Yen spillout

ZHANG YUJUN/FOR CHINA DAILY

Shockwaves from sharp depreciation of the Japanese currency could trigger a financial crisis in Asia

The Japanese yen, a traditional safe-haven asset, has recently weakened sharply, becoming one of the worst-performing currencies in the global foreign exchange market this year. The exchange rate of the yen against the US dollar has reached its lowest point in the past 24 years. From Dec 31,2021 to July 19, 2022, the yen against the US dollar has depreciated by up to 20 percent.

The US Federal Reserve's move to raise interest rates and shrink its balance sheet has led to a significantly wider gap in the interests rates between the US dollar and the Japanese yen--the direct reason for the sharp depreciation of the yen against the US dollar. From Dec 30, 2021 to July 14, 2022, the interest rate gap between the two currencies widened from 1.43 percentage points to 2.73 percentage points, marking the largest gap between them since the global financial crisis in 2008.

The Japanese economy is faced with substantial downside pressure under challenges from the COVID-19 pandemic and the Russia-Ukraine conflict. To spur economic growth, the Bank of Japan has adopted a loose monetary policy. The different economic performance and inflationary situation of the United States and Japan has intensified the differentiation in monetary policies between the two nations. As a result, the interest rate gap between the US and Japan has widened, heightening the pressure for Japan in large-scale capital outflows and triggering a sharp depreciation of the yen.

Japan's international balance of payments has gradually worsened as a result of rising commodity prices driven by the Ukraine crisis. Rising global commodity prices have pushed up the cost of Japan's imports, leading to the peaking of its trade deficits. Japan's trade in goods deficit hit 2 trillion yen ($15.02 billion) in May 2022, marking the second-largest deficit in decades.

The sharp depreciation of the yen has caught the attention of the global market, but the Bank of Japan remains committed to its loose monetary policy. In June, Haruhiko Kuroda, governor of the BOJ, reiterated the stance of loose monetary policy, stating that the Japanese central bank will continue to carry out the ongoing loose monetary policy centered on yield curve control. The goal is to stimulate Japan's economy and achieve a 2 percent inflation target in a sustainable and stable manner. In July 2022, the BOJ said in an announcement that it will continue adhering to an ultra loose monetary policy, maintaining short-term interest rates at minus 0.1 percent, and keeping long-term interest rates at around zero through the purchase of long-term government bonds.

As the former BOJ governor Masaaki Shirakawa says in his book Tumultuous Times: Central Banking in an Era of Crisis, no matter which political party is in power, once Japan's economic situation deteriorates, the central bank will be required to implement loose monetary policy. The reason behind this practice is that Japan has long faced serious government debt problems.

In recent years, the balance of Japanese government bonds has amounted to 250 percent to 260 percent of the GDP. Japanese government bonds are basically domestic bonds, and about 90 percent of their holders are domestic institutions and individuals. With the increase of social security expenditure because of Japan's aging society, the fiscal balance of payments continues to deteriorate, which, coupled with the slowing of economic growth, may hit the confidence of residents in the capacity of government bonds to repay capital with interests. Fiscal sustainability is the most important precondition for supporting currency stability. The loss of confidence may eventually lead to a debt crisis or even an economic crisis. In other words, the BOJ's lowering of bond yields helps reduce the cost of government debt and avoid the outbreak of fiscal and debt crisis.

The market is now more concerned about two issues. First, will the BOJ change its monetary policy stance and adopt a tightening policy like other countries under the pressure from the international environment? Second, what is the influence of the sharp depreciation of the yen?

We believe that the BOJ will not change its stance of loose monetary policy under the current circumstances. On the one hand, spurring economic growth still tops Japan's agenda. It is reasonable for Japan, a large open economy, to uphold independence in its policymaking and continue putting in place a loose monetary policy.

On the other hand, the depreciation of the yen benefits the Japanese economy. The sharp depreciation of the yen not only benefits Japanese exporters but also encourages companies with overseas investment to repatriate their profits back home. In recent years, the appreciation of the yen has spurred a large number of Japanese companies to move their factories overseas. Japan has long been among the top three sources of foreign direct investment outflows. The sharp depreciation of the yen can give businesses investing overseas greater incentives to turn their retained profits into the yen and send back to their home country.

Even though the depreciation of the yen can usher in more benefits than harm for Japan's economic growth, its negative spillovers cannot be overlooked.

In fact, an important context for the Southeast Asian financial crisis in 1997 and 1998 was the significant depreciation of the Japanese yen against the dollar after the Fed's series of interest rate hikes. Meanwhile, the Thai baht, Indonesian rupiah, Malaysian ringgit and other currencies used the dollar as the benchmark in their exchange rates. This led to a significant appreciation of these currencies against the Japanese yen, which resulted in the over-valuation of the currencies. In the end, shock waves brought about by speculative capital resulted in the sharp depreciation of the currencies, leading to the outbreak of the currency crises and financial crises in these countries.

Recently, the Fed's interest rate hikes and balance sheet shrinking have pushed up the yields of long-term US Treasury bonds and the exchange rate of the US dollar, which has led to massive short-term capital outflows in some emerging markets and developing countries, mounting depreciation pressure on their currencies, a decline in their domestic risky asset prices and economic slowdowns. In this context, the sharp depreciation of the yen against the dollar may exacerbate the negative shocks faced by emerging market countries, especially countries in Southeast and South Asia.

Most of these countries are export-oriented and have close ties with Japan in terms of trade and investment. If their currencies appreciate significantly against the yen, it may reduce the revenue of their exports to Japan, and lead to a withdrawal in investments from these countries by Japanese companies. This means that once the yen depreciates significantly against the dollar, these countries may be forced to follow the yen in depreciating their currencies against the dollar, which could even result in a competitive devaluation. Once the sharp depreciation of currencies triggers domestic economic and financial turmoil, the post-pandemic recovery of Asian countries may come to a stop.

In the first half of this year, economies with persistent current account deficits, overvalued exchange rates in currencies and inflated domestic asset prices, including Pakistan, Sri Lanka, Lebanon and Myanmar, have experienced debt crises and economic crises one after another. The possibility of Asia experiencing a financial crisis and economic stagnation is rising significantly in the face of the multiple shocks from the sharp depreciation of the yen, the aggressive interest rate hike by the Fed and the conflict between Russia and Ukraine.

Zhang Ming is deputy director of the Institute of Finance and Banking at the Chinese Academy of Social Sciences and deputy director of the National Institution for Finance and Development. Chen Yinmo is a researcher with the National Institution for Finance and Development. The authors contributed this article to China Watch, a think tank powered by China Daily.

The views do not necessarily reflect those of China Daily. Contact the editor at editor@chinawatch.cn.