Why Europe has a yen for a stronger Japanese currency

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The Independent Online

Mention Essen to a football fan, and he will probably recognise it as the birthplace of Arsenal and Germany goalkeeper Jens Lehmann. Located on the banks of the river Ruhr, it was formerly one of Germany's most important coal and steel centres, and is still home to 13 of the country's largest 100 corporations. But on Friday, it will add another string to its bow as it plays host to the world's most powerful finance ministers and central bankers when they gather for their latest G7 meeting.

If there is one subject which has dominated discussions in the run-up to the meeting, it is the weakness of the Japanese yen. The three European powerhouses - Germany, France and Italy - have been unusually vocal, complaining that it is undermining their export competitiveness and giving Japan an unfair advantage. They plan to take up the issue in Essen and apply pressure on the Japanese to strengthen their currency. The declaration of intent has triggered wild swings in the yen in recent days, as traders trimmed short positions. Indeed, it has been more volatile against sterling than at any point in the past two years.

Peer Steinbrueck, Germany's finance minister, complained openly last week about the yen's impact on Europe's businesses. "For European industry, and for the European car industry in particular, the fall of the yen in the past three years has had an important impact on their business," he told the European Parliament. Romano Prodi, the Italian Prime Minister, simply described the situation as a "serious problem".

So how weak is the yen, and why is it falling? Whichever way you look at it, it is an invalid facing the prospect of a long stay in intensive care. On its trade-weighted index, it has fallen to a 21-year low. It has hit a record trough against the euro, having plummeted by 60 per cent in the last six years. Against sterling, last month it touched its lowest since 1992. And against the dollar, it is languishing at four-year lows.

The basic reason for the yen's weakness is Japan's rock-bottom interest rates. At 0.25 per cent, they are a fraction of the 5.25 per cent in Britain and the US and 3.5 per cent in the eurozone, encouraging investors to dump the yen and seek higher yields elsewhere. But it has also been a victim of the so-called carry trade, where investors borrow yen at a low interest rate and then invest in higher yielding overseas assets, selling the yen for the destination currency. Assets ranging from equities to corporate bonds, from commodities to property, have enjoyed record runs fuelled by these carry trades, all at the expense of the yen.

Given the G7's impressive track record on influencing exchange rates, the markets are understandably nervous in the run-up to Friday's meeting. G7 meetings have generated some of the biggest sea-changes in foreign exchange trends over the last 20 years, from the orderly reversal in dollar weakness in 1995 to shared concern over euro weakness in 2000. And yet, despite the jitters, most analysts believe the Essen meeting will make absolutely no difference to the yen's fortunes.

Chris Turner, head of foreign exchange strategy at ING, points out that calls from the G7 for exchange rate adjustments have historically been part of a co-ordinated, usually monetary, solution. "The shared concern over yen strength in early 2000 came at a time when Japan was battling deflation and had adopted a zero interest rate policy," he said. "Equally, the call for a firmer euro in September 2000 was backed up by two quick quarter-point hikes from the European Central Bank and co-ordinated foreign exchange intervention from the G7 nations. However, we very much doubt that the G7 will formally include 'shared concern' over yen weakness in their forthcoming communique."

The reasons for this, according to Mr Turner, are two-fold. First, the G7 tends to pick battles it can win. "Unless G7 nations feel that Japan can back up these calls for yen strength with rate hikes and intervention, a lack of policy co-ordination may actually do more harm than good," he said. With inflation barely above zero, the Bank of Japan is in no hurry to lift interest rates, and the authorities have not waded into the market to prop up the yen since mid-1998.

Second, US authorities have so far shown no signs of supporting European calls for a stronger yen. Indeed, Hank Paulson, the Treasury Secretary, has made clear that he feels the yen is priced appropriately in an open and competitive marketplace. "US officials are well aware that the external financing of the US deficit is a delicate proposition and that any suggestion they favoured a weaker dollar/yen could trigger destabilising flows out of the US debt markets," Mr Turner said.

For Britain's part, Gordon Brown, the Chancellor, will not be joining his European counterparts in putting pressure on Japan and is understood to be relaxed about the yen's weakness and its impact on UK business. "We do not comment on exchange rates or other countries' exchange rate policies," a Treasury spokesman said. "The G7 communique last year made clear that exchange rates should reflect economic fundamentals."

Chris Furness, currency analyst at 4Cast, said a fresh bout of yen selling on Monday morning in the aftermath of the G7 meeting was likely. "The ultimate sanction on the Japanese would be to intervene, but that's never going to happen," he said. "The best that could happen is that Japan will be publicly named and shamed in the communique, but I suspect that won't happen either. I think there will be nothing in the communique but plenty of talk on the sidelines. Without anything stronger, the yen will resume its slide on Monday."

Japanese officials are unlikely to stand in its way. The last time it stemmed the yen's slide, many foreign investors were abandoning Japanese assets, but there is no fear of capital flight now. Today's yen sellers are much more diverse, including individual Japanese investors seeking higher returns abroad and speculators, such as hedge funds. That diversity means a lower risk of a sudden, sharp reversal in currency markets, lessening the need for policymakers to counter market moves. It may be some time before Japanese officials start to feel that the yen's decline is dangerous. In the meantime, its exporters will continue to reap the rewards.