Yen's Renewed Strength Weighs on Japan's Exporters

Japan's economy is showing signs of life and manufacturers are again ramping up production, after months of cutbacks. Even the central bank, whose forecasts tend to rely on a more cautious wait-and-see approach, has become more optimistic. On June 16, the Bank of Japan said that the recession—the country's worst since World War II—no longer seems as bad as it was earlier this year, after the bank's policy board decided to keep its target for key short-term interest rates at 0.1%. "In the coming months, Japan's economy is likely to show clearer evidence of leveling out," the Bank of Japan said in a statement.

The news led to the yen's biggest jump against major currencies in three months. In late afternoon trading, the dollar was near 96.5 yen, with the yen up 1.4% from earlier in the day. Against the euro, the yen appreciated to 133, from around 135 in New York the previous day. UBS (UBS) currency strategist Ashley Davies predicts the yen could appreciate to 95 per dollar and 114 per euro a year from now. (The BOJ's quarterly Tankan business sentiment survey, which polls more than 10,400 Japanese companies, puts the dollar at 96.70 yen in the second half of the fiscal year through March 2010.)

The U.S. financial crisis had lifted the yen in recent months. But lately the yen's rise reflects a sunnier outlook for the world's second-largest economy. Many economists think that governments' economic stimulus measures will help Japanese exporters sell more of their cars and TVs around the globe. Goldman Sachs' (GS) Tetsufumi Yamakawa figures Japan's gross domestic product will grow in the April-June quarter by an annualized rate of 1.7%, following the record 14.2% contraction in the January-March quarter and a 13.5% shrinkage in the final quarter of 2008.

Exporters Exposed to Currency Swings

Market watchers say betting on the yen has its benefits: It offers a way to avoid the fallout if the dollar sags under the weight of the U.S. government's massive debt and rising inflation or if concerns that big European banks are sitting on bad loans in Eastern European countries weaken the euro. For non-Japanese companies, banks, and nations that have tapped the Japanese credit market by selling yen-denominated, or samurai, bonds, it's been a lucrative few months. Most samurai bond issuers use currency swaps to convert the yen they raise from investors into dollars. In recent months, the yen's rise contributed to dramatically wider dollar-yen swap spreads. "It was a good deal for the issuer because they were getting a better rate when they swapped yen for dollars," says Mizuho Securities credit strategist Tetsuo Ishihara.

When traders and investors push the yen higher, though, it can bring pain for export-dependent manufacturers such as Toyota (TM), Honda (HMC), Sony (SNE), and Panasonic (MC). Generally speaking, Japan's major exporters are at the mercy of currencies for one reason: Most of their costs are in Japan—research and development, new factories, and pay for employees and executives—but the bulk of their profits come from elsewhere. Those companies have little choice but to repatriate a chunk of their overseas earnings to cover what they spend at home.

When the yen strengthens, it erodes the value of exporters' overseas earnings. Sony said the yen's 14% surge against the dollar and 13% gain against the euro wiped out about 279 billion yen ($2.88 billion) in operating earnings last fiscal year through March. It's expecting the strong yen to hurt revenues again this year. Nintendo had a similar problem. It sells its video game consoles and software in Europe but doesn't make any of its products there. Credit Suisse (CS) analyst Koya Tabata estimated that Nintendo made 4 billion yen ($41 million) less in operating profit just because of the yen's rise against the euro.

Honda's Currency-Related Losses

Analysts watch the Japanese currency's movements against the dollar because plenty of other currencies move in step with the greenback. Japanese companies do what they can to limit their exposure by building factories overseas and procuring parts and materials locally. But they are often unprepared for abrupt changes in the currency markets, like those over the past year.

Japan's automakers, for instance, often use forward contracts to lock in the price of materials three months down the road. But that doesn't insulate them from unexpected losses (or gains) if there's a sudden hiccup in currencies. What's more, those companies rarely dabble in any kind of currency hedging longer than a few months.

For companies with operations in far-flung regions, other currencies can throw off their earnings. Consider Honda. Its biggest car market is the U.S. but its motorcycle business has given it a presence in emerging markets. Last fiscal year, nearly 10% of the company's global motorcycle sales and more than 3% of its cars came from Brazil. Honda's operations there are a textbook case in currency countermeasures: The company say its factories in Brazil assembled every one of the 1.36 million motorcycles and the 120,000 Fit and Civic models sold there. Even so, it shipped about 3% of the motorcycle parts and 40% of the car parts from other locales. And at fiscal yearend, Honda repatriated the revenues.

This year won't be much different. The result: The yen's expected rise against the Brazilian real could erase about 35 billion yen ($360 million) from Honda's operating earnings this fiscal year through March 2010, according to Deutsche Securities (DB) analyst Kurt Sanger. (The company estimates the real's weakness could hurt earnings by about 45 billion yen, or $464 million.) That compares to about 36 billion yen ($371 million) in expected dollar-related losses and 26 billion yen ($268 million) in expected euro-related losses. "They still face some painful adjustments," says Sanger.

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