The yen has risen 16% against the dollar, with the yen/dollar rate now standing at Y90/US$, after hovering below Y107/US$ before the subprime turmoil. The yen strength is the result of the increased preference for safe assets following the global financial crisis. However, we believe it appreciated too much. Excessive rises in the yen delayed the Japanese economic recovery and protracted deflation. Even in terms of effective forex rates, the yen is highly overvalued. As such, we believe the yen will soften going forward.
△Three reasons for yen softness
Going forward, we expect the yen to weaken for the following reasons. First, the BOJ is expected to favor yen weakness. The BOJ left the key rate at 0.1% at its meeting last week, while passing an unexpected plan for additional liquidity injections (W20tn), which we believe is aimed at yen depreciation. So far, the central bank has refrained from hinting at supporting yen weakness, stating that the liquidity injection was not an attempt to control forex rates. Despite the central bank’s rhetoric, we believe it needs to soften the yen if it is to revive the economy. Even if it does not opt for aggressive measures, it will likely take other passive policies to weaken the currency, at a time when the US intends to soften the dollar to benefit its economy.
Second, advanced currencies are softening all around the globe. Indeed, economic recovery in the US, UK, Japan, and eurozone are much slower than in emerging nations. Moreover, exit strategies are unlikely this year for advanced nations, which should further widening the interest rate gap with emerging nations that are likely to raise their key rates. Furthermore, fiscal deficit is deepening, indicating the yen strength cannot be sustained.
Third, economic conditions in Japan are not strong enough to sustain the yen. Japan has yet to rise out of deflation, while emerging nations are entering inflation and the US and Europe have shrugged off fears of deflation. Thus, deflation is likely to make the yen soften.
△Yen softness to favor yen carry trade
Yen depreciation should lead to the resumption of yen carry trades. Given historic-low yen funding rates in terms of three-month Libor, yen carry trading is highly likely to resume. And, if the yuan appreciates, we believe it is even more likely.
Yen weakness and the resumption of yen carry trading should signal the shift in investor preference from safe assets to risky assets. Once yen carry trading begins, money should flow into emerging equities and property.
Historically, money from yen carry trades headed to Australia and New Zealand, with limited funds coming into Korea. However, yen carry trades should increase overall global investment, and if so, foreign money should move towards Korea, benefiting the Korean stock market.
However, there are some negatives for yen carry trading. For one, we note lingering credit risks. Fiscal deficits in Europe have yet to fade. Thus, if credit issues spread again, global investors will favor safe assets again, dampening yen carry trading. In addition, if the US economy picks up more quickly than expected from April, the preference for safe assets may increase, and China’s tightening policies may undermine investor sentiment.
Still, we do not believe that credit issues will resurface or deteriorate further. The US and global economies are unlikely to face a double-dip recession, and China’s tightening measures are unlikely to derail the ongoing economic recovery. In conclusion, we expect yen carry trading to resume soon.
△Yen carry trade to increase inflationary pressure on emerging countries
Yen weakness and carry trading should gradually increase inflationary pressure for emerging countries. Yen carry capital should flow into asset markets in emerging countries, triggering liquidity expansion and inflation in the relevant countries. Some of the carry capital could trigger cost-push inflation by flowing into crude oil and commodity markets and raising commodity prices.
As major developed countries are unlikely to raise rates in 2010 and emerging countries are only expected to raise rates slightly, inflationary pressure could expand in emerging countries due to liquidity effects and economic recovery. Overall, developed countries should also be exposed to inflationary pressure due to their weakening currency.
Meanwhile, if the yen weakens and yen carry trading resumes, it should negatively affect Korean exporters. Given the fierce competition between Korean and Japanese export goods, a weak yen should enhance the price competitiveness of Japanese goods, weighing on Korean exporters in terms of prices, unless export volume expands sharply.
Korean companies enjoyed global market share expansion during the financial crisis due to the weak won and strong yen. If the yen turns weak, domestic companies’ market shares are likely to drop.
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