(The author of this article is Zhao Jian, President of Xijing Research Institute)
I went to Tokyo at the end of March to give a presentation, which coincided with the Japanese economy going through a number of historical records: the Nikkei index hit a new high of 41,000 points, and housing prices returned to their historical high, recovering the "lost 30 years" in one fell swoop; Prices have bid farewell to decades of deflationary slump and inflation unseen in nearly half a century; The Bank of Japan has also bid farewell to 17 years of interest rate cuts and nearly a decade of YCC, and has begun to raise interest rates for the first time in history......
As I walked through the streets of Tokyo that day, I watched the crowds and thought about the great changes that had taken place behind the peaceful daily life. In fact, many of the so-called earth-shattering waves of great changes are transmitted to the daily life of individuals, and they are just a small ripple for the time being, and of course they will be constantly impacted later. In the face of various historical records, although ordinary Japanese people have also felt the pain caused by the high cost of living, the extremely low unemployment rate and huge wealth effect have also brought great welfare improvement and confidence to Japan. Overall, everything is still getting better.
However, there is one historical record that needs to be taken out separately, and that is the shocking depreciation of the yen. At that time, the exchange rate had fallen to a multi-decade low of 150 yen per dollar. A number of trading experts attending the meeting at that time agreed that the yen would bottom out and rebound, and the Bank of Japan would not let the yen fall below 150, so it was recommended to overweight the yen. However, the market slapped the "fatal conceit" of various linear extrapolations and trading forecasts, and the yen not only unexpectedly fell below 150, but also continued to fall after breaking through 150, breaking through various support points in one fell swoop, until 160 city down. Finally, on April 29, it fell below 160, setting a record since 1990. Panic began to arise, after all, the yen took on the role of a safe-haven currency for a long time. The depreciation of the yen exchange rate so miserably has also greatly discounted or even lost money on the conversion of Japanese stocks and houses that have finally risen into the currency of the country. As a result, the top investors who predicted the rebound of the yen at the forum also suffered huge losses, and investors who had been confident in the Japanese economy and assets began to waver. There are even assertions that a financial crisis will occur in Japan.
However, soon the yen exchange rate reversed dramatically, and after the exchange rate broke 160, it was violently pulled up by the bulls by 500 points. It's like an ambush battle that lures the enemy into depth, and suddenly a big counterattack regains many lost ground. We can't help but ask, what is the Bank of Japan doing, what is it going to do, and why is it adopting such a strategy to create such a large amount of volatility? What happens next?
To understand the current strategy of the Bank of Japan, it is necessary to understand the current situation facing the Japanese economy. In Japan's current situation, it can be said that both the economy and policy space are caught between multiple contradictions.
First of all, although inflation has finally been achieved out of decades of deflation, people's sense of pain is still relatively obvious because the driving force of imported and cost-push inflation is relatively strong, and income growth cannot keep up with prices. Fortunately, the employment situation is unprecedentedly strong, and the situation of young people is improving. But the latest data shows that signs of falling inflation and economic weakness are starting to emerge.
Second, although asset prices have come out of a long bear market, considering the marginal thrust of foreign capital, especially hot money, there are also greater risks hidden behind the new high asset prices. Once external funds are withdrawn, both the stock market and the housing market will have huge shocks.
Third, the unexpected reflation in the United States, the Fed's larger-than-expected delay in cutting interest rates, the interest rate differential between Japan and the United States continued to widen, and the CARRY trade continued to squeeze the value of the yen.
Fourth, the structure of the balance of payments has been further distorted, with the primary income surplus mainly relying on overseas investment income, and most of the investment income has been retained overseas, without repatriating domestic consumption and investment to generate GDP and employment.
Special mention should be made of Japan's overseas investments and the resulting special balance of payments structure. According to a recent report by Nikkei, Japan's balance of payments structure has undergone tremendous changes in recent years. Prior to 2010, Japan maintained a current account surplus due to its manufacturing strengths and strong global demand. Since 2011, the current account trade deficit has increased, and primary income, such as interest and income from overseas investments, has become the core of the surplus. As a result, Japan has developed a balance of payments structure that does not rely on exports but on investment.
In recent years, there has been a trend that overseas earnings do not return to Japan. According to statistics, Japan's primary income surplus in 2023 is 34.5 trillion yen, a record high. Of this amount, the direct investment income from overseas subsidiaries of Japanese companies was 20.6 trillion yen, and the reinvestment income accumulated by overseas subsidiaries as retained profits was 10.3 trillion yen. Half of these profits remained overseas and did not return to Japan. So to sum up, the current situation facing the yen is:
1. Inflation has returned, but the economy has begun to weaken and is likely to enter a mini-stagflationary cycle, which is a worrying problem;
2. A large influx of foreign capital has regained lost ground in asset prices, but in the case of no interest rate cut by the dollar, foreign capital is likely to flow out at any time, and there is a risk of asset price collapse;
3. The interest rate differential between Japan and the United States continues to widen, and the CARRY transaction is likely to draw domestic liquidity again, resulting in the ineffectiveness of domestic monetary policy;
4. A large amount of overseas investment income does not flow back to the country, earning GNP but not GDP, how to attract domestic capital to return to serve the local real economy is a policy option.
In the face of these four contradictions, choosing a sharp depreciation of the exchange rate is a good move, but of course it is also a risky move - any policy needs to pay a price, it is impossible to have both and want, only need to judge the situation and choose the analytical solution with greater benefits and less cost. The beauty of the yen's choice to depreciate in a "one-step" manner and then rebound quickly at 160 points is as follows:
1. Stimulating external demand and changing the distorted trade structure, on the one hand, can stimulate the export of goods under the current account, make Japanese manufacturing more high-quality and cheap, and improve competitiveness in the current situation of increasingly scarce global demand; On the other hand, housing prices and stock prices, which were originally historically high, have become cheaper again in the face of a sharp depreciation of the yen, which has attracted a large number of overseas tourists to spend and invest in the country.
2. Block the CARRY arbitrage trade around the interest rate differential between Japan and the United States. According to the theory of interest rate parity, if there is arbitrage space between the two currencies on the interest rate, in order to achieve equilibrium, it is necessary to hedge the exchange rate in order to make the profit of the CARRY transaction zero and achieve an arbitrage-free equilibrium, otherwise capital will continue to flow in one direction. The interest rate differential between Japan and the United States is now almost 4%, and if the yen appreciates by 4%, then the equilibrium of monetary assets will be achieved. How to make the yen appreciate by 4%? It is to carry out an overshoot type of rapid depreciation, and after depreciating to a certain position, the market agrees that the exchange rate will be overshoot (depreciation to the limit and overshooting, and the rest is appreciation), so that there is a reflexive expectation of appreciation, and this equilibrium will be realized, and the outflow of Japanese capital through CARRY transactions will be stopped.
3. The depreciation of the yen makes it cost-effective for Japanese capital and retained profits to return to China for consumption and investment, and the overseas capital of the yen will return to China under the stimulus of the depreciation of the exchange rate, which will have a stimulating effect on the domestic economy.
4. Lock in the overseas capital that entered Japan in the previous stage to speculate in real estate and stocks (many are Chinese investors, but there are also European and American investors such as Warren Buffett), and let their gains be locked in the yen. Because once you want to sell your yen assets and exchange them for other currencies for remittance, you will find that because of the sharp depreciation of the yen, the investment income will be greatly reduced or even lost.
It can be seen that for the yen, which is in the midst of multiple "big changes", the rapid depreciation is indeed a smart move, but it is also a dangerous move. Because such a drastic depreciation is a huge drain on the country's credit. Fortunately, Japan is a developed financial system in which interest rates and exchange rates are completely market-oriented, and capital can flow completely freely. The Bank of Japan has set up a line of defense at the point of 160, but it is not the last line of defense, in fact, no one can say for sure, but at present, it has formed a psychological line of defense.
As a result, the vast depreciation zone of 120-160 has indeed replaced more policy space in general at the expense of the exchange rate. Does this have any enlightenment for the RMB exchange rate, which is in a "triangular problem"? In the past two years, because the interest rate differential between China and the United States has set a historical record in terms of duration and inversion, and has also produced a huge CARRY transaction, resulting in the currency generated by the domestic easing policy being sucked off by the high-interest dollar like a black hole, and there has been a strange situation of "the United States collects water but inflation, and China releases water but deflation", which is actually the siphon effect of the US dollar interest rate hike.
To change this, the market needs to have an expectation of RMB appreciation similar to the interest rate differential between China and the United States (about 3% annualized), otherwise people will continue to exchange dollars (or even low-interest loans for dollars) and then buy US dollar wealth management with a stable yield of 5%. One is to increase the yield on RMB assets, whether it is bonds, stocks and real estate, to ensure a yield of at least 5% (assuming that the RMB exchange rate is stable), so as to achieve a marginal balance in asset selection compared with the yield of US dollar assets. The second is to increase the value of the renminbi itself, that is, to increase the appreciation expectation of the renminbi exchange rate.
Drawing on the Bank of Japan's clever move, there is actually a lot of room for maneuver in the RMB exchange rate, especially under the pressure of deflation. Of course, in the case of negative returns from real estate, it is also a good choice to make the A-share market have a stable money-making effect.
(The author of this article is Zhao Jian, President of Xijing Research Institute)
The views expressed in this article are solely those of the author.