Weak yen urges Japan’s status quo shift from within

The yen weakened further to the upper-148 range against the U.S. dollar at the time of writing. Its weakness should be taken seriously. Much of the related coverage by newspapers and magazines is focused on interest rate differentials between Japan and the United States, and there is no doubt that the yen’s latest fall has been triggered by the widening of the interest-rate gap between the two countries due to the U.S. Federal Reserve Board’s recent string of sharp increases in its benchmark interest rate. Nevertheless, I don’t think it makes sense to argue that this factor is entirely responsible for the yen’s slump.

The latest round of yen weakness goes back to the period from February to early March this year. On Feb. 24, Russia launched its invasion of Ukraine. The intensity of the impact of this on foreign exchange markets was incomparable to certain other market-moving factors, including a chain reaction of seemingly irrelevant events suggested by the Japanese metaphorical saying, “When the wind blows, bucket makers thrive.”

In response to the invasion, the West implemented a series of massive sanctions against Russia with striking speed, while Moscow imposed retaliatory measures. That process brought some facts to light yet again. Both the United States, which spearheaded the Western sanctions campaign, and Russia are surplus producers of energy and food — the two most important daily necessities.

The United States, which has been one of the world’s largest food-producing countries for many decades now, used to be an energy importer. Then the “shale gas revolution” began, enabling it to emerge as a leading global energy exporter.

Russia did not necessarily fare well in oil and natural gas production in the 20th century, including the decades of the now-defunct Soviet Union. Then it successfully enhanced its production of energy resources by luring in Western technology and capital. The country eventually became a major energy exporter thanks to a significant improvement in its capability to deliver energy to Europe and other destinations. Russia then joined hands with the Organization of the Petroleum Exporting Countries (OPEC) to set up the oil cartel OPEC+, of which it and Saudi Arabia are now leading members. As for food, Russia once had to rely on imports for food supplies, but the “good” effects of global warming and an improvement in agricultural technology have helped it rise to be a major grain exporter.

Declining strength

Regrettably, it seems in hindsight that few people sufficiently recognized these extreme changes in the United States and Russia, and their repercussions, to contemplate in advance what measures should be taken in response.

Japan relies on imports for about 90% of its energy and more than 60% of its food. We should bear in mind that the yen’s exchange rate reflects how such vulnerability is assessed in the market. As such, even if the interest rate differentials between Japan and the United States narrow, the yen will not necessarily revert to its mid-March value of about 115 per dollar.

The exchange rate of a country’s currency reflects its total strength. Shouldn’t Japan, therefore, realize on its own that it is now being evaluated at a lower level by foreign investors than in the past?

Japan’s inability to be self-sufficient in resources is not new at all. The same holds true for Germany.

Both Japan and Germany exerted themselves for decades after the end of World War II to update their industrial technology to make up for their vulnerability — namely, the scarcity of resources available at home. However, the two countries have lately been experiencing a decline in their technological superiority due to challenges from neighboring economies, such as South Korea and Taiwan and the Netherlands and Finland. Japan and Germany have so far managed to cover their vulnerability in terms of resources security by virtue of their respective “home grounds” — the Association of Southeast Asian Nations as a relatively open marketplace and the European Union as an integrated bloc.

Japan and Germany have manifestly differed in past decades in their approach to the foreign exchange values of their currencies. Germany, reflecting on post-World War I hyperinflation, stuck to a foreign exchange policy that prioritized maintaining the value of the deutsche mark, in principle. After its currency was integrated into the euro, Germany has continued its efforts to maintain the value of the common currency under the guise of blaming southern European countries for their inept fiscal governance.

Meanwhile, Japan suffered from rounds of sharp yen appreciation stemming from the so-called Nixon shock of 1971 and the Plaza Accord of 1985, which caused traumatic economic problems in the country. As a result, it became obsessed with the narrative of favoring a weaker yen and avoiding the angst of a stronger yen. Despite the economic structural transformation since the beginning of the 21st century, the political and business communities and the mass media in Japan keep their eyes closed and remain under the spell of calls for a weaker yen.

Deflation-induced rise?

A certain economic theory posits that the currency of a country with high inflation decreases in value relative to other currencies and, inversely, the value of the currency of a country with either deflation or low inflation increases. This theory can be applied to certain economic stages, such as the one in which the role of the concerned currency is limited to settling transactions of goods.

This theory leads people to accept, though incorrectly, that the appreciation of the yen since the turn of the century has been “excessive but unavoidable, as long as it has been in line with that academic theory.”

For about 30 years now, I’ve been questioning the above theory, saying that the argument that the currency of a country like Japan with deflation — unlike one with low inflation — can go up and strengthen is not consistent with economic common sense. But I don’t think anyone has come up with a rebuttal so far. Many people appear to be unable to squarely face the deterioration of Japan’s industrial technology, economic strength and national strength, and cannot recognize that the yen used to be extraordinarily overvalued.

Many market prices move symmetrically upward or downward to some extent, but it should be noted that foreign exchange rates change asymmetrically.

Even if excessive appreciation of a currency goes on and on, its economy will not collapse. Instead, the currency will eventually make a U-turn and enter a weakening phase once the economy begins shrinking in the wake of the negative effect of the appreciation — namely, a decline in export competitiveness resulting in lower sales abroad — mitigating the positive effect of reduced import prices.

In contrast, currency depreciation is not embedded with a mechanism that causes it to halt at a certain point. Even if export prices denominated in foreign currencies drop, there is no guarantee that products from a country with a weaker currency will sell well abroad unless they are attractive enough. As long as the economy is unable to pick up, currency depreciation remains unstoppable, causing a cascade of events — an unabated surge in import prices, increasingly stagnant domestic sales and drawn-out currency depreciation.

When the latest round of steep yen depreciation began, multiple business leaders asked me with concern: “Won’t Japanese businesses be bought up by foreign investors as a further weakening of the yen sharply lowers their U.S. dollar-based corporate valuation?”

Regardless of this situation, I don’t think foreign investors are on a buyout rampage in Japan or that they’re increasingly inquiring about acquisitions. Foreign investors are actually buying up real estate — not business entities.

Low corporate buyout activity by foreign investors does not appear to mean that Japanese businesses have watertight protection from a viewpoint of corporate security for safeguarding critically vital technologies. Even though some behind-the-scenes buyout approaches may be underway, it needs to be acknowledged that foreign investors do not see many compelling reasons to acquire Japanese businesses now that corporate assets in this country have become less attractive.

Japan must ascertain on its own whether its overall economic strength has begun declining, including its industrial technology. Turning points often arise thanks to external stimuli. Nevertheless, isn’t it necessary for Japan to exhibit foresight and a priori change the status quo on its own initiative?

Hiroshi Watanabe

Watanabe is president of the Tokyo-based Institute for International Monetary Affairs. Previously, he has served as vice finance minister for international affairs and governor and chief executive officer of the Japan Bank for International Cooperation.