The second largest economy in the world behind the United States is Japan. The starting point for understanding the fundamentals of the Yen is Japan’s economic history. First of all, the Japanese economy, in contrast with the United States, has few natural resources. Due to this fact, Japan had a large military force prior to World War II, which it used to occupy Korea, Taiwan, and parts of China. This was seen by the country as necessary, due to the vulnerable position that its lack of natural resources would have otherwise put it into.
World War II set the country back considerably in economic terms however with approximately 40% of its industrial plants and infrastructure being destroyed. Thankfully this actually turned out to have a silver lining for the Japanese Economy. Due to the fact that so much of their infrastructure had been destroyed, this provided the Japanese with the opportunity to significantly upgrade it, which gave them an edge over other economies from the victor states as they had much older factories.
Following World War II Japan was occupied by the United States, which led to the development of a democratic nation that was dominated by industry, rather than the military. The Japanese focused on rebuilding their industries rather than focusing on the military and as a result they were able to not only match their pre war production levels by 1950, but actually surpass them. Japan proved very competitive on the international stage in the following decades, and its economic growth in the 60’s, 70’s and 80’s was incredibly impressive.
The quality of Japanese products and services has remained very high since the 80’s, however Japan’s economy was disrupted in the early 1990’s, which led to the busting of one of the most famous asset price bubbles in history.
The Japanese population had one of the highest savings rates in the world in the following decades after World War II. This meant that there was more money available for investment, which in turn made access to credit a lot easier than it had been before. Due to Japan’s economy being an export oriented economy, this caused the value of the currency to rise dramatically during this period. Through a combination of a strong economy, easy access to credit, and a strengthening currency Japanese assets became very attractive to investors.
As its economy continued to grow, and newly wealthy Japanese saved more and more money, much of that capital was invested into the stock and real estate markets. As evidenced by the chart below, the stock market grew exponentially throughout the 1980s, almost quadrupling in value in 5 years. According to wikipedia.org, in some of the most expensive districts, real estate prices reached levels as high as $139,000 per square foot.
Both the stock and real estate markets declined slowly and continuously from the highs reached in 1990 and did not bottom out until 2003, from a top of approximately 39,000 to a bottom of around 7600. The decline was so dramatic in some cases that some of the most expensive commercial real estate properties stood at 1/100th of their pre bubble bursting peak, and $20 Trillion in wealth had been wiped out in the stock and real estate markets.
In an attempt to reign in speculation which was driving stock and real estate prices to incredibly high levels, in 1989 the Bank of Japan (BOJ) started raising interest rates, and the government introduced limits on total bank lending to the real estate sector.
While the aim of the central bank was to simply take the foot of the gas and tap the breaks, unfortunately the market’s reaction was dramatic, and resulted in a stock market and real estate crash starting in 1990. The effects of decline in real estate and stock market prices started a chain reaction, which reverberated throughout the economy and whole Japanese financial system.
First of all, the most important aspect to understand here is that the economic slowdown, in combination with dramatic falls in the stock and real estate markets, led the financial position of Japanese banks to rapidly depreciate.
Japanese bank loans which utilized the land they on which the loan was being taken out on as collateral, caused much of the speculation that was pushing real estate prices so high. Due to the fact that the quality of the loan was linked to the value of the real estate backing that loan, as real estate prices dropped, so did the quality of the bank’s loan portfolios.
Second of all, in Japan large institutions such as banks cooperate with one another, and as a result of this, hold large quantities of each other’s stock. Stock holdings are an asset for the banks and are included in the bank’s capital numbers, which define how financially sound a bank’s balance sheet is. When the value of these stock holdings tumbled lower, so too did the bank’s capital position, which added more pressure on the stability of the individual banks in Japan, and the Japanese Banking System as a whole.
Finally, as the economy slowed as a result of all this, the individuals and corporations who had taken loans began to struggle to make their payments, further weakening the quality of the bank’s loans, and stability of the banking system.
It is a common argument, in part due to weak corporate governance, that Japanese banks did little to adjust to the financial difficulties that they faced, instead preferring to wait for stock and real estate prices to move back in their favor towards their pre bubble bursting levels. The government also did little to tackle the problem until 1995, when it became obvious that if the government did not intervene then there would be massive bank failures.
It is argued that the Bank of Japan took too long to take any action to rectify the economic weakness, but they did eventually respond by cutting interest rates from over 8% in 1990 to as low as zero percent in 1999. While Japanese interest rates have increased since then, they are still easily the lowest of any of the major economies and currently stand at only 0.25%. Due to this fact, the cost of borrowing Japanese Yen is very low, which has led to it becoming the primary funding currency for carry trades, a subject which we covered earlier in this course. It is difficult to completely understand and predict movements in the Japanese Yen, without fully understanding the concept of the carry trade, so it would be advisable to review this subject again if you are not completely comfortable with it.
As stated previously, Japan has very limited natural resources of their own, which means that they are an economy that depends on imports of natural resources such as oil. This is something that should be taken into account when trading the currency, because as Japan imports almost 100% of its oil from overseas, any increase or decrease in the price of oil will generally have an effect on the value of the Yen.
Another thing that it is important to bear in mind is that the Japanese economy is extremely reliant on exports such as cars and electronics for growth in their economy. Due to this fact, the value of Japan’s currency is an even more key factor in their economic growth compared to countries that are not so reliant on exports to drive domestic growth. As we covered when discussing trade flows, a stronger Yen will translate as Japanese goods and services being more expensive for overseas consumers, which will harm Japanese exports.
To prevent the Yen from rising to the point where it would be harmful to the Japanese economy, the Bank of Japan has been known to intervene in the foreign exchange markets, which can result in the Yen value falling dramatically.