Monday, May 28, 2007

The Extent of the Yen's Decline

There is a joke in Swedish that it is always safe to lend to a Japanese because "de betalar alltid i-yen" (they always pay back [the money]), alluding to the phonetic similarity between the name of the Japanese currency and the Swedish word "igen" which in this context means "[pay] back".

In reality though, lending to Japanese have proven to be one of the worst deals around, at least during the latest decade. Not only is interest rates extremely low, but the exchange rate of the yen have been very weak during the latest decade. While the U.S. dollar have fallen against most currencies, including virtually all European currencies and the dollars of Canada, Australia and New Zealand, it have actually risen against the yen. Implying of course that other currencies have risen even more dramatically against the yen. And while the appreciation of the Chinese yuan against the U.S. dollar have been too slow, at least it have changed in the right direction, in contrast to the yen which have changed in the wrong direction.

Interestingly, this depreciation of the yen occurs at the same time as Japan have had much lower inflation than other countries, seemingly putting the purchasing power parity(PPP) theory into question.

The PPP-theory is valid as a basic framework for analyzing long-term trends in exchange rate movements. But one should always be aware of the fact that there are factors which cause deviations from this basic pattern. Or in other words, there are things that cause fluctuations in the real (PPP-adjusted) exchange rate. One of the most important of them is fact that differences in productivity in sectors with traded goods help bid up wages in the non-traded sectors (where productivity is more similar) of high productivity countries and so help raise the price level in those countries. Note that this is a factor which would cause real exchange rate fluctuations inside currency unions as well.

The other highly important factor is asset price differentials, and particularly bond price differentials or in other words bond yield differentials. Unlike the previous one, this factor would not exist in a currency union. Japan's extremely low bond yields have been a key factor in pushing down the real exchange rate of the yen.

There are other factors apart from these two which cause differences in real exchange rates, but they are the most important and relevant for the case of Japan.

So just how big have the yen's decline been? While OECD estimates ( found here) of real exchange rates should be taken with a grain of salt, they are still likely roughly true. While the yen have fallen so that a dollar now costs 122 yen compared to 85 in 1995, the PPP-exchange rate have fallen from 170 to 124 in 2006. And with inflation in Japan running about 3%:points lower than in the U.S., the PPP-exchange rate should fall to about 120 this year. Meaning that in just 12 years the real exchange rate of the yen has been cut in half (from 170/85 to 120/122).

This dramatic decline in the yen's real exchange rate reflects in part that Japan have had lower population- and GDP growth and so helped push down relative domestic prices. But in recent years, the carry trade phenomena have been a important factor in pushing down the yen.


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