Japan's Yen Rises Above War Jitters, Deflation

Japan is again suffering from deflation. Prime Minister Yukio Hatoyama's ability to spur the economy is sharply constrained by record public debt exceeding 882.9 trillion yen ($9.78 trillion). It has the lowest interest rates of any developed nation in the world. Worst of all, North Korea has been accused of torpedoing a South Korean naval vessel, and it has cut off all relations with the South. After South Korea, Japan is tops on Pyongyang's enemies list: North Korea has in the past launched missiles over the Japanese archipelago. If shooting were to start, Japan likely would be involved.

Yet Japan's currency is not weakening as the economic and diplomatic uncertainties mount. The yen has actually strengthened against the dollar by more than 4 percent in the last month. It has risen 11.5 percent vs. the euro and 14 percent when compared with Australia's dollar. The South Korean won has dropped more than 10 percent against the greenback in the same period.

The yen's serenity in this turbulent sea stems from a number of factors. One is that the Japanese, unlike the South Koreans, have just enough physical and emotional distance to give them perspective on the crisis. "The fact that the yen [has] stood firm suggests people don't really think that this time political tensions will turn into a war," says Daisaku Ueno, president in Tokyo of Gaitame.Com Research Institute and widely regarded as Japan's best foreign-exchange analyst. It helps that foreigners hold only a small share of Japan's outstanding government bonds. Outsiders would find it hard to trigger a run on Japanese debt, which would damage the yen as well. Japanese savers, meanwhile, stubbornly hold on to their bonds.

With the fear of conflict discounted, the yen can benefit from a quirk in the markets. Because it has such low rates, traders and investors typically take out loans in Japan and exchange the proceeds for higher-yielding bonds from nations such as Australia, New Zealand, and Brazil. In times of global economic turmoil, like now, traders reverse these bets. As a result, money flows back into Japan as the loans are paid off, triggering a rise in the yen. This reversal of the so-called carry trade has a much bigger impact on the currency than war jitters from across the Sea of Japan.

The final element supporting the yen is that Japan still records huge trade surpluses with the U.S.—more than $28 billion in 2009. The country's deflationary domestic economy is weak, but the Japanese export machine beats anything a weakened America or Europe has to offer, with the possible exception of Germany. Yen strength is "absolutely not" a reflection of Japan's attractiveness, says Nicholas Smith, director of equity research at MF Global FXA Securities. "The yen is strong because the U.S. and Europe are in the tank." That strength may still be sapped if the Korean crisis lurches out of control. Right now, investors are betting otherwise.

The bottom line: War jitters in Korea aren't pulling down the yen. Other factors like the turmoil in Europe and the carry trade affect the yen much more.

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