For months now, European manufacturers and European politicians have complained over an overly cheap yen. While the euro had been rather stable relative to the US dollar, the yen has continued to lose against the euro over much of 2006, losing another ten percent on top of the more than 30 percent the Asian currency had already lost since the end of the New Economy bubble in 2001. Altogether Japan has thereby depreciated so much that travellers going to Tokio now regularly report that the city “isn’t really that expensive” and that if you stick to simple eateries “you don’t spend more money than in Berlin” – by itself remarkable given that Berlin is much cheaper than other European capitals. Of course, this has also consequences for manufacturing industries: The recent problems of European car makers are surely to a good part related to the improvement in competitiveness of their main competitors by 40 percent.
However, even though the weak Japanese currency has been very much on the mind of the European policy makers, there was very little public pressure on the Japanese to change the situation. One problem was that it was not the Japanese central bank directly which had contributed to the weakness by intervening in the foreign exchange market (as it used to do earlier this decade). Instead, the weakness was a result of a relatively new phenonemon called carry-trades, large institutional investors borrowing cheap money in Japan and investing it in markets with higher yields such as the US or Europe. These carry-trades have not only weakened the yen as they have created additional supply of yen and additional demand for other currencies, but have also helped to prop up equity notations in the rest of the world. But as the only thing the Bank of Japan could have done would be to increase interest rates sharply, which would have put the Japanese recovery in jeopardy, Europeans have been relatively silent.
Over the past days now, the trend of the week yen driven by carry-trades seems to have started to reverse: Starting with the market panic in Shanghai early last week, investors have moved their money into safer havens and away from risky assets. As a result, equities have lost value world-wide, depressing the yields for financial investments. With less attractive investment opportunities, the carry-trade suddenly looked much less attractive even though short-term interest rates in Japan continue to be at an extremely low 0.5 percent. Some of the carry-traders thus seem to have liquidated their positions in stock markets in Europe and the US and moved their money back to Japan, paying back their yen-denominated debt.
From Monday to Friday last week, the yen thus gained 3.5 percent both against the euro as well as against the dollar. And with the risk of a rapid yen appreciation now growing, some more of the carry-traders might rethink their position, so that more of the carry-trades might unwind over the coming weeks, propelling the yen even higher (and closer to something resembling “fair value”).
However, even though the Europeans now get the more expensive yen they have so long asked for, the risk remains that this unwinding of the carry-trades has serious side-effects which rather hurts Europe and might undo much of the beneficial effect of a more expensive yen. First, the fall in equity prices which is the logical consequence of the unwinding of the carry traders’ long positions in European and American equity, hurts household wealth and thus consumption as well as corporates’ financing conditions and investment. (Morgan Stanley in a recent analysis calculates that a drop in Eurozone equity prices by 10 percent will lead to a GDP growth .15 percentage points lower than in the baseline scenario.)
A second risk is that large and sudden exchange rate movements take down one of the bigger actors in international finance and lead to systemic problems. With a sudden yen appreciation and a fall in equity prices, there is the risk that some of the carry-traders (or alternatively hedge funds playing in these markets) gets caught by surprise. If suddenly the investment in the stock market turns sour while the yen denominated debt increases in value, a so far seeminly safe carry-trade-investment can suddenly carry large losses. (Remember that the LTCM crisis came about when volatility in certain markets moved beyond that what was predicted by their founders’ models.) In an extreme scenario, a large hedge funds or even an important institutional investor might get wiped out. As far as this fund or investor is connected to other large banks, this might be sufficient – if not to create a global financial crisis – at least to decrease sharply the risk appetite and thus the willingness of large banks to hand out credit, hurting again the financing conditions for European companies.
While the European business cycle actually does look very robust at the moment and might well weather a certain correction in the equity and credit markets, the recent appreciation of the yen is thus not necessarily only welcome news to Europe.
