No. 2 — January 19, 1996


Weekly Review

--- by Douglas Ostrom

The yen ended 1995 almost exactly where it began at around ¥100 to the dollar, but appearances are deceiving. During the course of the year the Japanese currency went on a wild ride, at one point trading at a rate of around ¥80 to the dollar, the highest rate for the yen vis-a-vis the American currency in approximately 50 years. Movements against currencies other than the dollar showed a similar, although somewhat less pronounced, pattern. This suggests that the big fluctuations in the yen-dollar rate reflected conditions in both Japan and the United States.

The year just ended can be divided into four sections for purposes of describing the yen's movement. As shown in Table 1, in January and February the Japanese currency remained stable, as it had since around July of 1994, at around ¥100 to the dollar. In late February through mid-April the yen surged against the American currency, hitting a closing high of ¥80.3=$1.00 April 19 in Tokyo. From mid-April to September the yen fell almost as rapidly as it had risen, returning by the end of the summer to around ¥100 to the dollar. Since September Japan's currency has moved relatively little from that benchmark.

As Table 1 also indicates, the duration of the swings in the dollar-yen relationship in 1995 were hardly unprecedented in other recent years, but the magnitude of the variation was highly unusual. Rarely, for example, has the yen risen by roughly 25 percent against the dollar in the space of about two months as it did in early 1995. Even rarer has been a complete reversal of that rise in the subsequent five months.

These unusual patterns suggest that new forces may have been behind the changes in the yen-dollar relationship in 1995. Many analysts believe that currency markets were affected to an unusual degree by equally unprecedented fluctuations in the political relationships between the United States and Japan. According to this view, trade tensions in the spring and early summer precipitated the yen's meteoric rise. At that time the Clinton administration came within hours of imposing stiff sanctions on Japanese-made luxury car imports in retaliation for Tokyo's intransigence in negotiating an agreement addressing the relatively closed market in Japan for imported motor vehicles and automotive parts. In this interpretation currency traders were expecting that foreign exchange markets would have to accomplish what trade negotiators could not achieve in terms of boosting Japanese imports. A higher yen leads either to lower-priced imports or else higher profits for the producers and the distributors of goods made abroad; either way sales of such products in Japan could be expected to rise.

This interpretation also would appear to explain the yen's reversed course during the summer. The automotive dispute was settled after a fashion in midsummer (see JEI Report No. 24B, June 30, 1995), and, perhaps more important in this view, the Clinton administration's attitude toward Japan seemed to undergo a transformation. Washington let it be known that henceforth it would emphasize the implementation of existing trade agreements rather than the negotiation of new ones. Further, not a few analysts believe that the problems of the Japanese financial system threw a scare into U.S. government officials. According to this line of reasoning, the high yen adversely affected the balance sheets of Japanese banks, increasing the likelihood that one or more institutions could face financial difficulties severe enough to disrupt international financial markets. In addition, many analysts argued that weakened Japanese banks might be less able to play a constructive role in Japan's economic recovery. Without economic growth, imports might stagnate — the strong yen notwithstanding. To the extent that these arguments were valid, the high yen served the interests of neither Washington nor Tokyo, motivating the Clinton administration to act to support a higher-priced dollar, according to this interpretation.

These views are subject to considerable debate, not only because of the implied linkages among trade negotiations, trade imbalances, the health of financial institutions, economic growth and exchange rates but also in the perception that such linkages may have influenced the Clinton administration. Washington's actions — in contrast to its motivations — are less open to debate. U.S. monetary authorities, in cooperation with the Bank of Japan, intervened actively in currency markets over the summer, succeeding at least temporarily in the apparent objective of pushing the yen down against the dollar.

As noted previously, by yearend the yen-dollar relationship had returned to almost the same point from which it had begun in January. While the temporary run-up was responsible for an average 8.6 percent appreciation of the yen against the dollar for the year taken as a whole, the Japanese currency depreciated 3.6 percent from yearend to yearend. The depreciation against the dollar was in the midrange of the yen's change against a selection of European and Asian currencies (see Table 2), suggesting that the yen's volatility was not entirely made in America. (Comparisons of the yen's April run-up and subsequent decline against the dollar with movements in cross rates over the same period show a similar pattern of variation affecting the yen, even in the absence of yen-dollar factors.) Given that inflation in Japan is less than in either the United States or most of Japan's other trading partners, the yen's yearend-to-yearend real depreciation typically is somewhat greater than shown in Table 2.

Japanese and American analysts both forecast that the yen-dollar exchange rate in 1996 will change relatively little, although consensus forecasts in the two nations point in opposite directions. An early January Wall Street Journal survey of 64 business and academic economic analysts produced an average prediction that the yen would depreciate from a December 3, 1995 value of ¥103=$1.00 to ¥104.7=$1.00 by June 30 and ¥106.6 by yearend. The Journal's Japanese counterpart, Nihon Keizai Shimbun, in early January surveyed 20 forecasters and came up with a consensus estimate of ¥100.3=$1.00 for June 30 and ¥99.7=$1.00 for December 31.

If history is any guide, both forecasts will be wrong. As it did in 1995, the yen-dollar exchange rate almost certainly will move well beyond the projected range. Last year the mostly American group of 64 forecasters predicted in June that the yen would end the year at ¥89=$1.00, implying far less variation than actually occurred over that six-month period. Not one of the 64 analysts expected the yen to drop to as little as ¥101 to the dollar, let alone the ¥103 value actually reached by yearend.

The Nikkei group, which expects some appreciation of the yen, has the better argument than the Journal experts, who anticipate that the yen will fall against the dollar. Precedent is one reason; as shown in Table 1, the yen generally has risen in recent years. Moreover, the reasons for the yen's long-term appreciation are still present. Inflation rates in Japan remain lower than in this country. Hence, constant real rates imply continuous nominal yen appreciation. In addition, rising investment income from abroad suggests the constant strengthening of the yen in real terms for the foreseeable future in order to maintain any given current account balance in Japan. These long-term trends are hostage in the short term to beliefs — right or wrong — about the effects of currency intervention, stances in trade negotiations and other factors. With national elections likely in Japan as well as the United States in 1996, the reelection prospects of incumbent political parties on both sides of the Pacific could become a factor in exchange rates. Although few analysts anticipate that currency markets will offer a repetition of the wild ride of the past 12 months, the unsettled economic and political situation, particularly in Japan, is likely to generate at least sporadic excitement.

The views expressed in this report are those of the author
and do not necessarily represent those of the Japan Economic Institute

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