A ‘Yen’ for a Weaker Currency

December 15, 1997 – I have been conspicuously quiet about the Yen for many months. After very successfully riding the Yen’s strength from the ¥120’s and selling at ¥80 in 1995, we have been on the sidelines. The reason is that the outlook for the Yen has been very uncertain, and more importantly, even though the Yen has steadily been weakening, I did not believe that the Japanese government would cave-in to the demands of American politicians. However, it is becoming increasingly clear that they have.

From the 1960’s until a couple of years ago, the Yen was one of the world’s strongest currencies. It appreciated more than four-fold against the Dollar during this period, from ¥362 at the old post-Bretton Wood exchange rate to ¥80 at its peak. It has subsequently weakened to ¥130, and further yen weakness is likely.

The Japanese have some serious problems. Their economy is in dire straits, and even more worrying is the poor financial health of their financial services industry – both the banking and the insurance sectors are reeling from a mountain of bad debts. These debts threaten the Yen because all Yen in circulation – as is the case for all national currencies – are liabilities of some bank. The Yen in checking, savings and time deposits are liabilities of the bank in which those deposits were made. Therefore, these Yen deposits are only as good as the assets of the banks holding those deposits.

For example, to make my point simple to explain, assume the balance sheet of all the Japanese banks added together had assets and liabilities totaling ¥100. The ¥100 of liabilities are the total deposits of the banking system, and these are obviously dependent upon the quality of the assets – liabilities can only be repaid if the assets on the balance sheet enable the financial obligations to be met. However, the assets of the Japanese banking system are not worth ¥100. The banks are riddled with countless bad loans.

Maybe the assets are worth ¥90, maybe ¥80. No one really knows, but the absolute level is not of primary importance. What is important is the realization that the assets of the banking system do not equal the liabilities, that the banking system when viewed as a whole is insolvent.

Assuming for our analysis that the assets in our sample, contrived balance sheet are worth only ¥85 – which I sincerely think is probably an accurate assessment of their true value if the assets in the banking system could be accurately evaluated and measured – then there are ¥15 of liabilities that cannot be repaid. This resulting imbalance of liabilities greater than assets leads to two different alternatives.

In the 1930’s banking collapse, liabilities were allowed to decline until they reached the value of the assets. For example, in the US, banks were allowed to fail, and each failure reduced the total liabilities of the banking system to pay Dollars to their depositors.

M3 actually dropped by more than 20% during the 1930’s banking crisis, but when the quantity of Dollars was finally reduced to this low level, the remaining assets were sufficient to restore confidence in the banks because they were of good enough quality to meet the remaining obligations, i.e., the balance of M3 in banks that did not fail. The outcome was deflationary because of the resulting contraction in the money supply.

The Japanese government is not pursuing a deflationary outcome for today’s banking problems. Instead of letting their money supply fall from ¥100 to ¥85 (or perhaps even lower) to get rid of those Yen liabilities for which the banks do not have the financial capacity to service, the government is instead trying to fill the ‘black hole’ on the asset side of the balance sheet. In other words, the ¥85 of good assets are being supplemented by ¥15 of government assistance so that none of the ¥100 of liabilities will be reneged.

This outcome may not be inflationary in itself for Japan because the quantity of Yen may not change significantly. However, the outcome will still nevertheless debase the Yen because the government is attempting to replace with the stroke of a pen the hard-earned wealth lost in all of the bad loans. The debasement that will result from this action by the Japanese government can be measured by the further weakness in the international exchange value of the Yen that will result.

There are similarities here to what happened in the Mexican crisis a few years ago, and what is now happening in Korea. I don’t expect the Yen to plummet quite as severely as the Peso or the Won, but if the Japanese government continues to pursue its present course of action, there is no doubt the Yen will continue to weaken.

A weak Yen need not be the only outcome. The Japanese government has another alternative to fill the ‘black hole’ on the asset side of the Yen’s balance sheet, but they are not pursuing it. Here is where they seem to be giving into the demands of American politicians.

The black hole could be filled by selling the $200 billion of US government debt instruments the frugal Japanese have accumulated over the years. They have been exporting tangible goods and services to the US, and in return, importing IOU’s from the US – rather than goods and services of equivalent value to their exports. By drawing down on these accumulated ‘savings’, rather than creating Yen out of nothing by ‘printing’ it, the Japanese have a prudent alternative – dipping into their savings during these ‘rainy days’.

So why haven’t the Japanese been selling US government debt instruments? It appears that the Japanese government is complying with the wishes of Robert Rubin et al. The sale of this debt would undoubtedly cause US Dollar interest rates to rise, which in turn would create a nasty shock to an already over-stretched stock market.

Therefore, this huge pool of Japanese savings appears to be off-limits and untouchable. The Yen will suffer as a result, and along with the decline in the Yen, every Japanese person who holds Yen will also suffer. They may not suffer as badly as the Koreans holding Won are now suffering, but the direction and the outcome for the Yen seems clear.

The Yen is heading for ¥150 or perhaps even ¥180, and it probably won’t take long for it to it there.