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Can Yen Appreciation be Corrected?

Implications of Yen Evaluation and Switzerland’s Unlimited Interventions

Hidetaka Yoneyama, Senior Research Fellow

January 6, 2012 (Friday)

1. Evaluating Yen Rate Using Real Effective Exchange Rate (REER)

The appreciation of the yen continues at a rate of seventy-some yen to the dollar, and concerns about the adverse effects on Japan’s economy grow ever stronger. As when the yen appreciated in the past, many export companies and related midsize and small businesses are calling for a correction of appreciation.

The recent appreciation has been called “super appreciation” or “historical appreciation”; let us look more closely at these terms. If we compare the rates of Japan and other countries not simply against the dollar, but with the nominal effective exchange rate’s weighted average based on amount of trade (which shows the yen’s general value against main currencies), we see that the yen’s value is higher than it has ever been. This is what is meant by “super appreciation.” (Figure 1)

 Figure 1: Nominal Effective Exchange Rate

Source: BIS

However, as has often been pointed out, while Japan has been in a trend of deflation these past 10 years or more, prices in other countries have been going up. Looking at only relative prices, it should be obvious that countries with high rates of price increase have currencies that are going down in value, while Japan’s currency has increased in value due to deflation. If we compare using the real effective exchange rate (REER), which adjusts for price fluctuations, we see that while the yen has basically appreciated according to 2005 levels, there is no appreciation worth mentioning at present (Figure 2). In fact, the RMB is the currency which has undergone the greatest increase in value since 2005. This is due to China loosely inducing appreciation as it continues to grow economically.

 Figure 2: Real Effective Exchange Rate

Source: BIS

Whether we look at the nominal or real effective exchange rate, the currency with the lowest value since 2005 is the South Korean won. The reason the won has not appreciated is because the South Korean economic structure is very export-dependent (South Korea’s exports account for approximately 60% of its GDP, compared to Japan’s 20%) and it has adopted depreciation policy which is advantageous when it comes to exports. South Korean authorities will not admit to it, but their repeated and disguised interventions are well-known secrets, and financial policy has been carried out in a tone of easing which will result in fairly high inflation rates.

If the won is kept low while the yen appreciates even slightly, then Japan will lose its exporting competitiveness in products for which it competes with South Korea. Even if the yen were not experiencing historical appreciation by the standard of REER, Japanese export companies would still find the current appreciation very troubling because the yen continues to appreciate while rival Asian countries such as South Korea maintain their inexpensive currencies.

2. Evaluating Yen Rate Using Purchasing Power Parity (PPP)

Next, let us look at how yen appreciation is evaluated by comparison with PPP. Let us compare nominal rate against the dollar with PPP. As is often pointed out, even if the nominal rate varies in the short term, it tends to return to the PPP level in the long term. PPP is a numerical value calculated by the OECD by surveying approximately 3000 products and services for each country.

Comparing nominal rate and PPP, we see that after the Plaza Accord of 1985 the nominal rate rose markedly above the PPP, i.e. the yen appreciated, after which this divergence slowly shrank until from 2005-2007 the two drew very close together (Figure 3). After the Lehman Shock, however, the American economy slowed to a crawl and the FRB went ahead with significant financial easing, resulting in the gap between the two rates widening once more. However, the current gap is not particularly much larger than it was in the past, and so from the point of view of the PPP it is hard to say that the yen is “super appreciated.”

Nevertheless, the reason companies find the current appreciation so burdensome is that after the Plaza Accord they were forced to continuously take measures dealing with appreciation, and even though the nominal rate and PPP drew close together for a time from 2005-2007, at this stage the yen is appreciating away from the PPP once again.

 Figure 3: Nominal rate and PPP

Source: OECD, IMF (Note: nominal rate for 2011 is the mean from Jan-Aug.)

3. Relationship between Real Effective Exchange Rate and Purchasing Power Parity

I have examined how the current yen appreciation can be evaluated based on REER and PPP, and I have found the relationship between the two can be straightened out as follows. For ease of explanation, I use the real exchange rate with the dollar instead of the REER. Also, please note that the unit of the real exchange rate ($/¥) used here is the opposite of that of the nominal exchange rate (¥/$).

Whereas the PPP is calculated by taking the ratio of Japanese prices to American prices (Jprice/USprice), the real exchange rate is calculated by multiplying the reciprocal of the nominal exchange rate with (Jprice/USprice). The PPP is calculated from the prices of Japan’s and the US’s goods and services while the real exchange rate is calculated using price indices. The value of PPP divided by nominal exchange rate is:

(Jprice/USprice)/NER = Jprice/(USprice x NER)

which is the ratio of Japanese and American prices (yen base) for the same goods and services, i.e., the difference between domestic and foreign prices. This difference between prices and the real exchange rate are in fact, as the above formulae show, the same thing: the former being (Jprice/USprice)/NER and the latter being 1/NER x (Jprice/USprice).

We can therefore interpret the REER as showing the directionality of changes in the difference between domestic and foreign prices. Basically, the fact that REER is rising means that the difference in prices is growing larger. However, because REER is calculated such that it is set at an index of 100 in 2005, we do not know the magnitude of the change in prices, but only the direction.

4. Significance of Swiss Unlimited Intervention

As I have explained above, from the point of view of the REER and PPP, the current yen is not particularly appreciated compared to the past. Even so, companies are finding the current rate quite severe due to increasingly stiff competition with rival South Korea and because the exchange rate at one time approached the PPP’s level.

On the flip side of the strong yen lie the weak dollar and euro, and Japan will find it difficult to correct this with policy alone. In fact, it is entirely possible that the yen will continue to appreciate in the future due to the US’s enacted policy and the eurozone’s continued debt problems. At present, the Federal Reserve Bank is very cautious of introducing QE3, but if it did take the plunge and introduce QE3, the dollar would depreciate again, meaning the yen would possibly appreciate rapidly.

Switzerland was also caused much grief by an appreciated currency, but on September 6 it set a limit of 1 euro = 1.2 Swiss francs and declared unlimited intervention should the limit be exceeded. This intrepid policy shocked the market, but it was taken by many to be serious and thereafter the Swiss franc’s appreciation faltered.

In the past, Lars Svenson, the deputy governor of Sweden’s central bank, suggested a policy that would allow Japan’s economy to escape from deflation: in addition to unlimited yen-selling interventions to bring down the exchange rate, introducing price-level targeting to control inflation expectations. In other words, escape deflation by depreciating the yen, and enact policy to set price-level targets so that inflation doesn’t get out of control. Switzerland’s price increase rate is right around zero, an incredibly low rate, which shows that its policy is in keeping with Svenson’s suggestion.

Pegging the exchange market with the euro would result in the undesirable loss of freedom in financial policy, but if doing so effectively restrains the advance of the Swiss franc’s appreciation, then the policy will have achieved its goals. In emerging countries, capital controls are often used as a method of constraining currency appreciation, but developed countries find it difficult to use such regulations and therefore often use exchange interventions. However, despite repeated interventions, Switzerland has been unable to stop the Swiss franc appreciating and the Swiss Central Bank has taken heavy foreign exchange losses.

In contrast, according to VP Svenson, if unlimited intervention gains confidence, the exchange rate can be stabilized without actually carrying out unlimited interventions, unlike with simple interventions. The central bank can thus avoid its balance sheets expanding out of control. We must watch the progress of this policy to see if it actually works in reality.

5. Japan Must Make the Most of the Strong Yen Now!

In theory it would be possible to enact the same policy with the yen, but because it is one of the three big currencies and many exchanges are done in yen, it is doubtful that this could be done in reality. Depreciating the yen through intervention when the dollar and euro are being forced to depreciate for reasons of their own carries the problem of whether or not it would be accepted on the international political stage. Furthermore, even if Japan announced unlimited interventions, it would likely be very difficult to gain the confidence of the market.

For this reason, the only remaining realistic policy for Japan is a combination of additional financial easing (augmenting funds through purchasing assets, etc.) and simple interventions, but the government and the Bank of Japan are currently keeping such policy on the back burner until the yen appreciates even further.

Given this point, we must be very skeptical that the yen will be corrected any time soon. However, the current yen appreciation will not necessarily continue for six months or a year. Currently, there is a strong sense that the dollar and euro are being oversold due to worries that the dollar’s REER has fallen to its lowest level ever. Before long, the American economy’s downside risk will reduce, the furor in the eurozone will calm down, and the dollar and euro will start to be bought back.

If that is the case, then one possible option for Japanese companies is to make an aggressive sortie and buy up foreign companies and plants in order to make the most of the strong yen while they can. The truth is that Japanese companies’ buyouts of foreign companies have increased recently. From January to July of this year, the number of buyouts of foreign companies by Japanese companies was 26% (260) of last year (according to Recof). This is an even higher pace than 2006, which saw the greatest recent number of buyouts. Moreover, after the great earthquake, the months of April to July saw 161 buyouts, 33% of last year—the highest level since 1990.

If the exit of companies from Japan continues to accelerate, the foregone conclusion of hollowing out will become an ever greater worry. However, we should take this to be a process of making clearer the separation of roles within and without; Japanese companies use foreign profits as a foundation for domestic investment and R&D for production of high-value-added products. Japan’s declining population means that the domestic market is shrinking, and at this stage companies will have to use revenue from overseas if they want to put bread (or rice) on the table. For this reason, Japanese companies should look positively at the current yen appreciation as a good opportunity to strengthen their overseas bases.