Mar 22, 2011

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Key Strategy Issues Vol.K292

The historical significance of the G7 intervention: The end of the yen’s prolonged upswing

Condolences to Earthquake and Tsunami Victims We extends our sincere condolences to the victims of the tragic earthquake and tsunami that struck the Tohoku region of Japan.


A catastrophe that happens only once in 500 or 1,000 years has created damage and losses of a magnitude that are incomprehensible. Nevertheless, this disaster will have only a limited negative impact on Japan’s GDP growth rate for a number of reasons. The four prefectures of the Tohoku region, where the earthquake occurred, represent less than 4% of the country’s total GDP. Furthermore, the most serious damage was caused by the tsunami and is thus located only along the coast. Most of the factories in the region, which are located on higher ground, escaped major damage. Furthermore, the infrastructure in the affected region can be rebuilt in a relatively short time in most cases. The negative impact of the disaster on manufacturing activity will probably end in the second half of 2011. We also expect the benefits of disaster-response initiatives like monetary easing, additional public-sector spending and measures to weaken the yen to help manufacturing recover and generate construction orders to rebuild the devastated area. Even more significant is the unexpected joint intervention in currency markets by the G7 that was prompted by this catastrophe. This intervention very likely signals the end of the yen’s prolonged upturn, thus creating a key turning point that will finally end “Japan’s lost 20 years.” Why was March 11 a turning point? The reason is that the world truly needs a recovery in Japan. In this report, we examine why Japan is so important to the world, the rapid shift in the geopolitical environment for the economy and why a recovery in Japan is closely linked to the well-being of the United States. (1) Joint currency intervention is a major turning point (2) Why will this intervention benefit all of the G7 countries? (3) The need for a downward correction of the yen from a geopolitical perspective (4) A turning point is near for the dollar’s prolonged downturn (1) Joint currency intervention is a major turning point

The unexpected G7 intervention in currency markets

Representatives of the G7 countries held an emergency telephone conference on Friday March 18 that resulted in the announcement of a joint intervention in currency markets. In response, the yen quickly bounced back from an all-time high of \76 to the dollar to the \81 level. The G7 stated that “excess volatility and disorderly movements in exchange rates have adverse implications for economic and financial stability. The countries went on to say that there would a “concerted intervention in exchange markets” at the request of Japan authorities by central banks of the United States, United Kingdom, Canada and Europe. The countries said they will “monitor exchange markets closely and cooperate as appropriate.” In addition, the G7 countries stated that they are ready to provide any needed cooperation. This statement as well as the implementation of market intervention was surprising even to financial authorities in Japan.

Joint G7 intervention signals the end of a long-term trend

As Figure 1 shows, the G7 has intervened in currency markets five times in the past: (1) the September 1985 Plaza Accord (in response to the dollar’s excessive strength); (2) the February 1987 Louvre Accord (to halt the decline of the dollar); (3) August 1995 intervention to prevent the yen from becoming even stronger; (4) June 1998 intervention to stop the yen’s decline; and (5) September 2000 intervention to prevent the euro from weakening. All five interventions created a turning point in a long-term foreign exchange trend. This time as well, G7 intervention is very likely to end the long-term upturn of the yen. There are two reasons for this outlook. First, this intervention is in synch with current economic fundamentals (Japan is forced to enact further monetary easing while the United States and Europe are starting to consider ending their easy-money policies.). Second, intervention may be beneficial to the United States, which has ended measures to prevent deflation and is shifting emphasis to overseas investments. (2) Why will this intervention benefit all of the G7 countries?

The global deflation scenario, the basis for strong-yen speculation, has disappeared

The joint statement by the G7 included currency market intervention as well as humanitarian support. Preventing the yen from appreciating is in the interest of all G7 because speculation based on expectations of a stronger yen would block the global economic recovery that is just now beginning. Speculators who expect the yen to strengthen base their actions on the global deflation scenario. Investors who adopt this stance buy the yen and sell U.S. stocks. Furthermore, a stronger yen is the symbol of the scenario of global risk avoidance (risk off trades), which causes prices of assets with risk to fall worldwide. These scenarios are therefore two sides of the same coin. The Fed in the United States cannot permit either of these scenarios due to its goal of raising prices of stocks and other assets by using QE2 to increase investors’ appetite for risk. In addition, speculators who expect the yen to appreciate are harmful to Japan, which is staging a weak economic recovery and has just sustained a severe blow from the earthquake. As Figure 2 and 3 illustrate, the yen alone among major currencies has been appreciating steadily since 2007. But the yen has become excessively strong from the standpoint of purchasing power. At present, purchasing power parity gap between the yen and dollar has once again widened to 49% (Figure 4). As the yen rose to an unreasonable valuation, Japan suffered from severe deflation and Japanese stocks posted extremely poor returns. This explains why the yen’s strength prevented an economic recovery in Japan.

The unreasonable and anti-social aspects of strong-yen speculation

Now that an unmistakable economic recovery is taking place in the United States, speculation based on the outlook for a stronger yen is obviously no longer logical and even anti-social. After all, the yen’s strength is a product of supply and demand and speculation. The earthquake forced many investors to make offsetting trades as people liquidated past yen carry trade positions and sell risk on trading (buying Japanese stocks and selling the yen) positions. These events caused investors to take advantage pessimistic views to sell their holdings at the same time, which produced enormous selling pressure. Speculators seeking opportunities created by the misfortune of others were responsible for the emergence of a formidable enemy called G7. Some movements of capital are normal and others are negative. Normal movements involve a shift of funds to investments yielding higher returns, a process that maximizes economic efficiency. Negative movements are a sign that investors have given up on seeking higher returns. All they want to do is preserve their principal. Economic growth is blocked by this mindset. Capital movements since 2008 that caused the yen to appreciate do not appear to be constructive shifts by investors seeking higher returns. With little demand for investments, people with money to invest were unable to locate attractive places to park their funds. Pure speculative demand is probably the only reason that investors moved their money to Japan even though the long-term interest rate was only about 1%. The only possible explanation is that investors assumed that there would be a self-fulfilling appreciation of the yen. These negative shifts of capital were all rooted in the global deflation scenario. As a result, the yen strengthened every time U.S. stocks fell when warning signs appeared about the sustainability of the U.S. economic recovery. “By exerting downward pressure on Japan’s economy, the yen’s strength is having a direct impact on Japanese stocks, the weakest link in the world’s financial markets. Furthermore, a strong yen may cause deflation in other countries by soaking up capital from around the world. This is why the rising yen is one milestone for deflation in Japan as well as the entire world. Consequently, yen speculation must be suppressed so that Japan can return capital to the world. This is essential to ending the negative cycle leading to worldwide deflation. As an illustration, let’s assume that Japan intervenes in foreign exchange markets by buying \30 trillion ($350 billion) worth of U.S. Treasury securities. Making these expenditures would provide enormous support for the additional monetary easing measures that the Fed is currently considering. Consequently, establishing a coordinated international program to block the yen’s appreciation would be beneficial to Japan’s ego and for the entire world.” (Strategy Bulletin Vol. 27, “Preventing global deflation by stopping the rising yen,” September 1, 2010) (3) The need for a downward correction of the overvalued yen from a geopolitical perspective

The surprising G7 intervention

The decision to initiate a joint G7 currency market intervention was reached with remarkable speed, even by Japanese authorities. Why? Probably because of a geopolitical factor: It is vital to support Japanese economy by reducing the yen’s value. Although the objective is the same as in 1995 when the G7 joined forces to stop the yen from appreciating, there is a critical difference this time.

The U.S. must rebuild the Japan-U.S. alliance

People may be puzzled about why the whole world has decided enthusiastically to back up Japan. Massive earthquake and tsunami damage and the need to help victims are not the only explanations. Japan is in a key position from a geopolitical standpoint. We have seen a dramatic shift in how the U.S. views Japan since the second half of 2010. The rapid and thorough U.S. response to the recent derogatory remark about Japan by U.S. diplomat Kevin Maher was an unmistakable illustration of this shift. Assistant Secretary of State Kurt Campbell was sent to Japan immediately to apologize. John Roos, the U.S. ambassador to Japan, visited Okinawa to apologize. And Maher was lost his job. Responses to this incident are clear proof of how important Japan is to the United States. Following the earthquake, President Obama stated repeatedly that Japan and the United States are close friends and allies. He said that the United States is prepared to provide a broad range of support. Naturally, these actions were taken from a humanitarian standpoint. But U.S. actions are also closely linked to U.S. interests because the Japan-U.S. alliance is becoming even more important than in the past.

The Japan-U.S. alliance holds the key to keeping China in check

As a super power, United States has been moving in earnest since 2010 to respond to China’s rapid economic growth and its growing military and political power. To offset the clout of China, the United States has been deepening its alliance with Japan, Asia’s largest democracy. Holding China in check while continuing to apply pressure to make changes from within will require increasing the clout of Japan, which is one of China’s neighbors. Eastern Asia would be significantly destabilized if Japan started to drift because the Japanese public lost faith in globalization and a market-based economy. This is why revitalizing the Japanese economy has become a vital component of the global strategy of the United States. This U.S. position is probably what made possible this swift G7’s intervention to end the yen’s unusual strength that was imposed on the country as a penalty, as I explain below. Looking back, the Japanese economy underwent a significant change starting in 1990. One result was long-term deflation. A big shift in the nature of the Japan-U.S. security treaty was a major cause. The Japan-U.S. alliance changed from “an alliance to protect Japan” into “an alliance to keep Japan in check.” When the Soviet Union and communism worldwide collapsed in 1990, Japan and the United States lost a common enemy. Furthermore, U.S. companies were constantly losing at that time to Japanese companies in key industries like consumer electronics, semiconductors, computers and automobiles. Holding back Japan’s economic growth and preserving U.S. economic superiority became the most pressing issues with respect to the U.S. global strategy. The Japan-U.S. alliance was regarded as a “cap in the bottle.” There was a widespread belief that the United States maintained a very costly military presence in Japan for the purpose of preventing Japan from once again becoming a military power. Under this military subjugation, Japan adopted policies that reflected U.S. requests and most often acceded to those requests.

An extremely overvalued yen was the key to holding back Japan

Allowing the yen to become extremely overvalued was the decisive step in the process of holding back the Japanese economy. Early in the 1990s, the yen was overvalued by 100% in terms of purchasing power parity. Of course, this overvaluation raised operating expenses for Japanese companies to twice the international standard. Since salaries for workers in Japan were twice as high as for overseas workers, Japanese companies had to cut their workforces, hire temporary rather than permanent employees, move production overseas and take other dramatic cost-cutting measures. Taking these steps greatly reduced unit labor cost, enabling Japanese companies to remain competitive. But wages in Japan were sacrificed to achieve this goal. As wages declined over many years, Japan became mired in deflation. *For more information, see Strategy Report No. 291 “Geopolitical change in East Asia holds the key to the resurgence of Japan’s economy” and The Lost 20 Years by Ryoji Musha (2011, Toyo Keizai). Thus, protecting U. S. interests and the international order based on it were the primary causes of the past direction of the yen. The current joint intervention in currency markets by the G7 signals a change in this global consensus. (4) A turning point is near for the dollar’s prolonged downturn Currency market intervention can also be viewed as the sign of a turning point of a long-term trend for the dollar, as can be seen in Figure 7. The dollars (the real effective dollar exchange rate) has gone through many major peaks and valleys. U.S. national interests are obviously the cause of this volatility.

(1) Stronger dollar from 1979 to 1985 = Goal was to cap inflation

This was a period of benign neglect by financial authorizes. The dollar inexplicably appreciated even though many people believed the United States was becoming weaker due to inflation, a declining competitive edge and other problems. Making the dollar stronger was vital to lowering inflation, which was the most pressing U.S. economic issue at that time. As the dollar appreciated, U.S. wages automatically became much higher than the international standard. The result was pressure to make big cuts in wages. In fact, the growth rate of U.S. wages slowed rapidly starting in 1979, when the dollar started to appreciate. Slowing wage growth triggered a steep downturn in unit labor cost, which had been climbing rapidly. See Figure8.

(2) Weaker dollar from 1985 to 1995 = Goal was to make exports more competitive

The strong dollar eliminated the risk of hyper-inflation at the price of making U.S. companies much less competitive. The U.S. trade deficit surged as a result, particularly the Japan trade deficit. If nothing was done, many people thought the enormous trade deficit would cause an U.S. economic crisis. To prevent this crisis, large-scale initiatives started in 1985 in accordance with the Plaza Accord to achieve a downward correction of the dollar.

(3) Stronger dollar from 1995 to 2001-02 = Goal was to increase overseas investments by U.S. companies

In 1995, U.S. Treasury Secretary Robert Rubin stated that a stronger dollar was in the best interests of the United States. Measures were taken to start boosting the dollar’s value. Having completed restructuring program, U.S. companies were increasing their profitability. Furthermore, the information revolution was making U.S. companies more competitive. At the same time, unit labor cost at these companies dropped along with an improvement in productivity. At that time, encouraging U.S. companies to use their strong operations and financial soundness to make overseas investments was in the best interests of the United States. And a strong dollar was the means of achieving this objective.

(4) Weaker dollar from 2002 to 2011 = Goal was to prevent deflation

Following the end of the IT bubble, the risk of deflation in the United States started to increase quietly after the 9/11 attacks in 2001. Demand was persistently inadequate. One reason was the after-effects of the IT bubble and the excessive creation of credit. The need to deal with problem loans and excessive debt was another reason. After the IT bubble’s demise, the U.S. economy was rocked by the collapse of the subprime housing loan bubble. This created a greater imbalance between the supply of labor and demand, increasing the risk of deflation and falling wages. To deal with this problem, the United States had to lower the risk of deflation and exert more upward pressure on wages. These goals could not be accomplished without using a weaker dollar to lower U.S. wages in relation to wages in other countries. The result was a steady downturn in the dollar’s value.

(5) 2011 and afterward = Forecast

We are very likely to see the completion of QE2 as the 2011 economic recovery continues. Upward pressure on prices will probably increase. The main causes are more costly natural resources and the end of the downturn in rent for residential property, a category that fell sharply and helped bring down the CPI. On the other hand, with earnings at an all-time high, U.S. companies have a large volume of excessive capital. U.S. companies are moving quickly to build a global earnings base by utilizing globalization and advances in Internet technology. This is an environment that calls for using a stronger dollar to make it easier for companies to invest in other countries. Looking back at the dollar’s ups and downs, we can now see that these movements are closely linked to U.S. national interests as well as the country’s highest priorities during each period. Factors driving the dollar exchange rate can be divided into two major categories. Cyclical factors are the first category. A stronger dollar is needed to combat the risk of inflation and a weaker dollar to fight deflation. Overseas strategies are the second category. During times of U.S. economic difficulties, a weaker dollar is preferable for collecting returns on investments from many years earlier or for using exports to earn income. But when the U.S. economy is healthy, a stronger dollar is preferable for making overseas investments that can produce returns in the future. I believe that the United States determines its foreign exchange policies by selecting one of the four options that are outlined above. From this perspective, there is an excellent possibility that we are approaching a reversal in the dollar’s decline that has been taking place almost 10 years constantly since 2001. I believe this upcoming shift in priorities of U.S. policies is the background for the recently announced G7 currency market intervention.