Fear and Loathing in Japan

An article in the Feb 5th issue of the Economist (also pointed out to me by 100B student, Winston Chan) talks about what we are going to cover in class today.

Exporters are complaining that Japan’s yen is overvalued, and that this is affecting their business negatively. However, the article points out that the yen has, in fact, been historically undervalued and might just be going through a correction. Low interest rates in Japan allowed traders to borrow yen and lend it out to foreign markets at higher interest rates, pocketing the difference (this is known as a carry trade). Even Japanese traders took part in this, and bought foreign instruments to capitalize on the interest-rate differences. The net effect was a lot of yen being exchanged for other currencies, which resulted in the price of the yen decreasing and undervaluation. Part of this story was low interest rates in Japan, but the other part was a fair amount of stability (and thus, predictability) in global financial markets.

With the recent instability in markets, and foreign interest rates going down, foreign (i.e., non-Japanese) traders have now been exiting these transactions, resulting in other currencies being sold off, and exchanged for the yen. The net effect of this is an appreciation in the value of the yen. With Japanese traders sitting on large amounts of foreign currency (worth ¥13.9 trillion, according to the article) they are expected to follow suit. Also, with the expected future economic uncertainty, individuals are expected to bring more yen home. All of this combined, will result in foreign currencies being sold and exchanged for the yen, and greater appreciation in the yen.

Your text book calls the mass selling of a currency, a consequence of fear, and the mass buying of a currency, a consequence of greed. In the above example however, it’s the opposite – the selling is a result of greed and the buying back, a result of fear. This behavioral explanation of the rise and fall of the real exchange rate, and its relationship with interest rate differentials will form the basis of the exchange rates part of the flexible price model, that we’ll be covering in class today.

Ironically, in the month or so since the article was published, we are still seeing the yen being devalued (which should be making exporters happy). The article is talking about much longer periods than a month, though, and – as we should all know by now – the nominal yen-dollar rate is not the complete picture, one should look at the real, trade-weighted exchange rate index.

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