Falling Exports and Rising Yen – Japan Can’t Catch a Break

Just six months ago Japan was at the head of the class when compared to the other G7 countries, and while no one felt that Japan was immune to the global economic downturn, many analysts felt that Japan was best placed to weather the storm. Even the International Monetary Fund (IMF) said that Japan’s Gross Domestic Product would contract much less than other industrialized nations. Unfortunately for Japan, things have not worked out as predicted. So what happened?

In short, Japan’s economy has been hammered on two fronts – and speaking of “hammered”, Japan’s Finance Minister – Shoichi Nakagawa – announced yesterday that he would be resigning amid allegations that he was a tad tipsy while attending a G7 conference this past weekend. Nakagawa claims that too much cold medicine was the cause of his slurred speech and tendency to nod off during debate and that he only had a “sip” of wine. Whatever – but the rest of Japan’s ministers might want to lay off the, ahem, cold medicine; at least until some degree of order can be restored in the economy.

The first blow to Japan’s economic well-being came in the form of the credit crunch that swept through the industrialized nations in the fall of 2007. Fuelled by the subprime mortgage crisis originating in the U.S., corporations and consumers soon found it increasingly difficult to borrow money for everything from electronics to new automobiles. As a world leader in these sectors, Japan suffered a disproportionate loss of revenue as its export markets in the U.S. and Europe contracted dramatically.

Then the second blow landed; the yen started to appreciate against the other major currencies, gaining more than 17 percent over the U.S. dollar and the euro in the past few months alone. While it’s true that the U.S. and European economies are also in terrible shape right now, the rise in the yen is not the result of a “flight to safety” on the part of nervous investors. No, the main reason the yen is appreciating is the unwinding of billions of dollars worth of carry trades.

A carry trade is a trading strategy comprised of a currency pair where the two currencies have a wide interest rate differential. The goal is to buy the currency with a high yield and sell the currency with the low yield – the difference between the amount received and the amount paid in interest is known as carry – hence the term carry trade – any positive carry is retained as profit.

During the early 2000s, Japan’s interest rates were very low – essentially zero-bound for most of this period – while interest rates in countries such as Australia and New Zealand were much higher, often exceeding 7 and even 8 percent. As a result, carry trades that shorted the yen and held long Aussie or New Zealand dollars were very popular.

However, as interest rate differentials narrowed over the past year or so, the use of carry trades in this manner declined. To close-out these positions, it was necessary for traders to buy billions of yen to cover the short positions and – I’m sure you can see this coming – the sudden demand for yen, forced the value of the yen upwards.

At a time when demand for her exports are falling, the last thing Japan needs is an appreciation in the value of the yen. The increased costs to convert dollars and euros to yen has further reduced demand for Japan’s products and as a result, many of Japan’s flagship companies have announced year-end losses – in some cases, for the first time since the post-war era.

Even some of Japan’s most successful companies – firms such as Toyota which is cutting output and Toshiba which recently announced thousands of job cuts – are struggling. In yet another twist, several Japanese companies have announced that they will seek off-shore jurisdictions with lower costs in order to produce goods in a more cost-effective manner. It was not all that long ago that Japan was that off-shore jurisdiction.