Friday, March 18, 2011

The Yen and the Earthquake

Dramatic events in currency markets this week. First, the value of the dollar vs the yen fell substantially on Monday through Wednesday. Then on Thursday the plunge in the yen/dollar exchange rate deepened, finally to be followed by the announcement yesterday evening of a highly unusual coordinated action by the world's major central banks to prop up the dollar against the yen.

LONDON (MarketWatch) — The United States and Canada joined other Group of Seven nations Friday to sell Japanese yen as the world’s major industrial nations intervened jointly in the foreign exchange markets to help Japan cope with last week’s devastating earthquake and tsunami.

The Bank of Canada confirmed it sold yen for Canadian dollars as North American trading got under way. The New York Federal Reserve also sold yen for U.S. dollars, traders and a person familiar with the situation said.

Whether joint intervention will be effective in the longer term remains to be seen, but the dollar surged versus the Japanese unit after the G-7 announced during Asian trading hours that members would move jointly to weaken the yen. The dollar traded at ¥81.15 in recent action, up from about ¥79.14 before the announcement.
What's going on here? Why have traders been so eager to buy yen in the wake of the disaster in Japan? After all, wouldn't common sense suggest that the disaster will weaken the Japanese economy, and by extension weaken the yen?

But clearly common sense is missing something in this situation. It's always difficult to forecast exchange rate movements, largely because there are so many different forces that have often countervailing effects on currencies, and it's rarely possible to tell which force is going to prevail. But to help understand the complexity of the issue, here is a list of a few forces (note that this is certainly not an exhaustive list) that will be acting on the yen as a result of the disaster:

1. Repatriation of capital. Japanese corporations and individuals will need to sell off some of their financial assets in order to rebuild their physical assets, such as factories and homes. To the extent that some of those Japanese-owned financial assets are in other countries, they will need to sell foreign currencies and buy yen. This force tends to increase the value of the yen.

2. Diminshed economic growth in the short term. For the rest of March (and possibly a bit longer), economic activity in Japan will be sharply curtailed due to destruction of assets as well as supply chain disruptions. This force (particularly when accompanied by firmly expansionary activity by the Bank of Japan) tends to weaken the yen.

3. Increased economic growth in the medium term. Once damage has been controlled and supply disruptions have been overcome, the serious cleanup and rebuilding will begin. In addition, Japanese firms will be trying to make up for lost production. Hence economic growth through the remaining 3/4 of the year is likely to be higher than we would have guessed two weeks ago. This force tends to strengthen the yen.

4. Lower national savings in the medium term. The Japanese economy will be using some of its savings to rebuild. This makes it likely that Japan will not export as much capital (i.e. it will not run such large current account surpluses) as it would have otherwise, much as with West Germany post reunification with the East. Smaller current account surpluses are effected in part through a stronger yen.

5. Decreased productivity. It's possible that the disaster has made a serious dent in the overall productivity of the Japanese economy through the destruction of physical assets and efficient supply networks. If so, then this loss in relative productivity may require a compensating depreciation of the exchange rate in order to maintain a given level of exports. This force tends to weaken the yen.

With all of these different forces to take into account, I am not willing to guess about how the yen/dollar exchange rate will move over the coming months. But a lot of traders apparently believe that the forces that tend to make the yen stronger will be more powerful than the forces tending to make the yen weaker. Hence this week's activity in the currency markets.

As a last note, let's throw a bit of anecdotal evidence into the mix. The following chart shows the exchange rate of three countries that suffered catastrophic natural disasters: Japan with the 1995 Kobe earthquake, Indonesia with the 2004 tsunami, and Chile with the massive 2010 earthquake. (I couldn't find exchange rate data for Haiti, otherwise I would have included that one as well.)

As you can see, after the 1995 earthquake the Japanese yen strengthened considerably, which is consistent with what we've seen this week. Meanwhile, for Indonesia and Chile the various effects apparently roughly canceled each other out, leaving their exchange rates with no noticeable change. Only time will tell how things will play out this time around.

UPDATE: Greg Ip at the Economist suggests that much of the recent rise the yen's value is due to the abrupt unwinding of short positions taken on the yen - the so-called "carry trade". I'm sure that Greg is right about that; add it to the list of factors influencing the yen exchange rate. However, it does raise the question of exactly why so many investors have just this week suddenly sought to unwind their short positions on the yen. Items #1 through #5 above probably have something to do with it.

UPDATE #2: One additional possible mechanism for the earthquake to have caused the sudden increase in the pressure on the yen to appreciate is highlighed by Rebecca in comments: the recent fall in US interest rates - exacerbated by the possibility that the Japanese disaster will be a further drag on the global recovery - has encouraged an unwinding of the carry trade, and more generally has made the dollar less attractive relative to the yen.

UPDATE #3: Rebecca Wilder provides a nice comparison between this intervention and previous central bank exchange rate interventions.


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