The BoJ faces a dilemma in containing a sharp depreciation of the yen while not causing significant disruption to global financial markets. — Bloomberg
THE Japanese yen recently hit 150 against the US dollar, the market psychological threshold, which also marks the weakest level not seen since August 1990. That was the level that market investor thought could prompt Bank of Japan (BoJ) to intervene to prop up the currency, to be accompanied by its exit of super easy monetary policy.
Since the US Federal Reserve’s (Fed) rate hike cycle started in March 2022, the yen is the worst performing currency, down by 18.7% against the US dollar from March 2022 to Nov 8.
The main culprit driving the yen’s persistent weakness is the large interest rate differentials between Japan and the United States as well as prospects of high US interest rates for longer caused by surging US Treasury yields amid a resilient US economy compared with a slow recovery of the Japanese economy.
The land of the rising sun has been embroiled in almost three decades of economic stagnation and deflationary pressures.
Amid an uneven pace of economic growth, BoJ has been maintaining super accommodative monetary by keeping negative short-term interest rates since 2016 together with applying the yield curve control (YCC) policy, which pegs the 10-year bond yield around 0%, to control longer term interest rates through the buying and selling bonds of specific tenures.
In July, the BoJ has effectively widened its yield target band on the 10-year Japanese Government Bond by 50 basis points to 1% on either side, sparking market expectations that the yields tweaking is a precursor to the ending of negative interest rate policy.
Market investors remain unclear whether the central bank will continue to maintain negative interest rate policy to sustain domestic demand, or to raise interest rates to contain excessive depreciation of the yen.What will happen to the apanese economy?
It will likely shrink in the third quarter of this year on weak exports and consumer demand due to increase in consumer prices. Despite the yen’s depreciation, export volume has not increased, private business activity slowed, and industrial production shrank.
The services sector, in particular the tourism sector benefited from increased foreign tourists.
What happens to the underlying price increases? There are reasons to expect that BoJ will be able to sustain its inflation target of 2% on the following developments:
> Core inflation continuing to increase steadily at 2.7% in September, staying well above the 2% target for a 18th straight month. There are increasing signs that the price pressures have broadened. The yen’s weakness will hurt households and retailers by inflating the already rising prices of imported fuel and food.> Next spring’s annual wage negotiations or shunto between union workers and major companies could see their inflation-adjusted wages rise again that helps to sustain price increases.
The BoJ governor has alluded that the central bank would have enough wage data, including on the outlook for wages, which is a key factor in BoJ’s decision-making on the stance of monetary policy.
The BoJ’s September survey showed that 86.8% of Japanese households expect prices to rise a year from now, a tad higher than 86.3% in June.
Rapid price increases are viewed as a risk to financial stability for the policymakers, but for Japan, it is deemed desirable as the government is determined to prevent the economy from falling back into deflation as experienced in the bouts of deflation since the late 1980s and early 1990s.
The BoJ faces a dilemma in containing a sharp depreciation of the yen while not causing significant disruption to global financial markets.
The central bank has twice tweaked its YCC policy settings to manage risks to the currency and inflation outlook.
Excessive weakening
The yen’s depreciation has raised the probability of the Japanese authorities intervening to support the yen from too excessive weakening against the US dollar.
Foreign exchange intervention (via using foreign currency to buy yen) will reduce the money supply and tighten monetary conditions, which runs counter to BoJ’s expansionary monetary policy.Yen-buying intervention is more difficult than yen-selling.
While the currency interventions would only provide a temporary reprieve for the yen, it is costly and can deplete
Japan’s reserve assets of US$1.25 trillion at end-July 2023.
Moreover, Japan has a limited amount of foreign reserves that can be used to buy the yen.
In October 2022, BoJ’s intervention had helped to gain some strength in the weak yen for a few months, but the yen has consistently depreciated since January 2023.
There were a few periods where the central bank has had intervened intensely to counter the depreciating yen against the US dollar – in 1991-1992 and during the 1997-1998 Asian Financial Crisis, which saw the yen weakened, reaching nearly 148 per US dollar in August 1998. It was inflicted by the massive capital outflows in the region.
How soon will the BoJ call time on negative interest rates?
Governor Kazuo Ueda recently remarked that it has various options once it is confident that Japan has achieved sustained price increases accompanied by rising wages.
Interest rate normalisation
We expect the BoJ to embark on a normalisation of interest rate, probably in the first half 2024, once the policymakers have a better sense of the next year’s shunto (wage negotiation) outcome, which will provide a clear outlook in wage growth in 2024
We expect BoJ to adopt a gradual approach to raising interest rates, by carefully assessing the underlying economy and inflation while would not be too focused on reducing the side effects of monetary easing.
What does it mean for bond and foreign exchange markets? Japan has been the world’s largest net creditor for more than three decades, with a net international investment position of US$3.3 trillion at end-June 2023.
A prolonged period of rock-bottom or negative interest rates at home has encouraged yield-seeking Japanese private institutional investors to park their savings overseas, particularly in foreign bonds, as well as caused domestic and foreign investors to borrow cheap yen to invest in bond and equities for getting higher yields.The eventual exit of Japan’s negative interest rate policy will cause global spillover effects on capital flows and assets market.
A return to positive interest rates, albeit at a measured pace and the normalisation of Japanese government bond yields may unwind the yen carry trade and spark a decade-long repatriation of Japanese capital funds parked in foreign assets.
Hence, rising Japanese government bond yields could lure Japanese investors to plough back their capital back to domestic assets as well as help to attract more foreign investment inflows into Japan, a move that could trigger volatility in global financial and foreign exchange markets.The flow reversal is already underway.
Japanese capital reversal could hurt the valuation of overseas assets and put upward pressure on global yields by fuelling foreign sales by Japanese or purchases of Japanese assets by foreigners.
This was seen in December when the BoJ surprised markets by increasing its target band around 10-year yields.
Spillover effects
Such financial spillover effects would likely be larger in countries such as the United States, some eurozone countries and Australia, where Japanese investors own a large share of foreign countries’ debt.
Global bond yields’ volatility would dampen investors’ sentiment and appetite in the emerging markets.
With the Fed likely to keep high interest rates for a longer while, the yen is expected to strengthen against the US dollar and other currencies when BoJ starts reversing its negative interest rate policy.
Given that the bond yields and assets’ valuation impact as well as volatile currency moves were chiefly the side effects of the BoJ’s eventual departure from its super easy monetary policy, it is important that BoJ gives clear market communication and guidance about its future monetary policy stance.
This is vital to mitigate potential unintended consequences and heightened market volatility.
Lee Heng Guie is Socio-Economic Research Centre executive director. The views expressed here are the writer’s own.
