How Japan's Currency Policy Influences Global Markets

The Japanese yen is one of the world’s primary reserve currencies and is pivotal in international finance.

It is broadly used and held in public and private institutions across the globe, and it forms one of the essential elements of the central bank’s foreign currency reserves.

Given the currency’s wide global use and importance on the international platform, it is natural that policies formulated by the issuer country’s central banking authority, the Bank of Japan (BOJ), have implications far beyond its national frontiers.

As the institution responsible for Japan’s economy and currency, the BOJ wields vast powers through myriad policy tools. For example, the BOJ can finely tune the direction of the yen’s value through changes in interest rates or quantitative easing via large-scale purchases of financial assets.

Even marginal movements in the yen’s value can trigger a chain reaction that ripples through the global financial markets. This is because the yen is regarded as a highly vital pricing mechanism for many foreign exchange transactions that occur daily around the globe.

This article will explore how Japan’s currency policy impacts markets worldwide.

Japan’s Currency Policy

Japanese policy, mainly during the post-World War II era, devalued the yen to export goods and advance its manufacturing industry. This meant that, for an extended period, the external value of the yen was kept artificially low compared to the value of currencies like the US dollar. Through the 1990s, Japan gave way to more market-oriented exchange rates.

Also, the principal aim of the Bank of Japan’s monetary policy today is to attain price stability in Japan. Its principal policy instruments include short-term interest rates and quantitative easing through large-scale bond purchases. The critical target interest rate is the uncollateralized overnight call rate, which guides the BOJ within a range of -0.1% for ultra-low fund borrowing costs.

The BOJ policy is one of the significant influences on the USD/JPY analysis and trends. Over many decades, the BOJ has been taming the yen to relative weakness in the world due to its ultra-loose monetary stance. A weaker yen spurs exports from Japan, making them relatively cheap abroad. A lower yen also pinches more into imports into Japan by raising their prices and sitting well with domestic producers.

Impact on Other Currencies

The B OJ’s policies have significant implications for other currencies:

US dollar (USD): As one of the largest foreign holders of US Treasuries, BOJ bond buying activities influence US bond yields and the greenback. A weaker yen also impacts the USD/JPY exchange rate.
Euro (EUR): Loose Japanese policy puts downward pressure on the euro. It affects EUR/JPY and, indirectly, EUR/USD rates through forex cross-flows.
Chinese yuan (CNY): With China a key trade partner, Japan’s weak yen policy strengthens regional trade ties. But it also adds to the pressure of yuan appreciation compared to the Japanese currency.
Other Asian currencies: Many Asian nations, like South Korea and Taiwan, hold large reserves in yen. Thus, yen fluctuations strongly impact their exchange rates relative to the dollar and each other.

Global Spillovers

Japan’s currency manipulation to boost exports comes at the cost of other economies. A long-term cheap yen:

Distorts global trade flows: It gives Japanese exports an unfair advantage over foreign competitors like European manufacturers, the US, and China.
Trigger currency wars: Aggrieved trading partners may undertake countermeasures like competitive devaluation to offset yen impacts. This ratchets up global currency tensions.
Amplifies financial risks: Prolonged monetary loosening concerns investors and stokes worldwide volatility in forex, equity, and bond markets. It leaves countries more vulnerable to external shocks.
Hurts long-term growth: Weak currency policies discourage necessary reforms and fail to address Japan’s massive public debt problems. They store up economic and financial imbalances.
Inflates asset bubbles: Sustained yen declines fuel speculative yen carry trades, amplifying boom-bust cycles in global asset markets like the one that triggered the 2008 crisis.

Impact on USD/JPY

The USD/JPY pair represents one of the most significant currency relationships in the global financial markets. The greenback and yen consistently rank amongst the most traded pairs as the currencies of the world’s largest and third-largest economies. Unsurprisingly, the USD/JPY rate remains highly sensitive to shifts in monetary policy emanating from Japan’s central bank, the Bank of Japan.

If BOJ officials indicate their intentions to implement further quantitative easing through increased government bond purchases, it triggers expectations of lower domestic yields within Japan. The prospect of more significant monetary stimulus puts downward pressure on the yen’s value. Anticipated yen weakness motivates investors to sell the Japanese currency and buy USD, bidding the USD/JPY exchange rate higher.

Similarly, any signals from the BOJ that interest rates may be reduced from their already ultra-low levels or that the central bank balance sheet will expand at an accelerated pace also reinforce yen selling pressures. These factors strengthen the American dollar versus its Japanese counterpart.

Conversely, any hints from Tokyo that the BOJ may start to gradually reduce the scale of its bond-buying program or allude to future interest rate normalization tend to have the opposite impact. Such communications are interpreted as a less accommodative policy, implicating yen appreciation versus the dollar in the near term. The BOJ’s policy communications are also significant because they often synchronize USD/JPY moves with broader global risk sentiment cycles. As a safe-haven asset, the yen gains popularity when risk aversion rises, weighing on the pair.

Closure

As one of the world’s major currencies and economic powers, Japan’s exchange rate policies play a pivotal role in international finance. From influencing global trade balances to roiling forex markets, the BOJ’s efforts to devalue the yen generate widespread effects, but not all are positive.

Understanding how this impacts key pairs like USD/JPY is essential for forex traders and investors. In the future, Japan will need to manage its currency policies more delicately to promote sustainable long-term growth for itself and its partners.

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