2 The Yen: Summary of Staff Views

Tamim Bayoumi, Guy Meredith, and Bijan Aghevli
Published Date:
June 1998
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Bijan B. Aghevli

Sharp swings in the yen in recent years have had an important influence on the course of Japan’s downturn and subsequent recovery. In particular, the appreciation that began in late 1992 through mid-1993 weighed down aggregate demand, thereby amplifying the cyclical downturn in activity. In early 1995, as some of these recessionary pressures were beginning to unwind and initial signs of recovery were emerging, a further sharp jump in the yen caused equity prices to plunge, threatening to throw the economy back into recession. By contrast, the depreciation of the yen in 1996 and early 1997 provided support to activity.

The staff believes that these recent swings in the yen are too large to be explained by movements in fundamentals, implying significant deviations in the yen from its underlying equilibrium level. The conclusion that market exchange rates can deviate from their longer-term equilibrium levels underscores the need for the staff to have a methodology that provides an independent view of the level of the yen consistent with fundamentals. The possibility that misalignments may stem from “market failures” may also provide a rationale for offsetting policy actions.

The staff’s methodology for assessing misalignment in exchange markets involves comparing the external balance that would be generated by the current level of the yen—taking into account market expectations of its future path implied by interest-rate differentials—with the external balance consistent with Japan’s medium-term saving-investment patterns. To the extent that these two measures of the external balance are inconsistent, the staff’s view is that “tensions” are likely to emerge over the medium term that would tend to bring the yen back into line with fundamentals. As such, the analysis is not intended to provide a short-term forecast of exchange rate movements, but rather a longer-term assessment of potential inconsistencies between market expectations and economic fundamentals.

Looking at the events of the past few years, the sharp appreciation of the yen in the spring of 1995 took it to levels that appeared extraordinarily high in relation to the historical experience, even allowing for an upward long-term trend in the yen’s real value (reflecting Balassa-Samuelson effects). The staff’s analysis suggested that, if the yen were to continue to appreciate from this level at the rate suggested by interest-rate differentials between yen and foreign-currency assets, the external surplus would fall over the medium term to a level well below that implied by Japan’s underlying saving-investment patterns. Thus, the staff judged the yen to be substantially overvalued. Subsequently, the real effective value of the yen fell by about 35 percent as of early 1997, taking it below historical trends. If the yen were to appreciate from that level (¥127 per U.S. dollar) at the rate suggested by interest-rate differentials, the staff estimated that the external surplus would fall slightly over the medium term, but would end up somewhat above the level implied by saving-investment fundamentals.1 This implies some undervaluation of the yen as of the spring of 1997, but the absolute magnitude was significantly smaller than the overvaluation in early 1995.

The authorities’ view has been that, while it is not possible to identify an appropriate level for the exchange rate, sharp movements are undesirable. While accepting the difficulties of accurately determining exchange rate misalignments, it also seems problematic to judge the appropriateness of movements in the exchange rate in the absence of a view as to the underlying equilibrium level. Thus, the staff believes that the sharp depreciation of the yen from the overvalued level in mid-1995 was justified, as it brought the exchange rate better in line with fundamentals, whereas the earlier steep rise was inappropriate.

Exchange rate misalignments may be of concern for a number of reasons, including their implications for future volatility in financial markets and the distortions they cause to trade and investment patterns. From the point of view of macroeconomic policies, the importance of these considerations must be judged against the background of cyclical policy requirements. In early 1995, the overvaluation of the yen clearly threatened to undermine a recovery that was already tentative. The staff believed that decisive stimulus measures, particularly on the monetary policy front, were called for to offset the effects of the surge in the yen on activity. In the event, significant reductions in interest rates by mid-year were associated with both a reversal of the yen’s appreciation and a recovery in interest-sensitive components of domestic spending. The situation in early 1997 was quite different in that the weakness of the yen was acting to support activity at a time when near-term growth prospects were uncertain, large margins of excess capacity remained in the economy, fiscal policy was turning toward consolidation, and there was limited scope for further monetary easing. In such an environment, policy actions to address yen undervaluation were not called for.

In addition to monetary policy actions, the authorities have actively used sterilized intervention to influence exchange markets during periods of yen volatility. This was especially apparent during 1995, when official reserves rose by about $60 billion—equivalent to about one-half of Japan’s current account surplus. In general, the effectiveness of such intervention in Japan has been mixed, depending on the prevailing circumstances and whether it has been accompanied by other policy changes. In retrospect, the experience in 1995 appears to support the conventional wisdom that intervention is most likely to be effective when it signals a willingness to undertake more fundamental policy actions and when coordinated with other countries.

The staff’s view has been that such large-scale intervention can only be justified in the context of exceptional circumstances. The spring of 1995 represented such a situation: the yen had become substantially overvalued at a time when the recovery was in doubt, and the scope for further monetary easing was limited. However, intervention should remain the exception rather than the rule—sustained recourse to intervention would distort the normal functioning of markets, and create excessive reliance on official guidance as to the appropriate direction of exchange rates. At the same time, policymakers should continue to communicate to markets that the exchange rate remains an important consideration in setting policies, and that strong actions would be taken if yen misalignment were to again threaten to undermine macroeconomic stability.

In particular, the steady rise in Japan’s old-age dependency ratio is expected to result in a downward trend in the saving rate over the medium and long term.

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