Currency Profiles: Guide to Developed Countries Currencies

Japan

Economic Overview

Japan is the third largest economy in the world with GDP valued at over US$4Trl in 2002 (behind the US and the entire Eurozone or EMU). The country is also one of the world's largest exporters and is responsible for over $400bln in exports per year. Manufacturing and exports account for nearly 20% of GDP. This has resulted in a consistent trade surplus, which creates an inherent demand for the JPY, despite severe structural deficiencies. Aside from being an exporter, Japan is also a large importer of raw materials for the production of their goods. The primary trade partners for Japan in terms of both imports and exports are the US and China. China is becoming an increasingly important trade partner, as China's inexpensive goods have allowed it to gain a larger share of Japan's import market.

Japanese Banking Crisis

In the 1980s, Japan's capital market was one of the most attractive markets for international investors seeking investment opportunities in Asia. They had the most developed capital markets in the region and their banking system was considered to be the one of strongest in the world. The country was experiencing above-trend economic growth and near-zero inflation. This resulted in rapid growth expectations, boosted asset prices and rapid credit expansion, leading to the development of an asset bubble. Between 1990-97, the asset bubble collapsed, inducing a USD$10trl fall in asset prices, with the fall in real estate prices accounting for nearly 65% of the total decline, which is worth two years of national output. This fall in asset prices sparked the banking crisis in Japan. It began in the early 1990s and then developed into a full blown systemic crisis in 1997 following the failure of a number of high profile financial institutions. Many of these banks and financial institutions extended loans to the builders and real estate developers at the height of the asset bubble in the 1980s, with the land as the collateral. A number of these developers defaulted after the asset bubble collapse, leaving the country's banks saddled with bad debt and collateral worth sometimes 60-80% less than when the loans were taken out. Due to the large size of these banking institutions and their role in corporate funding, the crisis had profound effects on both the Japanese and global economy. As a result, enormous bad debts, falling stock prices and a collapsing real estate sector have crippled the Japanese economy for almost two decades.

With Japan experiencing deflationary conditions, each succeeding month of deflation raises the real burden of the banks' outstanding debt. To date, the Japanese Ministry of Finance and Bank of Japan is still grappling with this problem and has only injected capital into these ailing banks as a solution to prevent bankruptcies. Since the beginning of the crisis, they have hoped that the banks would grow their way back to health.

In addition to the banking crisis, Japan has the highest debt level of all of the industrialized countries, at over 140% of GDP. The chart below shows the country's deteriorating fiscal positions, with public debt continuing to rise, which has resulted in the country experiencing over 10 years of stagnation. With this high debt burden, Japan stands at risk of a liquidity crisis.

The banking sector has become highly dependent on a government bailout. As a result, the JPY is very sensitive to political developments such as speeches by government officials with rhetoric that may indicate potential changes in monetary and fiscal policy, attempted bailout proposals, and any other rumors.

Monetary and Fiscal Policy Makers

The Bank of Japan (BoJ) is the key monetary policymaking body in Japan. In 1998, the Japanese government passed laws giving the BoJ operational independence from the Ministry of Finance (MoF) and complete control over monetary policy. However, despite the government's attempts to decentralize decision-making, the MoF still remains in charge of foreign exchange policy. The BoJ is responsible for executing all official Japanese foreign exchange transactions at the direction of the MoF. Monetary Policy Meetings are held twice a month with briefings and press releases provided immediately. The BoJ also publishes a Monthly Report issued by the Policy Board, and a Monthly Economic Report. These reports are important to watch for changes in BoJ sentiment and signals of new monetary or fiscal policy measures, as the government is constantly trying to develop initiatives to stimulate growth.

The MoF and the BoJ are very important institutions who both have the ability to impact currency movements. Since the MoF is the director of foreign exchange interventions, it is important to watch and keep abreast of the comments made from MoF officials. Being an export driven economy, the MoF favors a weak JPY.

The most popular tool that the BoJ uses to control monetary policy is the following:

Open Market Operations: These activities are focused on controlling the uncollateralized overnight call rate. Since the discount rate is zero, the Bank of Japan cannot further decrease this rate to stimulate growth, consumption or liquidity. Therefore in order to maintain zero interest rates, the BoJ has to manipulate liquidity through open market operations, targeting zero interest on the overnight call rate. They manipulate liquidity by the outright buying or selling of bills, repos or Japanese government bonds. A repo transaction involves a cash taker (borrower) selling securities to a cash provider (lender), while agreeing to repurchase the securities of the same type and quantity at a later date. This structure is similar to a secured loan, whereby the cash taker must pay the cash provider interest. Repo transactions tend to have very short maturities ranging from one day to a few weeks.

In terms of fiscal policy, the Bank of Japan is currently considering a number of methods to deal with their non-performing loans. This includes inflation targeting, nationalizing a portion of private banks and repackaging the banks' bad debt and selling them at a discount. No policies have been decided upon, but the government is aggressively considering all of these and other alternatives.

Important Characteristics of the JPY

  Proxy for Asian strength / weakness

Japan is a proxy for Asian strength because they have the largest GDP in Asia. With the most developed capital markets, Japan was once the primary destination for all investors who wanted access into the region. Japan also conducts a significant amount of trade with its Asian partners. As a result, economic problems or political instability in Japan, tend to spill over into the other Asian countries. However, this spillover is not one-sided. Economic or political problems in other Asian economies can also have dramatic impacts on the Japanese economy and hence, JPY movements. For example, with North Korean political instability, Japan and the JPY are at the greatest risk of the G7 countries, as they have the strongest ties to North Korea.

  BoJ intervention practices

The BoJ and MoF are very active participants in the FX markets. That is, they have a lengthy history of entering the FX markets if they are dissatisfied with the current JPY level. Periodically they receive information on large hedge fund positions from banks and like to intervene when speculators are on the other side of the market, allowing them to get the most "bang for the bucks." There are typically three main factors behind BoJ and MoF intervention:

  1) Amount of appreciation/depreciation in JPY

  2) Current USD/JPY rate

  3) Direction of speculative positions

  JPY movements are sensitive to time; Fiscal year end, Japanese trading hours

JPY crosses can become very active towards the end of the Japanese fiscal year (March 31), as exporters repatriate their dollar denominated assets. This is particularly important for Japanese banks because they need to rebuild their balance sheets to meet FSA guidelines, which require the banks to mark to market their security holdings.

Japanese traders tend to take hour-long lunches between 10pm-11pm EST, leaving only a junior trader in the office. Therefore, the Japanese lunchtime can be volatile, as the market gets very illiquid. During Japanese and London hours, the JPY tends to move fairly orderly unless breaking announcements or government official comments are made or surprising economic data is released. During US hours however, the JPY tends to have higher volatility.

  Banking stocks are widely watched

Since the crux of Japan's economic crisis stems from the non-performing loans (NPL) of the Japanese banks, banking stocks are closely watched by FX market participants. Any threat of default by these banks, disappointing earnings or further reports of significant NPLs can indicate even deeper problems for they economy. Therefore, bank stock movements can lead JPY movements.

  Carry trade effects

The popularity of carry trades has increased in recent years, as investors are actively seeking high yielding assets. With JPY having the lowest interest rate of all industrialized countries, it is the primary currency sold or "borrowed" in carry trades.

Important Economic Indicators For Japan

  Gross Domestic Product

  Tankan Survey

  Balance of Payments

  Employment

  Industrial Production

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