Currency Devaluation—How to Get Away With It

Japan’s yen weakened to 100 per U.S. dollar Thursday for the first time in four years. This was a critical market level, both psychologically and technically, as investors watch to see if “Abenomics” – the policies unveiled by Prime Minister Abe last fall – can finally overcome years of deflation and lackluster growth.

Monetary policy is the cornerstone of Abenomics. Under Abe’s reign, the Bank of Japan (BoJ) has taken on a new governor and two new governors, all with more dovish attitudes. Not surprisingly then, this new BoJ has ratcheted up its version of quantitative easing. Hoping to reach a 2% inflation target in two years’ time, the BoJ plans to expand its monetary base to 270 trillion yen by the end of 2014. That means that each month, the BoJ is buying almost as many of its bonds (about $76 billion per month) as the Fed is buying with QE ($85 billion per month), but in Japan’s case, the buying is occurring with a notably smaller economy (one might call it “more bang for your yen,” or “more QE per capita”).

Expectations that the BoJ will keep expanding its balance sheet have led investors to sell yen. Indeed, even with the U.S. Federal Reserve following a similar path, the dollar strengthened by 28 percent versus its Japanese counterpart between the end of September 2012 and end-April. For those who do not actively follow currency markets, such a currency move, especially over such a short time frame, is a big, big deal. It’s turned Japanese equities into the stars of 2013 – the Nikkei is up nearly 37 percent just through early May (in yen hedged terms, of course). The equity rally in turn is starting to lift consumer and business confidence in Japan.

Japan gets that its policy step is a critical one to end years of deflation and lackluster growth, and knows it has to tread carefully to balance its domestic policy goals with potential foreign objections. Memories of 1990s trade war with the U.S., in part fueled by exchange-rate issues, remain top of mind.

So far it seems Japan is getting away with its devaluation – for two main reasons: it followed others’ footsteps and its actively trying to dampen opposition.

By opening the door to quantitative easing and currency “debasement” after the 2008 financial crisis, the U.S. made it more difficult at home to grumble if other countries followed suit. Indeed, U.S. Treasury officials have reportedly just asked Japan not to speak too loudly or too publicly about the weak-yen policy; they have not asked Japan to stop devaluing the yen.

In addition, though, Japan is trying to avoid trouble by helping its neighbors. Consider the United States. While U.S. exporters may not be happy with the weaker yen, the U.S. government is definitely happy to have investors buying Treasuries to keep yields low and in turn, support growth. Japanese holdings of U.S. Treasuries have climbed to $1.12 trillion, up 26 percent from two years ago and second only to China’s Treasury holdings, according to data from the U.S. Treasury in January.

Feeling the same pressure on the trade side, Japan has also made a point of helping Europe and Asia. In January this year, Japan’s finance minister said the government would purchase European Stability Mechanism (ESM) bonds – the latter funding Europe’s bailout fund agreed to in July 2012. Japan had already started buying EFSF bonds (bonds of a similar financial rescue facility). Meanwhile, Japan’s finance minister said earlier this month that Japan would invest in bonds issues by Asian neighbors in an effort to help those countries’ bond markets develop and gain liquidity.

Japan is not out of the woods when it comes to a possible currency-fueled trade wear. Indeed, China has already said Japan should not continue devaluing its yen. But China’s voice does not carry far on currencies, when its renminbi has clearly been heavily “managed” for decades. And Japan’s efforts to help neighbors through bond market participation may help quell their opposition.

For now, Japan looks like it might just get away with a major currency devaluation. USD/JPY at 100, check. 150 anyone?