Yen weakness undermines Japan’s growth outlook in 2022

  • The Japanese yen has been one of the hardest-hit major currencies in the wake of the Russia-Ukraine conflict. Its sharp depreciation against the US dollar is derived from a combination of Japan’s relatively weak economic fundamentals and a high degree of reliance on energy and food imports.
  • EIU expects the yen to continue to depreciate against the US dollar in the remainder of 2022 owing to diverging monetary policy settings in Japan and the US, with narrowing real interest-rate differentials diminishing the yen’s attractiveness to international investors.
  • Continued weakness in the yen will have limited support for Japanese exports owing to supply chain disruptions. However, it will constrain Japan’s economic growth this year through stronger inflation, softer consumer spending and delayed business investment.

The Japanese yen has come under renewed depreciatory pressure in 2022. The yen:US dollar exchange rate surged above ¥120:US$1, a threshold widely seen as a strong resistance line in foreign-exchange markets, in March. This was in line with the EIU’s previous forecast that the yen would weaken against the US dollar owing to monetary policy tightening in the US and that it would temporarily break above the ¥120:US$1 line in the first half of this year. However, we now envisage even greater depreciatory pressure on the yen in the remainder of this year as a result of a combination of the Russia-Ukraine conflict, Japan’s reliance on imported energy, the country’s relatively weak economic fundamentals and the continuing ultra-accommodative monetary policy of the Bank of Japan (BOJ, the central bank). This persistent weakness in the yen will exert a moderate negative effect on Japan’s economic growth through stronger inflation and a consequent dent on consumer spending.

Safe haven no more

In the month following Russia’s invasion of Ukraine on February 24th, the yen depreciated against the US dollar by nearly 6%, which was one of the steepest records of depreciation by major economies. This steep decline in the yen’s value amid military conflict between Russian and Ukraine runs contrary to the conventional perception of the yen’s safe-haven asset status, as it posits that the currency usually retains its value in times of global financial distress and heightened geopolitical tensions. However, the war between Russia and Ukraine, both important energy and grains exporters, exposed structural vulnerability of the Japanese economy, which aggravates the woes of the yen.

More than 90% of Japan’s energy consumption relies on imports. Although less than 10% of Japan’s energy imports come directly from Russia and Ukraine, the economy is vulnerable to volatility in global energy prices. Global energy prices grew steadily in 2021 when economic normalisation in major economies and production bottlenecks coincided to aggravate a demand-supply imbalance. Energy prices skyrocketed after Russia invaded Ukraine—Brent crude oil spot price temporarily reached US$128 per barrel, a level not seen since the global financial crisis in 2008. Even before the Russia-Ukraine conflict began, Japan’s current-account surplus had narrowed to a seven‑year low of 2.9% of GDP in 2021. The elevated energy costs inflated Japan’s import bill, leading to a sharp narrowing in the country’s trade surplus. Moreover, the deficit on the services account grew deeper as the tourism industry continued to be hamstrung by restrictions on inbound travelling. A dwindling current-account surplus also reduces support for the local currency.

The yen has also been weighed down by Japan’s relatively tepid economic recovery. Unlike those of neighbouring South Korea and China and fellow advanced economies in North America and Europe, the size of Japan’s economy is still smaller than its pre‑pandemic levels. Successive domestic covid‑19 outbreaks in 2021 and the first quarter of this year have resulted in a series of state of emergency measures in Japan, which have delayed a recovery in consumer spending and hampered business confidence.

Yen weakness will cast a shadow on Japan’s economic growth

Although economic growth will pick up from the second quarter of this year as commercial activities are revitalised following a lifting of restrictions in March, the decline in the yen’s value is likely to continue. Fresh depreciatory pressure on the yen will come from increasingly divergent monetary policy settings in Japan and the US. Amid a monetary tightening cycle by the Federal Reserve (Fed, the US central bank), in which we expect the Fed funds rate to reach just under 2% by year‑end, monetary policy in Japan will remain ultra-accommodative throughout 2022, as the BOJ will focus on boosting domestic demand. As interest rates in the US continue to rise while the BOJ keeps short-term interest rates negative and long-term rates around zero, the real interest-rate differentials between the two economies will narrow sharply in the remainder of this year, making the US dollar more attractive to investors than the yen. We now forecast that the yen will continue to depreciate against the US dollar in the remainder of 2022, with the yen:US dollar exchange rate ending the year above ¥124:US$1, compared with ¥115.1:US$1 at end‑2021. It is also likely that the yen:US dollar exchange rate will briefly overshoot ¥125:US$1 if Japan’s economy encounters more headwinds this year or the pace of the Fed monetary tightening appears faster than market expectations.

A direct consequence of a persistently weak yen will be stronger inflation, through elevated import goods prices and higher input costs faced by businesses. As most international transactions are denominated by the US dollar, continuing depreciation in the yen against the US dollar will further push up the prices of fossil fuels, grains and various metal commodities. Prices of food stuff, utilities and private transport have already increased, according to the consumer price index published by the Ministry of Internal Affairs and Communications, and costs of public transport will follow suit in a few months. Higher costs of these basic goods and services will strain household finances, with low-income families being the worst hit, as consumption of these is more difficult to reduce or postpone. Meanwhile, increasing utilities bills and input costs will squeeze business profit margins. Although Japanese firms are generally reluctant to pass on rising costs to customers for fear of losing market share, many of them will have to do this to avoid being driven out of business. 

These cost-push factors, in combination with the expectation of recovering consumer spending as the spread of the coronavirus slows in Japan and restrictions are lifted, will prompt us to raise our forecast of consumer price inflation to average 1.7% in 2022 as a whole, compared with 1.2% previously. Higher goods prices will constrain growth in private consumption this year, as families, particularly low- and middle-income households, are likely to pare back spending on non‑essential goods and services. Meanwhile, we will also revise down our forecast of private fixed investment growth on the assumption that small and medium-sized businesses will postpone investment plans as a result of increasing running costs. 

On the other hand, the effect of a weak yen in shoring up Japan’s exporting sector will be limited this year. Manufacturers will face the same problem of rising input costs. Moreover, the Russia-Ukraine conflict will create additional difficulties for Japanese exporters to boost outbound shipments. The war and the resulting surge in consumer prices will dent economic growth and private consumption in Europe, decreasing orders in an important overseas market for Japanese companies. International trade and financial sanctions on Russia and production disruptions in Ukraine will also disturb supply chains in that region. This will be a particularly acute issue for Japanese carmakers and electronics manufacturers, which rely on Russian imports of palladium (a metal used in automobile exhaust systems) and are exposed to disruptions of Ukraine-supplied neon, xenon and krypton, which are industrial gases used in the microchip-making process.

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