporations might have to liquidate part of their large non-yen denominated investment portfolio to fund relief and reconstruction efforts in Japan.

The Japanese government is the second largest foreign owner of U.S Treasuries after China, with $886 billion in holdings as of March 15. The market may have anticipated a partial liquidation of these and other investments and subsequent repatriation back into the yen.

Bargain Hunting
Another explanation for the strength in the yen might be a surge in buying of Japanese equities as bargain hunters looked for value in the Japanese stock market. The Nikkei 225 Index fell immediately after the earthquake struck, declining from the 10,400 level to a low near 8,200 a week later. This decline might have been seen as a buying opportunity by many institutional investors who then needed to buy yen to purchase Japanese stocks.

Warren Buffett, the famous value investor and CEO of Berkshire Hathaway (NYSE:BRK), said that the natural disaster would not impact Japan's economy and noted that events like these have historically provided opportunities to purchase stocks.

Export Economy
The strong yen eventually started to concern the Japanese government as that economy is based on exports and is impacted by currency rate fluctuations, with exporters hurt when the yen rises in value against other currencies. Toyota (NYSE:TM) estimates that every one yen move in the Japanese currency versus the U.S. dollar will cost the company $380 million a year.

This concern led to a joint intervention into the currency markets by Japan and several other members of the Group of Seven, an informal association of some of the largest industrialized countries in the world. This coordinated effort to sell yen brought the exchange rate back to the 82 level.

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GDP Impact
The cost estimate by the Japanese government covers only reconstruction and does not include any effect on the economy from the natural disasters. Economists have mixed opinions on the impact of these events on GDP growth.

The area in northern Japan hit by the earthquake accounted for an estimated 7% of the country's GDP, and was also the location of a large number of industrial facilities owned by major Japanese corporations. There was also a significant impact on the supply of power in Japan as many nuclear and other electricity generation plants were shut down as a result of the earthquake.

Supply Chain
The disaster in Japan may result in disruptions to production and an impact on the supply chain in many industries around the world, with the automotive industry being most affected. Honda Motor Company (NYSE:HMC) and other automakers were forced to cut output at plants across the world due to the disruption.

These negative effects on the economy are offset by the huge amount of spending that will be required over the next year to rebuild the areas devastated by the natural disasters. The Japanese government has also acted quickly to limit the impact of power shortages, with increased imports of fossil fuels to make up for lost power output.

The private sector has started to shift production from the affected area to other factories if possible, and has also moved quickly to restart production at factories that were originally taken offline. Hitachi (NYSE:HIT) recently announced that full production at its main plant would resume in April 2011, a disruption of only one month.

Other companies moved even quicker. Kyocera (NYSE:KYO), which makes products ranging from chemicals to phone handsets to semiconductors, restarted production at four factories within one week of the disaster.

The disasters also have a collateral impact on other economies in the region. The government of Taiwan estimates that its own GDP growth will be reduced from seven to 20 basis points in 2011, as the country expects to see exports to Japan be reduced by $1 billion due to reduced demand from Japanese companies. The Council for Economic Planning and Development still sees GDP growth between 4.72% and 4.81% in 2011.

The Bottom Line
The recent earthquake and tsunami that devastated Japan was a horrible tragedy that also had a ripple effect on the currency and equity markets, as well as an unknown impact on economic growth throughout the world. (For additional reading, see Lessons Learned: Comparing The Japanese And US Bubbles.)

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