Nov 05 2008

Up, up, and away! Why are the dollar and the yen on the rise?

Chart for JPY to USD (JPYUSD=X)In the last three months, the Japanese Yen has appreciated 15% against the US dollar. At the same, the dollar itself has appreciated 25% against the euro.

The appreciation of these two major currencies seems strange in a time when both country’s economies are experiencing major slowdowns. In most cases, currencies appreciate when one of two things happens:

  • If foreigners demand more of a country’s exports, demand for its currency drives up its value, causing appreciation.
  • If a country’s interest rates rise relative to other country’s, then demand for its currency rises as investors want to buy assets in that country to earn the higher interest rates.

Lately, however, the Yen and the Dollar have seen staggering rises in the absence of rising exports or rising interest rates in Japan or the US. So what IS causing the rapid and drastic appreciation of these two currencies? The Economist newspaper explains:

Many investors have been following a version of the “carry trade”, borrowing money in a low-yielding currency. All they had to do was earn a higher return from assets than the cost of their financing. Since the two big currencies with the lowest yields over the past year have been the dollar and the yen, those were the natural ones to borrow.

When asset prices fall, however, this strategy is disastrous. Investors dash to sell assets and repay their debts. Since those debts were incurred in dollars and yen, that means they have to buy back those two currencies—hence their sharp recent rises.

In the midst of today’s global financial meltdown, it seems that every day, phenomena new to mainstream economic theory are being witnessed. It would seem that from now on, when we learn about the determinants of exchange rates, we may have to take a look at the “carry trade” example.

In this case, it would seem, LOW interest rates combined with falling stock prices can lead to a currency’s appreciation. An investor looking to make a deal would borrow Yen from a Japanese bank charging low interest rates, convert it to, let’s say Brazilian real, to buy stocks in a Brazilian company. As long as the stocks gain value at a rate higher than the interest rate in Japan, the investor is making an easy profit. He can pay back the money he borrowed from Japan at the low interest rate, earn a high return on his investment in Brazil, and pocket the difference.

The problem arises when the value of the assets the investor has bought in Brazil begins to fall. With stock markets plummeting between 20-50% this year in most countries, asset values have fallen through the floor, meaning those investors who borrowed yen to buy foreign assets have rushed to sell the falling assets as quickly as possible to pay back their Japanese lenders before it’s too late. This causes a huge increase in demand for Yen on foreign exchange markets in a very short period, hence the yen’s appreciation.

Recently, the Yen and USD have managed to appreciate for a reason not conventionally understood. The rapid and drastic appreciation of these currencies is further exacerbating the weak aggregate demand in Japan and the US. A strong currency, while good for consumers for whom imports appear cheaper, can have debilitating effect on a country’s export sector. Not surprisingly, both the US Fed and the Japanese central bank have both cut interest rates in the last week in the hope of slowing their currency’s appreciation and protect export demand.


About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

5 responses so far

5 Responses to “Up, up, and away! Why are the dollar and the yen on the rise?”

  1. Palmi Angelovon 18 Nov 2008 at 7:06 pm

    We haven't really gotten much into exchange rates yet, but I find this a particularly interesting article, despite my current limited understand of it.

    However, it sounds as though, with the global market going rather haywire at the moment, things out of the norms are happening, such as investors earning a great profit from investing in low interest-rate currencies, which are currently the yen and dollar, and then investing in other markets. I think the reason this works is that these investors get very cheap loans, minimizing their opportunity costs, as far as the financing is converned, but still investing in the same manner as before. Profits are just as much as when one borrows the currency of the market they are investing in, but the costs of borrowing that money are as small as possible.

    However, as I understand it, seeing as stockmarkets have plummeted recently, there has been a massive loss of profit for investors, and they have hurried to repay their loans. This has caused a surprising turn of events, as this increased demand for the low-interest currencies has caused them to appreciate in value.

    I would question the methodology the US and Chinese governments are using in order to deal with this problem, seeing as they want to keep their currencies weaker to stimulate exports. Their proposal is to further lower interest rates. However, knowing the cause of this appreciation, wouldn't further lowering interest rates simply simply attract more investors, and spark this process over again? As such, I'd say it's a rather ineffective policy in this case.

  2. Christinaon 21 Nov 2008 at 8:55 pm

    I don't think it's ineffective because from what I understood (even though yes, we haven't done much on exchange rates so I don't know how well I got this) the reason the dollar and yen appreciated is because people actually want to get rid of their Yen and Dollar loans and so, as they've already converted this money to different currencies (I guess depending on where they live) they switch it back to yen and dollars in order to get rid of it. Quoting the article:

    "…have rushed to sell the falling assets as quickly as possible to pay back their Japanese lenders before it’s too late. This causes a huge increase in demand for Yen on foreign exchange markets in a very short period, hence the yen’s appreciation."

    So what I'm trying to say is, wouldn't the demand for Yen and Dollars drastically fall after investors have returned all the loans, causing the immediate depreciation of the currencies once again? So if the US and the Japanese are worried about their exports, I don't think they're following a wrong policy because even if lowering the interest rates brings the appreciation of their currency as a direct affect, I think the currencies will again depreciate very soon. I don't know if this is right but if it is, the Japanese and Americans can enjoy the cheap imports for now, while waiting for their currencies to depreciate again.

  3. […] Barack Obama takes office next year. Facing a recession and rising unemployment, combined with the recent appreciation of the US dollar, the pressure is on Obama to take immediate action to restore America’s manufacturing sector. […]

  4. Moritzon 04 Dec 2008 at 2:39 am

    This is a very interesting article because it goes against what we have studied in class. We learnt that as interests rates are lowered foreign investment will decrease therefore the currency will depreciate. However, this articles mentions that as Japan has decreased its interest rate the value of the Yen still appreciated. This is happening/happened because ceteris paribas was not true in this case (everything else did NOT stay equal).

    What happened was that because the interest rate of the Yen were so low people bought Japanese Yen to invest/buy stocks in Brazil, where the interest was very high. However, the aim to make money did not happen because the stocks began to fall. Very rapidly investors pulled their money ouf of the stocks and demanded Japanese Yen, appreciating the currency.

    This is a very unusual model, because ceteris paribas is not true, but it shows that low interest rates can also lead to the appreciation of a currnecy in special occasions.

  5. Mankaon 12 Dec 2008 at 7:07 pm

    I noticed that people tend to think that lower interest rates will attract more investors, therefore increasing the value of currency. but that's a different aspect of monetary policy, which is when domestic firms want to invest, they need lower interest rates. But globally, if foreign investors want to invest, they will only invest in a country where they can get higher returns!

    A fall in interest rates, ceterus paribas is NOT going to cause USD to appreciate. This is so because, now foreign investors will get less return on their money, since the interest are now low.

    and the main cause of appreciating dollar, i think, is that, since all investors realized that USD is depreciating after sub-prime crisis, they rushed to transfer/ take out their money from US banks. This suddenly increased the demand for USD, this causing it to appreciate!